Key points

• McKinsey predicts the IoT offers a potential economic impact of US$4 trillion to US$11 trillion a year by 2025.
• Investors should focus on industrial users in the initial stage of the trend, identify companies that supply the tools, and look offshore. It’s hard to find many direct winners from this trend on the ASX.
• Microsoft and Apple are the obvious choices and closer to home, think NextDC and Bulletproof Group.

Megatrends broadly fall into two categories: those with precedents in other markets, and those that are so new and disruptive that it is impossible to predict how they will unfold.

The ageing population, the middle-class Asian consumption boom and urbanisation are in the first category. Each is vast in scale and certain to surprise markets one way or another. But Japan’s experience with an ageing population, the development of middle-class consumers in western markets, and China’s urbanisation provide clues for investors on what to expect.

The so-called “Internet of Things” (IoT) is firmly in the second category. The digitisation of machines, vehicles and other physical goods – where devices talk to each other via the internet – is possibly the most powerful investment megatrend of them all. And the hardest to predict.

The fact will be better than science fiction

Normally conservative global consultant McKinsey & Co said in a recent report: “The Internet of Things – sensors and actuators connected by networks to computing systems – has received enormous attention over the past five years … Our central finding is that the hype may actually understate the full potential.”

McKinsey predicts the IoT offers a potential economic impact of US$4 trillion to US$11 trillion a year by 2025. Put another way, the range of outcomes is so great that McKinsey sees a US$7 trillion difference between its low and high estimates for the IoT. That suggests enormous volatility in companies that position for this trend, as the market grapples with how much it could boost earnings for providers, or lift productivity for users.

Using McKinsey’s upper estimate, the economic impact of the IoT would be worth 11% of the global economy within a decade. How many other trends can claim to affect about one in every 10 dollars spent in the global economy?

The potential is staggering. Factories will increasingly connect devices to better maintain operations and predict maintenance. Fewer staff and higher productivity will result. Cities will use connected devices for public safety, traffic and resource management to reduce traffic congestion and pollution, and operate more efficiently.

Office towers are already using connected devices, via cloud computing, to reduce energy costs and improve security and maintenance through centralised, remote management. Connected devices will do the same in homes and even automate some chores.

Health is another obvious winner from the IoT. Wearable technology, such as smart watches and fitness trackers, will help prevent or manage illness by providing real-time data to medical professionals, who use software to monitor it. Medical data professionals and personal data trainers (who help you work out and monitor your fitness data) will be boom jobs.

In turn, connected devices, through remote monitoring, will help more of the elderly stay in the home longer, before they move to an aged-care facility.

In transport, driverless cars will, within a decade or two, connect to traffic lights, parking sensors, and other road technology. The potential – fewer cars on the road, sharply reduced traffic congestion, far fewer accidents and more precise vehicle maintenance. And more time for people who have long commutes each day and can let a computer take the wheel.

This trend will also create business models and many winners. Data will become the most valuable commodity as the world is awash in real-time information. Companies that do the best job capturing, analysing and acting on data will be the new stars.

Conversely, the IoT could kill long-established industries – what will happen to panel-beaters and insurance companies when there are fewer road accidents, or aged-care facilities when technology helps people stay in their home much longer?

The big unknown is the speed of this trend. Ten million hardware devices in 1980 grew to 100 million in 1990 as more people bought a personal computer, and a billion devices in 2000 as the Internet took off. By 2010, there were an estimated 10 billion hardware devices as mobile devices proliferated. As the IoT takes hold by 2020, there could be 50 billion hardware devices across personal and industrial applications, according to Cisco.

Fund manager K2 Asset Management said this year: “What started with one mainframe computer in 1960 has grown to one connected device per person with personal computers, to two with mobile telephones, to three with iPads and laptops and is rapidly on its way to 10-12 connected devices per person with the onset of connected cars, homes, TVs and other appliances. Do the maths on 7 billion people and from a connected-device standpoint, 2015 is the year we enter the second half of the chessboard where the numbers start to get really, really big.”

