Why EM is the best way to play the transformation theme

Amazon. Tesla. Apple. Facebook. Netflix. Google. Uber. Waymo. SpaceX.

These are the usual suspects when people think of “transformation” and “disruption”: either US-listed, private or both. Most of the newest technological developments that we know of originate from Silicon Valley. Technological developments from the West Coast dominate the global news headlines.

We don’t disagree, but we also think that investors are missing out on what is probably the biggest proxy for transformative change: Emerging Markets. This is a glaring opportunity that surprising few people have spotted and even fewer are talking about, for obvious reasons.

The reason for this is simple: once a standard is established, the threshold of improvement needed to overthrow the incumbent is onerous. But for a country that has nothing, there is nothing to substitute for, nothing to “give up” or “compromise” on.

Put differently, for the economies that have nothing, “leapfrogging” is not only an obvious choice, it’s the only option. Emerging markets are installing the latest technology on what is effectively a blank sheet.

This top-down approach to innovation is why smartphone penetration in the Philippines has been more than 100% for years, while attaining 85% penetration in the UK is considered newsworthy in 2017. Similarly, Google Pay and Apple Pay are struggling to grow adoption in their home market, the US: Android Pay adoption in the US is estimated at only 5.3%, with Apple pay scoring slightly better at 12.8%. In both cases, the reason for not trying tends to be, “I’m satisfied with my current payment methods.” When life of pretty good, why go to the trouble to change it?

All across emerging market countries, we’re seeing evidence that adoption of new technologies is transforming lives at a fundamental level, taking people from a level of having very little, to full adoption of brand new technologies with the power to transform living standards, without the hurdle of inertia.

Case in point: Indonesia

It’s exactly this dynamic that has taken e-commerce sales in Indonesia to 5% of total retail sales after only 3 years of adoption, with McKinsey expecting that percentage to be 17-30% over the coming 5 years. The consensus, even in 2013, was that Indonesia, an archipelago of 17,508 islands with sparse mobile data coverage and complex logistical challenges, would be relegated to the slow grind of bricks and mortar retail. Moreover, with GDP per capita sitting at just under US$4k, the market expectation was that the consumer was neither sufficiently sophisticated, affluent or connected for e-commerce to present a credible threat to incumbent bricks and mortar department stores.

This expectation could not have been further from reality: while e-commerce remains the preserve of consumers located on the main island of Java, the pace of adoption has been breathtaking, with the market dominated by the regional subsidiaries of the Chinese e-commerce giants (JD, Lazada and Shopee) and locally born startups like Tokopedia. Indonesian consumers, faced with the offer of free shipping, sometimes within a day, and subsidised by the near-bottomless budgets of these new entrants, flocked to e-commerce sites, leaving incumbents shellshocked. For example, Matahari Department Store, one of Indonesia’s largest department store chains, saw their Same Store Sales Growth falling from 13.3% in 4Q13 to -26.0% in 3Q17, leading to store closures being needed to stem the bleeding to about 4% growth in the latest 3Q18 report.

Feedback loops and reverse innovation

Like their counterparts in developed markets, incumbents in emerging markets are finding themselves blindsided by the unexpected rate of change in what were hitherto placid markets. This illustrates the importance of non-linear, exponential thinking: the fact that things progressed along a certain path in the past is no guarantee that it will happen, regardless of how similar the comparison is.

No one in the world is more acutely aware of this than entrepreneurs in China, who battle endlessly in what Sinoventures Founder Kai-Fu Lee likens to a “coliseum of competition”. No rules, winner-takes-all competition means that nothing is impossible.

For investors, this represents a silver lining in the transformation story: emerging market entrepreneurs who invent new solutions to adapt to less comfortable, developed and protected environments will drive spectacular shareholder returns. Like gold being tested in fire, we see EM entrepreneurs undertaking what we call Reverse Innovation: not inventing (or even reinventing), but creating new solutions and pushing them to their limits.

Some companies are taking reverse innovation to the next level, creating feedback loops where “developed” markets turn out to be the ones playing catch-up. Prime example: Tencent’s and Alibaba’s success in driving mobile payments in China, allowing the country to go cashless overnight and move to (wait for it…) digital renminbi is a case a point.

If you’re looking for something to keep you up at night, just imagine what this trend could do to the global monetary system. Please don’t blame the messenger. Blame non-linear thinking, which has the power to open our minds and our portfolios to new opportunities.