Why we think the digital economy deserves a 3.0 Stars “Attractive” rating

• The rapid digital transformation happening across all industries and sectors will bring about many new investment opportunities within the digital economy.

• The digital economy is estimated to be worth USD 9.5 trillion today, approximately 10% of the world’s GDP.

• The long-term growth of the digital economy is propelled by several multi-year megatrends, such as rising Internet adoption rates and digital disruption. 

• Based on current valuations and the expected future earnings growth, we assign a 3.0 Stars “Attractive” rating to the digital economy.

• For exposure to the digital economy, investors can consider the O'Shares Global Internet Giants ETF (NYSE:OGIG).  

The world as we know it is on the cusp of a new technological revolution, known as the Fourth Industrial Revolution (Figure 1). This marks a turning point in human history, where the widespread use of digital technology such as the Internet is blurring the lines between the physical and digital world, forever changing the way we live, work and interact with one another. 

Figure 1: With the widespread use of technology, the Fourth Industrial Revolution is blurring the lines between the physical and the digital world.

Source:PNGflow

Unlike the previous three industrial revolutions, digital technologies today are evolving at such breakneck speeds that individuals and businesses alike are finding it hard to keep up with the changes at times. Those who fall behind run the risk of being rendered obsolete. 

The consequences of failing to keep up with technology is exemplified during the COVID-19 pandemic, during which many traditional physical-only businesses have been severely affected by social distancing measures. A case in point is the retail industry, with several brick-and-mortar retailers, such as JCPenney and Modell’S Sporting Goods, filing for bankruptcy during this period.

As we can see, the technology-driven changes brought about by the Fourth Industrial Revolution are no longer confined to the manufacturing and industrial sectors. Almost every corner of the economy, from retail, banking, to even the services industry, has been affected. 

The rapid digital transformations happening across all industries and sectors will bring about many new investment opportunities, particularly among companies that are able to adapt to the changes quickly. As more companies go digital, technology will likely become an integral part of every investor’s portfolio. 

What makes up the digital economy?

Among the various subsectors within the technology sector, the digital economy is by far one of the most exciting and promising one. While there is currently no universally agreed definition of what the digital economy is, and a lack of an industry classification system due to its complex nature, the digital economy can be broadly categorised into the following eight segments (Figure 2).

Figure 2: The eight segments that make up the digital economy

Collectively, these eight segments are worth approximately USD 9.5 trillion today. That’s roughly 10% of the world’s GDP. If it were a national economy, the digital economy would be the third largest in the world, behind only the US and China. 

Related Article: Invest in the world's fastest-growing Internet companies with this one ETF

Taking a look at changes in the world’s largest companies by market capitalisation across time gives us a sense of how quickly the digital economy has developed over the years. Compared to a decade ago when only two of the top five companies are considered digital economy stocks, every single one of the top five largest companies today are digital economy stocks (Table 1).

Despite their remarkable growth over the past decade, we do not think that this is everything the digital economy has to offer. Looking ahead, we believe that the sector still has plenty of room for further growth, supported by several long-term megatrends. 

Table 1: The top five largest companies by market capitalisation today are digital economy stocks

Megatrends driving the digital economy 

Rising Internet adoption: Despite expanding at an exponential pace in recent years, global Internet usage remains far from saturated. The number of Internet users worldwide currently represents about 58.7% of the global population, which means that a large part of the global population still lack access to the Internet or web-enabled devices.

Across the world, there are vast differences in the maturity and extent of digital services available in each region. North American and European countries are nearing Internet usage saturation, with penetration rates at 94.6% and 87.2% respectively.

The penetration rate in Asia, on the other hand, remains low relative to developed markets. This is despite the fact that Asian economies have a combined population exceeding four billion, accounting for over 55.1% of the global population. China, in particular, has the world’s largest population, yet Internet penetration in the country remains low at about 60% (Figure 3).

As the Internet penetration rate in Asia converges with developed markets, the digital economy is likely to see promising growth over the next few years, with Internet companies being the main beneficiaries.

Figure 3: Rising Internet adoption rates in developing countries to benefit internet companies

Digital disruption: As people around the world begin to spend more time online, digitalisation has become a necessity for businesses that wish to remain competitive in this new global backdrop. To stay ahead of the competition, companies across all industries and sectors have been adopting digital solutions as an alternative source of revenue and as a way to improve efficiency. 

The retail industry is a great example of this. Compared to the past, many brick-and-mortar stores today are turning towards e-commerce, vastly broadening their reach. 

Besides retail, consumer services is another area that has also seen rapid digitalisation. As Internet access becomes more readily available, online commerce has extended beyond physical goods to services. With a few taps on their smartphones, consumers can order food, call a cab, or even find a date using one of the many e-services that are available today.

The importance of digital readiness is clearly demonstrated during the COVID-19 pandemic. During this period, companies that have performed well are generally those that have an established digital presence, while those that don’t typically do not. After the pandemic, we believe that most businesses will likely speed up the adoption of technology, fuelling the growth of the digital economy. 

The abovementioned megatrends will drive the digital economy to greater heights than before, and we firmly believe that the digital economy will see plenty of growth opportunities ahead.

Exposure to the digital economy with one ETF

For exposure to the digital economy, investors can consider the O'Shares Global Internet Giants ETF (NYSE:OGIG). This ETF provides exposure to some of the largest global companies that derive at least 50% of their revenues from the internet. Its top 10 holdings includes the likes of Amazon, Alibaba, Microsoft, and Alphabet, just to name a few.

With a country allocation of 67% to the US, 21% to China, and the remainder to the rest of the world, this ETF brings together the best Internet companies from every corner of the globe, ensuring that investors obtain a globally diversified portfolio of Internet related companies.

3.0 Stars “Attractive” rating for the digital economy

We estimate that the digital economy (represented by the O’Shares Global Internet Giants Index) has an upside potential of approximately 20%. Our valuations are derived using a fair PEG ratio of 1.2X, a multiple which we feel is reasonable for high growth Internet companies. 

While a 20% upside hardly seems impressive, investors should bear in mind that the recent rally in tech stocks has pushed valuations up to a new high, thus reducing its upside in the near term. Taking into account the sector’s current valuations as well as its expected future earnings growth, we believe that the digital economy deserves a 3.0 Stars “Attractive” rating at this point in time.

Table 2: Valuations for O'Shares Global Internet Giants Index

That being said, we continue to hold a positive view on the digital economy over the long-term for its massive growth potential. Unlike the past, valuations of technology companies today are much more sustainable thanks to an improvement in fundamentals such as earnings growth. 

Though it is difficult to put a price tag on innovation, we firmly believe that given its structural importance to the global economy and the favourable tailwinds behind it, there is potential for the earnings of digital economy companies to multiply in the future. This should, in turn, lead to an upward re-rating for share prices.

As the world continues to experience more technological breakthroughs each day, the digital economy holds plenty of promise for the future.