Market Perspective

January 2015

Investing in digital disruption

We are living in an age of rapid and highly disruptive digital innovation
that is reshaping many industries. At Fidelity, we believe digital disruption
is a powerful umbrella theme that offers investors attractive opportunities
across industries as diverse as agriculture, entertainment and financial
services.

AT A GLANCE

Digital disruption is a powerful

secular investment theme
affecting global industries and
consumers

We aim to identify both the digital disruptors and the second-order

companies that benefit from innovations, through unstinting bottom-up
research, which takes account of evolving technological themes like the
Internet of Things, big data and computing.

Digital innovation can be highly

disruptive rejecting the status
quo of established markets and
redefining business models

Incumbent digital leaders are

constantly being challenged by
the innovation culture with its
low barriers to entry

Hindsight and industry patterns

can help to inform future
outcomes

Consumer demand is deep and

receptive to multiple product
cycles for the right products
and services

As companies fully embrace

digital at the same time as
technology innovations
converge, we could see a
major acceleration of disruptive
forces

Effective bottom-up research

can help to identify tomorrows
digital disruption beneficiaries

INTRODUCTION
Over the last 20 years, we have seen huge digital disruption in various industries,
which has helped to create some of todays leading corporate giants such as Alibaba,
Amazon and Google. As digitisation becomes more widespread and low start-up costs
enable more entrants, we can expect to see accelerated disruption in the years to
come.
Innovation is the root of all corporate sector disruption, but particularly in competitive
sectors with low barriers to entry. Innovative companies can topple the dominance of
established firms by launching new products and services in existing markets, and by
creating new markets for products and services that address new or unrealised
consumer needs.
THE INNOVATION CYCLE
Technological innovation typically follows a distinct cycle in terms of its development
from consumer awareness to actual market demand. This phenomenon of how a
technology moves through the hype phase to useful application has been captured in
a series of popular technology cycle charts from Gartner (see Chart 1 for emerging
technologies).
Chart 1. The Gartner Curve: How innovation moves from discovery through hype
to productive use

Source: Gartner, August 2014.

Early technical developments tend to go relatively unnoticed until concerted progress,

or more usually, the scope for substantial potential progress sees a hype phase where
the new technology moves into mainstream consciousness, attracting a range of
excited forecasts and predictions.
The hype phase can occasionally become overdone and is often followed by a lapse in
public consciousness or even short-term disappointment among would-be consumers.
However, technical progress typically continues incrementally until the technology
begins to gain traction via the development of killer products and applications that
support critical mass consumption.
The Internet of Things (IoT) is a good example of a potentially huge technological
theme that is already garnering a lot of attention. Industry researchers forecast that the
worldwide market for IoT solutions will grow from $1.9 trillion in 2013 to $7.1 trillion in
1
2020 and the number of active wireless devices will increase from 16 billion in 2014 to
41 billion in 2020.2 Despite many useful applications like smart thermostats and
wearable health monitoring bands already being available, for example, it may take a
few years before the IoT theme becomes deeply embedded in terms of consumer
usefulness and recurring market demand.
INNOVATION POWERS DIGITAL DISRUPTION
Innovation theory in economics is most closely associated with Joseph Schumpeter
and his analysis of business cycles. Clayton Christensen built on Schumpeters theory
3
of creative destruction' and its role in modern capitalism as a precursor to the idea of
disruptive innovation. In his book, The Innovators Dilemma, Christensen argued that
successful executives tend to follow the path of past successes in their decisionmaking. This helps to sow the seeds of their own demise by allowing other firms that
innovate to move beyond the status quo. He therefore defined the innovators dilemma
as doing the right thing is the wrong thing.
For example, in the 1970s, mainframe computer manufacturers were focused on satisfying
the needs of a few existing customers in doing so, they completely missed the untapped
demand for personal computers. Selling cheaper personal computers to businesses and
individuals was a disruptive innovation that came to dominate the computer industry.
While hindsight gives us a clear view of the history of disruption in computer sales, it
can also help to indicate the scope of further disruptions in the industry. Moores Law
tells us that the number of transistors on a microprocessor doubles every 18 months,
so by 2020 or 2030 microprocessors could be measured on an atomic scale, which
could herald the age of quantum computing. Computing industry experts say this could
be as disruptive as the first generation of digital computing. Quantum computing has
the potential to revolutionise computing by performing many more data calculations
per second than conventional computer processors. As we move to this new
paradigm, we can expect considerable implications for the companies that will benefit
from processing ever-increasing amounts of data.
INNOVATIONS: CONTINUALLY ALTERING THE CORPORATE LANDSCAPE
Chart 2 (see next page) shows the number of technology companies that have been
added (green columns) or removed (pink columns) from the S&P 500 since the early
1990s. These movements are closely linked to digital disruption in the S&P telecom
and technology space, which is a positive reflection of an innovative and
entrepreneurial free market economy. Companies have also left the index due to
having been taken private by investors, merged or downsized to the mid-cap category.
DIGITAL INDUSTRIES HAVE LOW BARRIERS TO ENTRY
With advances in areas such as the IoT, cloud computing, broadband and mobile
internet, the barriers to entry to launch a company in one of the digital industries are
historically low for would-be entrepreneurs. In the US, for example, the average
4
amount a start-up accelerator invests to launch a company is $22,890. This is a stark
warning to todays incumbent digital companies that they should innovate (or
undertake strategic M&A) or face the threat of being disrupted by innovative new
competitors.

