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Tuesday, 12 December 2017

The self-driving road to lower returns

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  • James Saft - June 2014

The development of self-driving cars is a good example of how, and why, the future may be a less profitable place for investors.

Volvo Cars, one of scads of technology and automotive firms working along the same lines, last week announced plans to test autonomous cars in London in 2017, touting how driverless technology will be a huge advance in safety.

It is this safety angle, rather than the wonder of the technology, which preoccupies legendary investor Warren Buffett, whose Berkshire Hathaway Inc owns insurer GEICO.

“Anything that makes cars safer is very pro-social, and it’s bad for the auto insurance industry,” he told CNBC Television on Monday, citing the potential for fewer traffic accidents.

“Cars have been made way, way safer, but now when you start making the driver safer, that would be a big, big jump, and that will happen some day, and when it happens there will be a lot less auto insurance written.”

Indeed, and quite possibly that insurance will be written at lower profit margins, given the reduced risk a GEICO or other company might bear. There is also the possibility that whatever car companies come to successfully compete in self-driving cars choose to self-insure their products, effectively cutting the insurance industry out of the deal entirely.

It is just these kinds of cascading consequences which should make the rapid pace of technological change as much a source of anxiety as of greed for equity investors, many of whom may find their apple-carts upset. Self-driving cars, should they arrive, massively cut down on the number of automobiles needed and sold, as a self-driving car could carry passengers during the long hours most cars now sit idle. They will also fundamentally change many ancillary industries, from insurance to gasoline retail to selling caffeinated energy drinks.

To be sure, it can be dangerous to overestimate the pace of technological change (where is that jet pack I was promised, anyway?), just as it is usually foolish to bet against human ingenuity. Still, there is reason to believe that digitization and the resulting new technologies represent something different than the incremental change of the previous 50 years.

Lower profits and higher risk?

For investors this implies lower profits and higher risk, both of which taken together should result in markets placing a lower value on the stream of future cash flow a share in a given company represents.

A recent report from McKinsey Global Institute touched on these forces in a report arguing that investors need to lower their expectations about future stock market returns.

“While digitization and disruptive technologies could boost margins of some companies in the future, the big North American and Western European firms that took the largest share of the global profit pool in the past 30 years face new competitive pressures as emerging-market companies expand, technology giants disrupt business models, and platform-enabled smaller rivals compete for customers,” according to the report. 

So of course fortunes will be made in the self-driving revolution, just as Amazon.com Inc has done well out of Internet retailing. This may be cold comfort to those whose investments are disrupted by autonomous travel, just as it was to bookstore and mall owners who’ve lost out to the forces represented by Amazon.

The key point is the rapidity and scope of revolutionary technology disrupting existing industries, either directly or collaterally. We’ve always had new businesses driving out the old, but looked at historically the past few decades may prove to have been unusually stable. And much of the disruption we’ve had has been due to globalization, which benefits investors if their companies decamp to cheaper manufacturing locations.

There is no geographic arbitrage for an auto insurance company to escape the impact of self-driving cars.

So, we might see a compression in price/earnings ratios, the amount of money investors are willing to pay for a dollar of earnings. A look at very long-term data on p/e multiples shows generally lower valuations in the late 19th century, perhaps in part reflecting the impact of another age of industrial ferment.

If investors begin to expect lower profits and higher risk of disruption, they will quite naturally want to be paid more for taking the risk, implying lower valuation for the market as a whole with a bigger gap between winners and losers.

Looking at companies like Amazon and Apple, perhaps we are halfway there.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

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