Managing the risk of disruption in the age of AI

The Fairlight investment strategy aims to identify attractively priced small and mid-cap companies with a proven record of generating wealth over time, thanks to enduring competitive advantages.

The research process involves a deep analysis of how companies performed in the past, particularly the return on capital they have been able to achieve through economic cycles. Subsequently, it involves an assessment of durability of these competitive advantages, as what matters most is how our portfolio companies will perform in the future. The assessment of new competitive threats is then an ongoing process.

Following up on last month’s report, artificial intelligence (AI), in its more modern ’generative’ form (GenAI), is the latest example of a new technology which has the potential to fuel a new wave of competitors eager to disintermediate companies with high returns on capital. We have thus spent significant research time to understand the impact of this threat for our companies. We also explored how many of our companies might be able to leverage this new technology to their advantage.

Our conclusion is that, on balance, the companies we own are more likely than not to benefit from technological change, including the advancement of artificial intelligence, rather than being disrupted. Superior research and development budgets, agile business models and a preference for decentralised management structures are common tenants held by Fairlight portfolio companies, which support them to embrace change.

Scale, decentralisation and financial strength

The risk of technological disruption is not a new phenomenon for our portfolio companies. GenAI is only the latest example of such risk. Under the classical model of capitalism, businesses that generate high returns on capital quickly attract determined competition, exerting downward pressure on returns towards the cost of capital. To minimise disruption risk Fairlight only focuses on high quality businesses that possess multiple layers of defence:

• Our portfolio holdings generally command a number one or two position in their respective markets, often operating in niches. These positions have been the result of decades of investment which usually results in significant scale advantages and provide superior ability to invest in the latest technologies.

• They are conservatively financed so are typically able to continue investing during conditions where others may be facing insolvency. The portfolio average Net Debt to earnings before interest, taxes, depreciation and amortisation (EBITDA) ratio is a modest 0.7x.

• Often our businesses have flat organisational structures and grant significant autonomy to middle and lower-level managers which allows them to quickly identify new market and technological trends, and pivot as required.

The data advantage

Furthermore, by owning the #1 or #2 competitor in each industry, Fairlight also benefits from the lesser appreciated development of AI – the benefit of owning data. Special purpose applications of AI demonstrate the benefits of building AI models on highly curated data sets. From dental device companies to credit decisioning engines, the collection of this data over decades often leaves the market leaders in a unique position to extend their competitive advantages further.

Gartner vs GenAI

Looking amongst the Fund’s largest investments, Gartner is perhaps the company that might see its value proposition eroded the most by the proliferation of GenAI. The company provides data and research globally to executives of large corporates to support them in their roles as leaders across the corporate functions of IT, supply chain, finance, legal and human resources. For instance, Gartner is currently, among many other topics, and perhaps ironically, also helping executives to understand how AI might shape their roles and organisations.

Gartner’s value proposition to executives is centred around speeding up decision making by providing specialised research for a relatively small cost. Given Gartner’s scale, it is better placed to stay on top of technological developments than stretched in-house resources. The question then is can GenAI do this even more cost effectively than Gartner?

Even if AI could generate research of a similar quality to that of Gartner’s, it is the ability to speak to one of their experts at any point in time that is instrumental when trying to make sense of complex topics. Furthermore, it’s difficult for executives to always be on top of change. In other words, it is hard to search for an answer to a question that they might not know yet that they should be asking. Engaging with Gartner’s experts on a regular basis is useful to uncover blind spots. As a result, the risk of Gartner being disintermediated by GenAI is low, in fact, the technology is more likely to further improve Gartner’s competitiveness when it comes to content creation and delivery.

When looking at GenAI beneficiaries within the portfolio, our IT services and IT hardware and software resellers are the best positioned to directly benefit from the broader adoption of this technology.

Picks and shovels of the GenAI era

The Fairlight investment strategy avoids investing in early-stage technology companies given the large range of outcomes when forecasting future cash flows. However, we believe the portfolio can still benefit from technological innovation while reducing risk by focussing on companies that provide the ‘picks and shovels’ (i.e. related tools and services), rather than the innovative products themselves. While the technology companies we invest in are less likely to become the next tech giant, they are also unlikely to face risks related to product specific obsolescence due to the advent of even newer technologies. Our technology companies are well-established and highly profitable leaders in their respective markets and are often agnostic to which type of technology will eventually prevail. Fund holdings Reply and Softcat exemplify this well.

Reply began its operation in 1996, to help large Italian corporations embrace new technologies. Since then, as technology progressed, so did Reply’s expertise. This ability to adapt has earned the company the reputation of a trusted partner that clients can rely upon throughout their digitalisation journey. While in the 1990’s Reply was focused on helping clients roll out their first websites and e-commerce strategies, today the focus is instead on cloud computing, data analytics, cybersecurity, the ‘Internet of Things’ and, you guessed it, AI. As technology continues to evolve, new products will be released, and old products will fade into obsolescence. However, corporations will always need a trusted partner like Reply with broad, product-agnostic expertise to help them navigate the increasingly complex environment.

Softcat is a leading hardware and software reseller in the UK, targeting those customers too small to be reached economically by the sales force of large vendors like Microsoft or to have their own sophisticated IT teams. Softcat bridges this gap, making itself an indispensable part of the IT value chain. We believe that all organisations need to have a strong core-IT infrastructure and modern security systems in place before they can benefit from GenAI. If GenAI, as most expect, becomes mainstream, demand for Softcat’s services should grow.

“GenAI , it’s an amazing technology. It’s going to do great things, and what we tell our clients is that they can’t use it unless they’re in the cloud, have data, and have modernised their core” – Accenture, 2023 Q4 analyst call

Fairlight View

Fairlight’s research process focuses on identifying and owning businesses with proven track records of generating wealth for their shareholders. We focus solely on those businesses which have had a long history of successfully protecting their competitive advantages by reinvesting into the future and we continuously assess new competitive threats as well as the opportunities that new technology, like GenAI, might bring. Weighing risks such a technological disintermediation with the opportunities that new technology brings and relating these back to the risk/reward implied in today’s share prices is one of the most important tasks of the investment team.