Tag: innovation

An antenna for disruptive innovation

Successful long-term investing requires investors to understand the competitive forces that are acting on a specific company, sector, etc. Our last post was about how even Amazon, that ran countless physical stores out of business, is itself facing a threat from Alibaba. Investors should play close attention to how companies handle disruption in their traditional businesses and hop onto the next growth phase. Because once a disruptive technology takes hold, it is only a matter of time before all niches within an industry feels the heat.

It is frequently mentioned how “show-rooming” destroyed Best Buy and other electronic stores. Would-be buyers would often just walk into a physical Best Buy store, check out the merchandise and order it online on Amazon. However, clothing was one area where a physical store still made sense. Buyers still prefer to try the clothes on before paying for it. It appears that Amazon is now trying to find a way around the problem. A Westfield shopping mall in London plans to offer a service to consumers that will allow them to try on clothes they purchased online. A bad fit or an unpleasing style can earn a customer a credit back on the spot. Online shoppers receive a text message when their item has arrived at the mall and is ready to be sampled. (SA) So instead of fighting show-rooming, the mall is making it easier for customers to do what they intended to do anyway. And retailers who sought refuge by going upmarket into clothing will now have to search for a new niche to occupy.

Amara’s law teaches us that we tend to overestimate the amount of change in the short term but under-estimate it in the long term. However, spotting disruptive business models early is very powerful but arguably difficult. Take a look at the newspaper industry, for example:

newspaper ad revenue

Years of steady linear growth followed by a cliff-dive.

In a recent article at HBR, Scott Anthony writes:

One way is to pay very careful attention to any development that fits the pattern of disruptive innovation – something that makes it simpler, easier, or more affordable for people to do what used to be complex or costly – emerging in the edges of your industry. You may see the signs in a fringe group of customers. Pay attention when college students pick up what appears to be an inferior product as a workaround substitute for one of your products. Or when they start behaving in new ways (as when they started providing status updates on social networks). Or you may see suppliers or distributors start to encroach on what you considered to be your business. Perhaps new competitors are starting to emerge from industries that historically had only a tangential connection to yours. Pay particularly close attention any time someone comes toward your market with a business model that looks highly unprofitable to your company or is based on a technology that no one in your company understands very well.

 

Easier said than done. But developing a keen sense of disruptive technologies in industries that one invests in is essential for success.

 

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Disruption in action

Long-term investing requires investors to understand the nature of innovation. No industry is safe from it, incumbents are constantly battling it and new business survival depends on it. The previous post briefly mentioned how Circuit City (filed for bankruptcy in 2009) was disrupted by Best Buy and was disrupted by Amazon. And, as it turns out, Amazon is now faced with similar disruption from Alibaba.

Before we discuss Alibaba, here’s the contrast between Best Buy and Amazon stock prices:

Best Buy Chart

 

Amazon chart

The business models of Amazon and Alibaba are different:

  1. Amazon has low margins (e-commerce), Alibaba has no margins (market-place monetized by ads)
  2. Amazon’s openly searchable and indexed website vs. Alibaba’s walled garden
  3. Amazon needs to make a sale in order to make money, Alibaba only needs visitors to search for something and browse through its pages

But if Alibaba can gain a foothold in the US, then it has to potential to impact Amazon’s economies of scale.

Juan Pablo Vazquez Sampere has this to say on the HBR Blog:

There are two possible ways in which Amazon can fight back:

  1. Amazon doesn’t react to this new challenge and continues focusing on its most profitable customers
  2. Amazon creates an independent business unit using Alibaba’s revenue model

 

Here’s the dilemma faced by investors:

  • e-commerce in the US is still a growth industry
  • e-commerce is still disrupting brick-and-mortar businesses
  • Amazon is still a dominant force in the e-commerce space in the US and is aggressively expanding overseas
  • Amazon is likely to lose money on low-margin businesses if it chooses to defend them against Alibaba, putting further pressure on its bottom-line
  • If Amazon decides to cede low-margin businesses and instead focus on extending the brick-and-mortar disruption that it had created, then it allows Alibaba to get a toe-hold. This is how most disruptive companies got their start
  • Both Jeff Bezos and Jack Ma are extremely competent leaders

 
Should investors hold or fold?
 
 

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Role of Innovation in Long-term Investing

I recently wrote about the difference between long-term investing and “buy-and-hold-forever”. Long-term investing requires investors to have a framework to deal with innovation. Sometimes, all it takes is one strategic mistake to sink an otherwise well run company. I am going to once again use the US context to frame this discussion, but it is applicable generally.

 

The rise and fall of Circuit City

Commercial broadcasting began after World War II. Few households owned TV sets but the medium was growing rapidly: The number of TV stations in the United States nearly tripled in 1949, from 27 to 76. The founder of Circuit City saw an opportunity and took it. Circuit City soon grew into a nationwide chain of discount electronic stores where commissioned salespeople helped the customers make their purchases. Salespeople were central to Circuit City’s business model, which depended on selling big-ticket, high-margin items and lots of extended service plans.

 

“Circuit City was at their strongest when consumers didn’t really understand what they were buying and were nervous about it.”

