Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Second Quarter: April 2014

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Networked Knowledge: Harnessing the power of 1000 Edisons.

In the late 1870’s, in Menlo Park, New Jersey, Thomas Edison and his staff were hard at work in his laboratory complex trying to develop an incandescent electric light bulb that was suitable for indoor use.

The challenge was to find a filament material that could sustain its glow for more than a few brief moments before burning out. Over the next two years, he and his team would try thousands of different filament prototypes before testing carbonized cotton thread, which produced a warm glow for over thirteen hours before finally burning out. Additional experimentation produced bulbs that could last for over 40 hours and set the stage for commercial use of indoor electric lighting. The exhaustive work on the electric light led Edison to quip many years later that “genius is one percent inspiration and ninety-nine percent perspiration.”

Edison and light bulb

Today, in places like Menlo Park, California, inventors like Edison would have found the solution much more quickly. With broadband access to the Internet, Edison would have been able to gather and evaluate detailed information on materials, collaborate with teams of researchers around the globe, use crowdfunding to raise needed capital and crowdsourcing to delegate the filament challenge to tens of thousands of bright and enterprising entrepreneurs all over the world. A process that took years of perspiration by Edison and his team might today have been accomplished in a matter of days leveraging all the power that the networking of people, technology and knowledge now allows.

We refer to this phenomenon as “Networked Knowledge” and believe it will have an enormous impact on the world and our lives in the coming years. It will create bold new solutions to age-old problems, accelerate the rate of change and growth, reshape entire industries, challenge established practices and vested interests, and turn the status quo on its head. Most of this change will be positive, driven by the optimism, ambition and creative energy of bright young people around the world. Some of it will be negative. It will be particularly tough on people without the skills to adapt. But, whether positive or negative, things will be different. From an investment standpoint, we think this is one of the most important investment stories of our lifetime.

In their new book, “The Second Machine Age,” M.I.T. economist Erik Brynjolfsson and Andrew McAfee argue that we have entered a second machine age which, like the original industrial revolution, is bending the course of human development in a profound way and allowing innovation to happen at an exponential rate of change.

Unlike the first machine age, which was primarily made possible by the creation of the Watt steam engine and the ability of man to leverage his physical abilities, the second machine age is being driven by a confluence of technological forces allowing man to leverage his intellectual power.

These forces include:

  • The Internet: the global network of millions of connected networks, billions of devices, and all the world’s information.
  • Digitized knowledge and content: the conversion of text, music, video and art, into digital format where it can be flawlessly copied and disseminated an unlimited number of times for almost no marginal cost.
  • Broadband Internet access: the ability to easily and cheaply disseminate large amounts of data.
  • Wireless Mobility: the ability to access the Internet, with broadband capabilities, on mobile devices, anywhere in the world.
  • Cloud Computing: the ability to store, share, and access knowledge and content in the Internet itself - i.e. using the Internet itself as your computer and hard drive.
  • Social Networking: the ability for individuals and groups of people to effortlessly network together around areas of common interest, and to develop and share collective knowledge.
  • Big Data: the ability to process and evaluate massive amounts of data and content to see larger patterns and solve larger problems.
  • Coding: the ability for a very small number of people to quickly and inexpensively create sophisticated and transformative software, solve problems, address unmet markets and needs, and disrupt entire industries.

These forces are made possible by ever-faster and smarter computers, evermore robust telecommunications networks, and ever-cheaper data storage. But together, and freely accessible to almost everyone, almost anywhere in the world, they form a toolkit for unprecedented innovation and change driven by three powerful new realities (with just a dash of hyperbole to make the point):

  • All the world’s information and knowledge is available to anyone, anywhere, at any time, in the palm of their hand.
  • Any person or group of people can easily find, communicate and collaborate with any other person or group of people. There is also a growing “network of things,” from cars to clothing to thermostats and appliances to machines, that communicate and share information.
  • The power and value of a network grows exponentially with the number and intelligence of people and things involved. Unlike a chain that is only as strong as its weakest link, a network is as smart as its smartest participants. Natural selection applies: the best ideas and content tend to rise to the top.

The impact and implications of these new realities are large. Just as Edison lit up the world with his electric light, we are now lighting up the world with knowledge, creating a powerful platform for future global economic growth and development.