Disruption is a key part of what

our analysts look for when
they examine investment
ideas. They investigate
changes in company or
industry growth and returns
profiles, perhaps due to a new
entrant, technology or
change to end-consumer
demand.
Future disruptive technologies
that our analysts and fund
managers are focusing on
include demographics and
associated healthcare
innovations, the Internet of
Things, and the car of the
future, specifically driverless
and connected cars as well
as innovative battery
technologies.
Henk-Jan Rikkerink
Head of Research

Chart 2. S&P 500 index joiners and leavers since 1990 digital disruption plays a defining role
30
March '00
ADSL home
launch

1250
August '91
World Wide
Web public
launch

1000
750
500

July '92
SAP R/3

250

March '06
Amazon Cloud
Launch
August '04
Google IPO

December '94
Netscape 1.0
release

25

Future...?
Internet of
Things

June '07
iPhone Release

20
15
10
5

0
-5
-10
'90

'91

'92

'93

'94

'95

'96

Companies Added

'97

'98

'99

'00

Companies Dropped

'01

'02

'03

'04

'05

'06

'07

'08

'09

'10

S&P Telecom & IT (Market Cap) 1990=100

'11

'12

'13

'14

-15

Net Change

Source: 2014 Tech Outlook, Evercore ISI, January 2014.

While there is a view that innovation is sparked by a start-up spirit, digital disruptions
can be achieved by companies of any size the US National Venture Association
states that a companys scale is not incompatible with disruptive potential. However,
proponents believe that corporates should be open to setting up new divisions and
trading older out of parts of their business to facilitate a truly innovative approach and
culture. At the top end of the US corporate pyramid, the pace of constituent churn in
the S&P 500 index is increasing today a typical S&P 500 company survives on the
index for an average of 18 years, down from 61 years in 1958. By 2027, an estimated
75% of the S&P 500 is likely to have been replaced.5

Music industry the evolution

of digital disruption

STRONG CONSUMER DEMAND EXISTS FOR THE RIGHT PRODUCTS

Internet-savvy consumers have been quick to adopt innovative digital technologies.
This consumer adoption has helped to create disruption of established businesses. For
the millennial generation (18-35-year olds) and billions of emerging market consumers,
their digital experiences are largely framed by smartphone and tablet screens. Mobile
technology is now pivotal in the digital experience mobile app downloads are
forecast to reach 268 billion by 2017, generating $77 billion in sales, according to
6
Gartner. This trend is set to increase as more wearable devices are launched.
However, some firms have been slow to catch on to mobile. In the first quarter of 2014,
30% of Fortune 500 companies did not have a mobile app and less than 50% had a
mobile website. While corporates around the world have to play catch-up, this will
directly offer them considerable opportunities in the digital disruption theme as well as
would-be innovators, not just in the developed world but in emerging markets too.
DIGITAL DISRUPTION A GROWING TRACK RECORD IN DIVERSE INDUSTRIES
We can clearly see the benefits that digital disruption has brought to many parts of the
global economy and we can estimate the scope for much more to come.
The second part of this paper looks at examples of how digital disruption is reshaping
various industries music, television and agriculture and highlights some of the
companies that are benefiting. We also focus on the Chinese internet industry in a
case study that shows the worlds largest digital market may have only just embarked
on its secular path of digital disruption.
THE MUSIC INDUSTRY HAS EXPERIENCED SUCCESSIVE DIGITAL DISRUPTIONS
The music industry model pre-internet was largely based on ownership of physical
products like vinyl records, tapes and compact discs. The infographic on the right
charts the successive innovations in music formats since the 1940s from the physical
products to various digital offerings. While the internet enabled new distribution models
like the MP3 format, it also facilitated peer-to-peer (P2P) file sharing, which
significantly impacted the music industrys revenues.

Source: Company reports; Fidelity Worldwide

Investment, January 2015.

