The rise of the smart machines

Machines may not take over the world just yet, say John Stepek and Phil Oakley. But early movers can profit from the new technology revolution. Here's how.

You wouldn't think that an object as mundane as a thermostat could ever become trendy. But then, until last year, the world had never seen a thermostat designed by former Apple engineers.

The learning' thermostat from Nest Labs (co-founded by Tony Fadell and Matt Rogers, who were key players in the creation of Apple's iPod music player) does more than just sense the air temperature.

It can also learn your habits, switch the heating off when no one's in the house, and be controlled remotely over the internet so you can make changes while you're out of the house if necessary. The whole point is both to save energy and make life easier for the user.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Nest's thermostat sums up what the internet of things' (also known as the industrial internet') is all about. As a buzzword, the concept has been around for a while. But the reality of a world where everything is connected and capable of monitoring its environment and adjusting its behaviour accordingly smart' machines is drawing ever closer.

As Steve Lohr points out in The New York Times, "low-cost sensors, clever software and advancing computer firepower are opening the door to new uses in energy conservation, transportation, health care and food distribution".

We're talking about smart heavy machinery that can tell users when it needs to be repaired; smart containers that can sense when the produce inside them is on the verge of going off; smart hospital rooms armed with tiny cameras, that can remind absent-minded visitors and medical staff to wash their hands when they enter and leave, and use facial analysis technology to look for signs of distress in patients and alert their carers.

This all might sound rather utopian, and like all these big, exciting stories, it'll probably take a while for its true potential to be realised. Electronic books were around for a long time before they started to threaten the publishing status quo, for example.

And the products that grow out of the smart' revolution won't all be as high-minded as energy-saving thermostats. As Russell Davies pointed out in an amusing piece for Google's Think Quarterly online magazine, for every water meter that can detect leaking pipes, there will be an artificially intelligent novelty hat that can tell you whether or not your train is running late.

But there's one thing that we can be sure of: the internet of things' is going to involve an awful lot more data flying around and being collected. That's where the opportunity for investors arises.

Swamped by data

It's not as though we're short of information as it is. According to IBM, 90% of the data that exists in the world today was created in the last two years alone. We're adding to it every second of every day. In its latest Visual Network Index report, network equipment maker Cisco notes that global mobile data traffic alone more than doubled in 2011 for the fourth year running. In terms of scale, the quantity of mobile data traffic sent last year was eight times the size of the entire global internet in 2000.

This is primarily due to the rise of the smartphone (mobile phones such as Apple's iPhone that connect users to the internet). Smartphone usage nearly tripled in 2011. While they account for just 12% of global handsets, they account for more than 82% of global handset traffic.

That's because they enable people to send and receive larger, more data-heavy applications, such as video content which accounted for more than half of global mobile traffic for the first time last year. Tablet computers, such as the iPad, are also becoming increasingly popular.

By the end of this year, Cisco reckons that the number of mobile connected devices will exceed the world's population. By 2016, data traffic will have grown 18-fold that's a compound annual growth rate of 78%. Within this, machine to machine traffic is expected to grow 22-fold by 2016. That takes you from a current level of around 1.3 exabytes (EB) a month (to see how big an EB is, see the column on the right) to 10.8 EBs a month.

How big is an exabyte?Kilobyte (1,000 bytes): Four KB would hold a very short written document.Megabyte (1,000 KB): A typical book of around 500 pages.Gigabyte (1,000 MB): The classic iPod has a 160 GB memory, which holds around 40,000 songs.Terabyte (1,000 GB): In its first 20 years of operation, the Hubble telescope recorded 45 TB of data.Petabyte (1,000 TB): The adult human brain has about 2.5 PB equivalent of memory storage.Exabyte (1,000 PB): Research in 2011 calculated that globally there was 195 EB of stored data in 2007.

Avoiding traffic jams

As one of the companies that maintains and installs the networks that all this traffic will be travelling on, Cisco of course has a certain vested interest in pointing out the staggering levels of growth we can expect. After all, the faster traffic is growing, the more likely carriers are to have to spend money on new equipment to keep that data moving smoothly. However, it's hard to argue with Cisco's conclusions because that's exactly what's happening.

Indeed, disputes are already breaking out in some countries over who will pay for all this extra traffic. For example, South Korea's biggest internet provider, KT Corporation (KT), is demanding a share of the profits from the next big thing: smart TV.

KT argues that streaming TV programmes over the internet is extremely data heavy and "can be likened to heavily loaded trucks slowing down the overall speeds" on the network, which means KT has to shell out to upgrade it.

Yet smart TV manufacturers whose products wouldn't work without these networks aren't paying anything towards the upgrade costs. As a result, KT temporarily blocked internet access through Samsung's smart TVs, arguing that it should get a share of the profits from smart TV. The two companies have since agreed to talk.

This particular situation is probably unique to South Korea government rules mean that KT cannot charge internet users according to their usage, hence the need to try to recoup the cost of rising traffic elsewhere.

However, it does demonstrate the pressure the internet is already under all across the globe. As Paul Hill points out in his Precision Guided Investments newsletter, in America "the likes of Verizon Wireless and AT&T... are racing to construct 4G Long-Term Evolution networks". These offer much faster download speeds than the existing 3G equivalents, which make more bandwidth-heavy online applications, such as gaming, run more smoothly.

Where can we put it all?

With all these extra people and devices getting online and sending increasing amounts of content to one another, the trails of electronic data we leave behind us are only going to grow.

One of social networking site Facebook's most recent innovations is the Timeline a sort of automated personal biography that records and displays your every action on the site for all your friends to see. Love it or hate it, it's a valuable reminder of the one thing we should all have learned about the internet by now: nothing you do online goes unnoticed or unrecorded.