 

Then along came Best Buy. While their basic model was similar to Circuit City, Best Buy carried a wide variety of low-margin products to get customers in the door, such as computer peripherals, video games and CDs. As consumer electronics became cheaper and more ubiquitous, customers no longer needed or wanted a salesperson to help them with many of their purchases.Circuit City, on the other hand, stuck to its commission-based sales force and its reliance on high-margin products and watched Best Buy take over its market share.

 

“It’s a story of hundreds and hundreds of smaller decisions that added up to be destructive.”

 

You can read the whole story on Scribd.

The article doesn’t mention Amazon, though. Amazon pretty much turned Best Buy stores into showrooms for its products. Best Buy too went through its own existential crisis last year.

Charts of Best Buy and Circuit City:

circuit city

 

 

Value traps

It might look obvious, given the benefit of hindsight, that Circuit City and Best Buy were/are doomed. But the problem is that the road to zero is long and winding. At many points in the journey towards zero, the stock might appear to be a bargain. Take the recent bullish commentary on Cisco for example:

 

The stock “could return 20% over the coming year, not because the competitive threat isn’t real, but because the stock’s valuation appears to factor it in, and then some,” Jack Hough writes, in a bullish article on Cisco (CSCO). Hough notes that the “new threat” to CSCO is software-defined networks, and although “SDNs are largely in a proof-of-concept stage” with widespread adoption still years away, “some 20% of CSCO customers by then could be tempted to try commodity gear.”

 

So CSCO’s high-margin gear that is sold with a whole bunch of profitable services contracts is under threat from low-margin commodity gear that are “good enough.” Is CSCO a value trap?

Lessons from the PC massacre

John Kirk has a wonderful article on Techpinions that is a must read for all long-term investors:

 

The reason people don’t see disruption coming is because they compare one product to another when they should, instead, be comparing the needs of the consumer to the product that best serves those needs.

 

Read: How The Tablet Made An Ass Of The PC

Conclusion

Long-term investing requires investors to have a framework to think about innovation. As you saw in the examples above, nobody rings a bell to announce the arrival of a game changer. But by asking the right questions, investors can get a sense of which way the wind is blowing and get out of the way before the tornado strikes.

 

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Long-Term Investing vs. Buy And Hold Forever

I recently bumped into an obituary of long-term thinking by Morgan Housel at Fool.com:

Long-Term Thinking lived an illustrious life since the start of the Industrial Revolution, when for the first time, people could think about more than their next meal. But poor incentives and the rise of 24/7 media chipped away at his health. The final blow came Monday, when a trader on CNBC warned that a 10% market pullback — which has occurred on average every 11 months over the last century — could be “devastating” for investors. “That’s it,” Long-Term Thinking whispered from his hospital bed. “There’s no more room for me here.” He died soon after Bloomberg published its daily tally of how much the net worths of the world’s billionaires changed in the previous 24 hours.

 

But what is long-term-thinking/investing anyway? Should you just buy a bunch of stocks, toss them into the attic and forget about them? I think there is a fair amount of confusion between what “long-term investing” entails and “buy-and-hold-forever” type of investing and investors get into all sorts of trouble because of that.

The Indian Nifty index is fairly new, data goes back only till 1995. So I am going to try and draw parallels from the American experience. When Charles Dow first published his famous index back in May 1896, it had the following industrial stocks:

American Cotton Oil
Laclede Gas
American Tobacco
North American
Chicago Gas
Tennessee Coal & Iron
Distilling and Cattle Feeding
U.S. Leather
General Electric
U.S. Rubber

The only company that’s still around is General Electric.

Do you know what happened to the rest? The US economy shifted from being “commodities/agriculture heavy” to “services heavy.” So if you had stuck to your investments in any of the other large-caps from that time, you would have had zero to show for it today.

Long-term thinking means coming up with an investment strategy that takes a holistic view of innovation, industry/sector trends and economic maturity that has the same tenure as your investment horizon.

For example, if you want to hold corporate recruitment related stocks as part of your portfolio, then your process should have automatically picked up Linked-In and reduced holdings of Monster:

LinkedIn +84.46% in one year:

Monster World Wide +17.39% in one year:

 

LinkedIn disrupting Monster’s online recruitment business is not an isolated, random event. Monster similarly disrupted newspapers’ “help wanted” ads. Apple disrupted Nokia’s handset business, and so on. So going back to our example, your investment process not only should have automatically picked LinkedIn, but it should have also indicated how much of it you should own. Will your allocation be based on market-cap (LinkedIn: $23.63B, Monster: $739.87M)? Will they be equally weighted? Would it be based on balance-sheet strength? Quality-to-price?

Now extend this example to your entire portfolio. What sectors should you own? How much? What are the competitive dynamics within those sectors? These are some of the questions that a long-term investing strategy should address.

So how often should you churn?

If you think of your investment horizon as an arch, then your portfolio review “points” allow for piecewise linearity in your thought process.

Shortening the duration between the points allows you to be precise whereas lengthening them allows you to be accurate. How you make the trade-off between precision and accuracy will determine your portfolio re-balance frequency and hence your fees, depth of research, allocation strategy, etc.

precision vs accuracy

I agree with Housel insofar as avoiding the second-by-second tracking that is in vogue. But investors should not equate long-term investing with “buy-and-hold-forever.” So, what is your plan?

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