As K2 notes, the Internet, cloud computing and Moore’s Law (where the power of computing hardware roughly doubles every two years, or halves in cost) is driving the proliferation of low-cost connected devices that provide real-time updates to consumers and business.

Profiting from this trend

Emerging investment megatrends so vast in scale, and so unpredictable, require a different approach to more linear established trends, such as the ageing population.

My approach to the IoT is threefold. First, focus on industrial users in the initial stage of the trend because companies are typically earlier adopters of new technology. Factories will receive the biggest potential effect from the IoT – up to $3.7 trillion a year on McKinsey’s estimates by 2025, followed by cities at US$1.7 billion.

Health and retail are the next biggest winners at $US1.6 billion and US$1.2 billion. Then it trails away to self-driving vehicles, homes, offices and so on. The most hyped areas – autonomous cars, internet-connected home and devices – while significant, will enjoy relatively lower economic benefits from the IoT than industry, at least at the start, predicts McKinsey.

The second approach is identifying companies that supply the tools. The investment maxim – own companies that sell the picks and shovels in a boom – will hold true for the IoT in the early part of the trend. In this case, the tools are semi-conductor manufacturers that provide computer chips for connected devices, and technology service providers that help companies move to and stay in cloud computing to capture and manage data, and integrate social media.

Device manufacturers, too, have great potential. At some stage, we’ll have to upgrade fridges, washing machines, TVs, cars and myriad other devices, so they connect via the Internet. But that “tipping point” is still many years away and finding winners now is hard work.

The third part of the strategy is to look offshore. It’s hard to find many direct winners from this trend on the ASX. Plenty of large Australian companies across industries will benefit from the IoT, but the absence of large technology companies on the ASX means investors must look to overseas markets for purer exposure to the trend.

Stocks to watch

US semi-conductor stocks are an interesting idea. Granted, several of these stocks soared last year as investors positioned for the IoT. Also, semi-conductor companies face continued falls in profit margins as chip prices fall.

Volume, not margin, is the big driver for semi-conductor makers. Computer-chip demand will grow exponentially as consumers move from three to four connected devices to 10 to12 in the coming decade, and companies connect thousands of devices across their operations.

Moreover, the market might be valuing semi-conductor stocks as a cyclical play on an improving global economy and overlooking the permanent, structural change underway in the semi-conductor market as more devices are connected.

US giant Intel Corporation and smaller Nasdaq-listed semi-conductor makers Skyworks Solutions and Avago Technologies have interesting prospects, and were hammered last week after disappointing sales news from tech companies.

Microsoft Corporation has outstanding potential in its cloud-computing services and Apple Inc Corporation is the clear standout among device makers. At US$125, Apple’s stock price trades on less than 10 times trailing earnings, after adjusting for its large cash balance, according to share-valuation service Skaffold.

Among Australian stocks, NextDC stands out as demand for cloud-computing and data-centre facilities rises. NextDC is cementing a first-mover advantage as an independent data-centre operator with state-of-the-art facilities in Sydney, Melbourne, Brisbane, Perth and Canberra. It enjoys stronger barrier to entry than widely realised, given the cost of such facilities and difficulty in securing prime city locations (data centres need access to a lot of water, for cooling).

NextDC spin-off Asia Pacific Data Centre Group (APDC), a listed property trust, is a lower-risk way to play the cloud-computing trend. At $1.26, it trades above its latest stated net tangible asset of $1.11 a unit. But APDC should benefit as NextDC signs up more customers, thus reducing its underlying tenant risk, and as demand for hosting facilities keeps rising this decade.

Bulletproof Group, a backdoor listing from 2014, also has interesting prospects. It is well positioned in the Australian market, as more companies need help to move to the cloud and store data from connected devices.

Unlike many emerging technology service providers, Bulletproof is profitable – underlying earnings in 2014-15 of about $4 million and revenue of more than $28 million for 2014-15 is expected – and the $32-million valuation is not excessive. As a micro-cap stock, Bulletproof suits experienced investors who are comfortable with higher risk.

– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at July 26, 2015.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.