That's good news for the companies that provide storage solutions for all this data. Indeed, JP Morgan believes that other than smartphones and tablets, one of the biggest growth areas for the technology sector this year will be enterprise storage'. "The explosion of data in the corporate and consumer environments has many storage facilities operating with limited excess capacity." As a result, even if there is a wider downturn, storage is likely to remain a key part of corporate IT budgets.

Indeed, server virtualisation' which is, in effect, a way to squeeze more out of existing computer servers rather than having to go to the cost of installing more is set to be ramped up rapidly. According to a JP Morgan survey, companies are aiming to virtualise more than 60% of their existing servers (from 21% now) in the medium term. "That is a big number." We look at the companies best placed to benefit from this long-term trend below.

Data analysis

What's the point in having all this data in the first place? A report by British IT company SAP noted that more than half of the businesses it surveyed said they had "more data than they can actually act upon", and the vast majority had difficulty "gaining valuable insights" from their customer data.

This is where another buzzphrase big data' comes in. Big data refers to hugely complicated data sets that are difficult to organise and analyse with standard database software. So why bother? Because, as McKinsey & Company put it in a 2011 report, analysing this big data will deliver "new waves of productivity growth, innovation and consumer surplus".

At heart, this is all about using data to spot patterns that can enable your company to provide a better, more personalised service to your customers. You might be pretty impressed with the way that Amazon can tell you about books or music you might enjoy, based on your past purchases.

But Graham Cooke of data processing group QuBit talks of online retail sites eventually being able to "understand intent" and basically read a user's mind. Analysis is also about finding ways to make your business more efficient. McKinsey reckons that American healthcare spending could be cut by 8% if the sector were to use big data "creatively and effectively".

As JP Morgan notes, "while there has been much discussion around the topic", companies' uptake of systems and software that can analyse big data has yet to take off in a big way. However, it's certainly a field to watch.

Keeping it safe

Meanwhile, there's the question of keeping all this data secure. When it comes to tales of hacking, the headlines are often grabbed by adolescent protestors wearing V for Vendetta masks, or shadowy government agencies wielding cyberweapons to undermine critical infrastructure.

But as we noted in a story on cybercrime last year, the real threat to most people is more prosaic it's plain old fraud. With more and more of our personal data online, there's a tempting trove of credit card and bank details for cybercriminals to target. Indeed, the British government reckons that cybercrime cost the economy £27bn last year.

This is a critical area for companies who store our data. After all, if customers don't have confidence that their details are safe, they will think twice about using a site for online gaming, buying online, or anything else. That makes cybersecurity a big business. In the same JP Morgan survey, security "was highlighted as one of the top priorities in most IT budgets".

Three leaders in the data field

By Phil Oakley

When it comes to tablets and smartphones, Apple (Nasdaq: AAPL) is the company to beat. With iTunes (its music and software applications retailer) and iCloud (its data storage service) in its corner, Apple is better placed than its rivals to exploit the trends in digital media.

Should Apple go on to develop a next-generation smart TV (as is rumoured), its dominance could grow further. The key to unlocking Apple TV will be content: and with a cash pile approaching $100bn, Apple is in a very strong position to buy broadcasting rights if it decides to. Yet it's currently being priced more like a value than a growth stock. At $517, it trades on 12.1 times 2012 earnings. If you strip out its large cash pile, that multiple falls to just 9.5 times, which means Apple shares still look cheap.

IBM (NYSE: IBM) could be an interesting play on business technology services. IBM's key strength is that it is already working with many of the world's top firms. This gives it a significant competitive advantage. It has a growing position in cloud computing (playing into the data storage theme), but its data analytics business also has lots of potential. It allows firms to analyse large amounts of complex information the Big Data' theme mentioned above and make forecasts based on its findings, which should pave the way for better business decisions.

IBM is also going where the growth is, aiming to make 30% of its revenues from emerging markets by 2015. It generates lots of free cash flow and will use it to increase dividends, buy back shares and spend $20bn on acquisitions. It is targeting earnings of $20 per share by 2015 if it succeeds in doing this, then at $192, the shares could be good value.

For a high-risk play on cyber-security, you could consider the RENN Universal Growth Investment Trust (LSE: RUG). We'll point out right away that this is not a play for widows and orphans. The trust invests in microcaps and unquoted firms in America, and has had a torrid time in recent years, partly because it held stakes in various Chinese firms that collapsed in value in the wake of the accounting scandals that gripped a number of US-listed Chinese firms last year. It currently trades at a discount of more than 30% to net asset value.


However, those firms have been cleared out. The trust's biggest holding now (accounting for more than a fifth of its net asset value) is a firm called AnchorFree. AnchorFree has been in the news recently due to its internet security application, HotspotShield.

Hotspot Shield is "the world's most popular virtual private network (VPN)", says the company. What that means is that it offers a secure way to browse the internet when using public Wi-Fi hotspots (such as in airports or hotels).

But it also has the happy side effect of enabling individuals in countries that censor the internet to sidestep such restrictions. As such it has garnered attention for playing a role in helping protestors in the Arab Spring to communicate.

The firm (which offers both paid-for subscription versions or free advertising-supported versions of its service) is "profitable and growing more than 100% a year in users, page views, revenue and earnings before interest, tax, depreciation and amortisation."

The company aims to go public or merge with a strategic partner. As we've already noted, this is high risk and it's just one of several holdings in the RENN trust. But if you want to take a punt on a small internet stock that may just be the next big thing, this is one of the few chances you'll get as a private investor.

This article was originally published in MoneyWeek magazine issue number 576 on 17 February 2011, and was available

exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.