No. of companies entering/leaving

S&P Telecom & IT Market Value 1990=100

1500

However, while the physical music market rapidly shrank, new digital models emerged
based around access rather than ownership, enabling digital revenues to climb from $4
billion in 2008 to $5.9 billion in 2013 to account for 39% of overall industry revenues.7
Streaming platforms, for example, are expected to increase from $848 million to $1.76
8
billion in the period 2014-2018 following recent rapid growth in demand for streaming
services (see Chart 3) as paid-for subscription services such as Spotify gain in popularity.
Spotifys revenues increased by 51.3% in 2013 compared with 2012). Spotify has
enjoyed rapid expansion, hitting 10 million subscribers in May 2014 across 56 markets,
up from only 20 markets the previous year.
Chart 3. Music streaming grows, taking share from mobile services*

Google is a good example of

how innovative companies drive
digital disruption across many
industries. Started as a website
search business 19 years ago,
Google has changed dynamics
in many industries such as
media, retailing and banking.
With many new initiatives like
fibre-to-home, home
automation, Google Car and
Google Glass, the company will
continue to drive creative
disruption in telecoms
infrastructure, utilities, and the
insurance industry.
HyunHo Sohn
Portfolio Manager
Global Equities

Note: Mobile products includes master ringtones, ringback tones, and personalised mobile products such as dedications
and voicetones, many of which were extremely popular in Asia. Source: IFPI Digital Music Report 2014.

TELEVISION VIEWING IS BEING DISRUPTED BY MULTIPLE DIGITAL INNOVATIONS

Television viewing continues to be disrupted by improvements in internet access and
bandwidth, as consumers move away from live programmed network television towards
time-shifted and online viewing via multiple devices (Chart 4 on the right shows the rapid
growth of new viewing methods).
Like the music industry, success has been predicated on how adaptable companies are
to new consumption patterns. While some companies, such as Blockbuster, remained
reliant on physical DVD rentals and sales, others like Netflix and Amazon Prime
developed the online subscription access model.
In recent years, securing exclusive rights to original programming has become critical for
these companies to boost and maintain their subscriber bases along with exclusive
access to established series via deals with content providers like HBO and Viacom.
BIG DATA COULD REVOLUTIONISE AGRICULTURAL YIELD
Digital disruption is not limited to industries like entertainment and e-commerce. Driven
by the need for improved crop yields, prescriptive planting has the potential to disrupt the
agricultural industry. This system uses big data applications to precisely understand
where in one of the 25 million mapped agricultural fields in the US to plant what type and
volume of seed to achieve the desired crop yield. Monsantos FieldScripts product
combines an extremely detailed database of 150 billion soil observations, 10 trillion
weather-simulation points and hundreds of thousands of seed-yield data points.
FieldScripts uses all these data to run machines made by Precision Planting, a company
Monsanto bought in 2012, which makes seed drills and other devices pulled along behind
tractors. Monsantos planting machines, which can steer themselves via GPS, can plant
a field with different varieties at different depths and spacing according to the climate
data.
Farmers that have trialled Monsantos system claim it has increased yields by around 5%
over two years. Industry experts believe the technology could increase Americas maize
yield from 160 bushels an acre to 200 bushels; a big boost to growers profit.
Using this data could revolutionise crop management and yields in the US, and if
applied to other regions around the world, it could have epic consequences for the
worlds food supply.

Chart 4. Television viewing patterns

are being disrupted (2013-2014)
63.7%

Internet video
Smartphone
video

46.4%

App/Web
on smartphone

32.7%
13.0%

Time-shifted TV
Scheduled TV
-20%

-2.7%
0%

20%

40%

60%

80%

Source: Neilsen Cross Platform Report Q2 2014.

CHINA CASE STUDY: HUGE OPPORTUNITIES IN THE NEW ECONOMY SECTOR

Chinas huge market, high consumer appetite for digital offerings, and the slower take-up
rate of the internet by many companies (particularly small-to-medium size) compared to
consumer adoption point to a market full of potential. In fact, some analysts are predicting
9
that a great wave of digital disruption has just begun in China.
Chinese internet appetite has been largely consumer-driven as businesses have been
slow to move operations fully online. Millions of Chinese businesses sell their products on
Taobao, an Alibaba-owned online marketplace which operates on consumer-toconsumer and e-commerce platforms, but only 20-25% of small firms in China are
actually internet-connected, compared with 75% of their US counterparts as Table 1
below shows.
Table 1. Chinas internet industry driven by consumers rather than enterprises
China

United States

Users

632 million

277 million

Penetration

46%

87%

Size

$295 billion

$270 billion

Share of total retail

7-8%

6%

Smartphone penetration (share of

installed base)

54%

69%

Enterprise cloud adoption rate

21%

55-63%

SMEs internet adoption ratio

20-25%

72-85%

Internet usage

Consumer

Enterprise

E-retail

Source: Chinas digital transformation: The Internets impact on productivity and growth, McKinsey Global Institute, July 2014.