Social Implications:

  • Computing power continues to improve at an exponential pace. The fact that most knowledge is now in digital form, in the language of computers, means that computers and software can “learn” and improve rapidly, constantly building on a growing base of knowledge and experience. Capabilities that were thought to be impossible a few years ago - such as automated assistants, universal translators and self-driving cars - are possible today and will be taken for granted tomorrow.
  • People are able to work smarter – more intelligently and with far greater productivity. Hours spent finding and gathering information, figuring out how to do something, can now be spent learning from growing bodies of research and knowledge. We now take it for granted that we can get the answer to almost any simple question we have by looking it up on our smart-phones. The entire Library of Congress can fit on a flash drive that we can each carry with us. But we can also tap into a wealth of collective knowledge and user experiences regarding, products, places, and problems. Scientists, engineers and medical researchers can easily find and collaborate with colleagues around the world to take on large challenges and solve complex problems, sometimes overnight.
  • Change happens faster: In his book “Little Bets” Peter Sims shows how most successful companies, products and services were not the result of some bold plan that turned out exactly as originally conceived, but rather the opposite; the result of a series of “little bets” and “smart failures” that were nurtured along and allowed to evolve and change course based on a constant stream of feedback. In a digital world, the process of experimentation, feedback, analysis and reiteration, based on data and software can occur and reoccur on a massive scale and much more quickly than in the past.

There are large changes to society, industries and institutions, and not all of them are positive. Humans now spend an unprecedented amount of time connected and engaged online, checking e-mails, news, texts, and tweets, updating their Facebook pages, often while engaged in other activities such as walking down the street or, too often, driving a car.

Traditional industries, jobs and practices are being disrupted and transformed: Google and Yahoo have changed they way we search for information; Facebook, Linked-in and Twitter have changed the way we connect with others; Amazon has changed the way we shop; iTunes and Netflix have changed the way we purchase and consume media; Fandango, Opentable, Yelp and Tripadvisor have changed the way we evaluate movies, restaurants, and hotels, as well as the way we purchase tickets and make reservations; Uber has turned the traditional taxi industry upside down; Google and Facebook have changed the way advertisers spend money to reach targeted audiences; Coursera, Udacity and edx are changing the way we learn. Mobile apps, digital wallets and Bitcoins are displacing the use of credit cards. And this is only the beginning. Most of these companies didn’t exist 10 -15 years ago.

  • All this technology may make us smarter and more productive, but it also means that many traditional jobs are being displaced, and will not be coming back. New jobs are being created to be sure, but not in the same industries and not with the same skill requirements. Robotics and software are displacing people. The changes in the service sector are most profound, where sales clerks, travel agents, tax-advisors, and stockbrokers are being replaced by sophisticated software. Higher levels of structural unemployment may be here to stay for some time, regardless of the overall health of the economy.
  • While everyone has general access to the same information and capabilities, the gulf between haves and have-nots is growing. Companies worth hundreds of billions of dollars in market value have been created in the last decade, with unprecedented fortunes being made by a relatively small number of people. The gulf between the top 1% and the top 1% of the top 1%, and everyone else, is growing at an alarming rate.
  • Our institutions – government, educational, not-for-profit, and private are not equipped to deal with such rapid change. They are products of a linear world, where each year is an incremental extrapolation from the year before, and the road is assumed to be straight for miles ahead. Meanwhile the road is starting to curve sharply: people, voters, customers and entire markets are changing direction in how they behave; how they learn, consume, entertain themselves, get advice, and connect with others. The world is now connected and empowered in a way unlike any time in history and it will change the landscape of our society in powerful and hopefully positive ways.

This is really happening:

It is easy to look at overall economic growth and employment numbers and not believe that anything extraordinary is happening in the economy other than slow, incremental growth. But while the overall economic growth numbers may seem lackluster on the surface, they mask the enormous changes that are occurring underneath. Aggregate growth numbers may seem low because they reflect the sum total of winners and losers, but it would be wrong to underestimate the power and importance of what is actually happening.

It is a human conceit to think that all the innovation is done, we have arrived, and things will proceed at a slower and more normal pace from here. People thought the same thing after the invention of the steam engine. It is both exciting and frightening to think that we may be in the early stages of a wave of exponential change and progress.

It is hard to imagine what will come next, but with so much room for improvement in areas of medicine, disease control, energy, agriculture, poverty, education and environment several billion people connected and engaged in finding a better way, it makes sense that we are just getting started. If one Edison can create a light bulb, think what a thousand Edisons networked together could accomplish.

Investment Implications:

We think that it is important for our clients’ portfolios to be positioned to “get in the way of” and benefit from the dramatic forces of innovation, and new growth that are underway, while also avoiding the many areas of risk and disruption that go hand in hand. Here are a few guiding principles that we use to incorporate these ideas into the management of client portfolios:

1. Think broadly, but with focus: “Networked Knowledge” is not just a technological phenomenon, but also a force that is reshaping all industries. Focus on companies and sectors that are most likely to benefit:

Technology and Communications:
Own companies - subject to valuation of course - that are providing the tools of change including communications, mobile, social, big data, and cloud computing.

Biotechnology: with the mapping of the human genome as a foundation, this field is ripe for breakthrough research and discovery, allowing scientists to develop increasingly targeted, individualized and effective cures for diseases.

Traditional Healthcare: This is one of the largest and most inefficient parts of our economy, including traditional pharmaceutical companies, medical practices, hospitals, insurance companies and government entities. All of these areas are ripe for disruptive improvement.