The labour productivity of Chinese small businesses is roughly two-thirds of the average
for all firms in China. The benefits that the internet can bring in areas such as marketing,
managing supply chains and collaborative research are eluding many firms.10 As more
businesses move online, however, this is expected to cause a huge amount of digital
disruption, leading to productivity gains and further GDP growth, supporting Chinas
objectives for an economy driven by knowledge, innovation and quality consumption.
Chinese consumer demand stokes digital innovation
On a global scale Chinese consumers have certainly bought into the internet by
number, China has more smartphone users and internet-connected households than any
other. The countrys e-commerce industry, which turned over nearly $300 billion in 2013,
is the worlds largest market, creating a solid foundation for further digital disruption. Yet
China still has considerable scope for growth; less than half of the country is internetconnected compared with nearly nine in 10 people in the US. Furthermore, with
smartphone penetration in China at 54% (US is 69%) there is already a significant move
towards mobile internet. Tencents Wechat and Baidu are beneficiaries of mobile
internet including areas like location-based service (LBS), focusing on mobile devices
locations, online-to-online (O2O) services, mobile gaming, e-commerce, mobile
payments and search services.
Chinese internet firms attempt to disrupt financial services
Mobile internet use is disrupting aspects of the financial market, benefiting internet giants
like Alibaba, which is seeking to diversify its e-commerce offering and leverage its brand,
customer base and distribution network. Would-be disrupted services include lending and
mobile payments. The internet finance trend is also expected to offer the squeezed
small-to-medium size businesses the so-called bamboo capitalists access to capital
which they have been denied by the favoured relationships between state-owned banks
and large enterprises crowd-funding, for example, has already been a success in
western markets. While traditional financial service providers oppose the internet
financiers, the Chinese government and regulators support the change as they seek to
foster more innovation in online financial services.

Digital disruption is an
ongoing trend and the rapid
surge in the use of mobile
devices in China has
increased the potential for
digital disruption across many
industries.
Nowadays, more and more
internet companies are taking
up business from physical
stores. Among all, department
stores and hypermarkets are
expected to be the key
victims of this trend. Against
this backdrop, I have already
reduced my funds exposure
to physical stores and remain
overweight in internet and ecommerce plays.
Raymond Ma
Portfolio Manager
China Equities

OUTLOOK
Digital disruption is an overarching, universal theme with the power to reshape almost
any industry which benefits from digitisation, connectivity, and sophisticated data
processing. We have seen clear evidence of companies successfully implementing digital
disruptions in various industries in recent decades and there is likely to be much more to
come. Digital disruption is a secular theme that will accelerate over time, thanks to a
number of powerful and converging sub-themes such as connectivity/ smartphone
penetration, big data and cloud computing.
Consumers in both developed and developing economies have been early adopters that
have supported initial waves of digital disruption. We can expect to see increasing
demand for new products and services as internet-connected mobile devices become
even more affordable and more available to an even wider group of users. On the supply
side, we can expect to see more innovations come to market as relatively low barriers to
entry enable more companies and entrepreneurs to offer innovative digital products and
services.
Companies worldwide, in addition to the examples of China and the US cited in this
paper, have a long way to go to fully engage with the digital age. Likewise, governments
and institutions motivated by cost efficiencies of delivering their services online also have
a lot of ground to make up.
Focusing on detailed fundamental company and industry-level research, the equity
analyst teams at Fidelity are in a strong position to identify disruptive themes well in
advance of their market impact. More importantly, they are dedicated to the specific
task of identifying the second and third-order beneficiaries of these innovations, as
these often tend to be the more overlooked and lucrative investment opportunities
in the long term.

REFERENCES
1. Worldwide and Regional Internet of Things (IoT) 20142020 Forecast, IDC, May 2014.
2. ABI Research, Internet of Everything Market Tracker, August 2014.
3. Capitalism, Socialism and Democracy (1942), Joseph Schumpeter.
4. Disrupt or be disrupted, The Economist, November 24, 2014.
5. Creative Destruction Whips through Corporate America, Innosight, Winter 2012.
6. Gartner press release, January 22, 2014.
7. Digital Music Report 2014, IFPI 2014.
8. Ibid.
9. Chinas digital transformation: The Internets impact on productivity and growth, McKinsey Global Institute, July 2014.
10. Ibid.

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ITL15-02