Industry: The availability of increasingly sophisticated robotics and automation processes, control and logistics software, along with cheap energy are spawning an industrial renaissance in the U.S.  

Energy: the combination of data on thousands of wells drilled over the last 50 years, and horizontal drilling and fracking technology is providing an abundance of lower cost oil and natural gas in the U.S. At the same time, advancements in battery, solar, and other alternative energy technologies are providing cost competitive alternatives to fossil fuels.

Retail: Internet and mobile technology is changing the way we shop and consume. We can now research and buy almost anything online, knowing that we are getting the best price, and receive it within 24-48 hours. It is hard for traditional retail malls to compete with the selection, pricing and convenience of online shopping.

Media: The way we create, consume and interact with media is changing rapidly. We have more access to media and content than ever before, and are virtually able to watch whatever we want to watch, whenever and wherever we want to watch it. It is increasingly easy and affordable for individuals to create sophisticated original content.

2. Be sufficiently diversified: In a rapidly changing environment, it is easier to determine the direction of change than to determine the individual winners and losers. The field of players is evolving rapidly and today’s leader can quickly become tomorrow’s laggard. It makes sense to own multiple horses in the race.

3. Think globally. It is easy to focus on how these new technologies and services benefit our lives, but the more important story is how they will benefit billions of people in the developing world, who are being “lit up” with knowledge for the first time and are highly motivated to use this knowledge to improve the quality of their lives.

4. Think Long term: Although changes underway are remarkable and fast-paced, the ride may be volatile as markets rise and fall and individual companies and investment styles fall in and out of favor. Be comfortable with the idea of having a portion of your portfolio that is more targeted towards long-term growth, with greater levels of attendant near-term volatility.

5. Valuation Matters: Great companies may not make great investments if they are overvalued, and cheap companies may offer little value if their businesses are being disrupted and displaced. It is important to differentiate between style and substance, and to adjust equity exposures based on a combination of business fundamentals, valuation and future opportunity.

Putting these ideas into practice, we have structured our client portfolios to include several dedicated investments that are specifically targeted at areas of change and growth, including emerging technology, biotechnology, media and communications.

Our core equity exposure is also tilted towards high quality, global, and more growth-oriented investment strategies that also focus on companies that should benefit from innovation across multiple industries.

We also are maintaining meaningful exposure to the developing/emerging world, especially focused on the emerging consumer. These economies are currently going through growing pains, but offer enormous untapped long-term potential.

Finally, and most importantly, we counterbalance these more targeted and growth-oriented investments with a significant allocation to defensive and alternative investment strategies to mitigate overall risk and volatility.

Current Investment Strategy:

The U.S. economy and financial markets got off to a chilly and somewhat bumpy start in 2014 with concerns about bad weather, Federal Reserve policy and rising interest rates, and the renewed specter of geopolitical risks, especially in Ukraine.

We think these concerns are temporary. While weather had an impact on US economic growth in the first quarter, we expect things to pick up as the ground and economy begin to thaw and sprout some new growth. It is widely known that the Federal Reserve plans to reduce its extraordinary monetary support, so that should not be a surprise, and at this point, we do not currently expect the Russia - Ukraine conflict to escalate much further or to have any significant global economic impact.

The more important takeaway is that there are always risks, both known and unknown, but the greatest risk of all is complacency. After flopping and fretting around for the first quarter, investors and markets are less complacent, and expectations are more muted. That, in our mind is a good thing.

We expect continued growth and improvement in the U.S., and recovering growth in Europe and Japan. The emerging/developing economies, and China in particular, continue to experience growing pains and indigestion, but China in particular, has significant resources to backstop its economy through its recovery and transition to a more consumer-driven economy. The good news is that most investors hate emerging markets, and so expectations are low.

Stocks are fully valued, and therefore not without risk, but represent the most attractive asset class for long-term investment both on an absolute basis and relative to bonds.

U.S. stocks are fully valued but offer the best combination of business quality growth and innovation. The recent sell-off in aggressive growth stocks may continue, but it is starting to offer an attractive opportunity to add to high quality positions. European stocks are less expensive and have more room for improvement, although in an environment of slower economic growth and less innovation. Emerging economy equities face the greatest near-term uncertainty, but also offer the greatest value and long-term potential.

The outlook for bonds remains bleak. Bonds that offer safety from credit and duration risk offer little or no return. Bonds that offer an attractive return come with significant valuation, credit or duration risk. We would rather own high quality stocks.

We therefore continue to favor a global mix of equities, balancing positions targeted at areas of growth, with a strong “defensive core” of defensive equity and alternative strategies, as well as modest exposure to bonds where appropriate.

As always, we welcome your questions and comments.

Jurika, Mills & Keifer, LLC
April, 2014

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.