This post explores the Late Harvard business professor Clayton Christensen work on disruptive innovation (The Innovator’s Dilemma: When new technologies cause great firms to fail), which could serve as useful mental model for the equity investor.
Disruptive Innovation: The Source of Real Growth
Disruptive innovation is an ongoing process inherent to capitalism that occurs whenever resources, technology, products, and services which used to be accessible only to a minority of consumers at high prices become simpler and more widely accessible at lower prices. This happens naturally by the forces of competition and entrepreneurial spirit. When it happens, many if not most incumbents get killed or barely survive.
Whenever disruption occurs, marginal costs of producing goods and services are substantially reduced. When marginal costs of production are reduced, so are prices, making goods and services even more accessible to more people. When prices collapse, however, it inevitably kills companies unable to adapt and companies that compete on prices only though industry consolidation.
The incumbents most threatened by disruptive innovation are the mature large-capitalization companies as the current market position they enjoy is the result of having been successful in maintaining high margins and high return on capital to please their best customers and investors without having to innovate in a disruptive way.
The Return on Capital Imperative
The classical models of success taught in business and corporate finance are based upon the idea that the higher the returns, the better. In classic economics, capital is said to be scarce. So, it is only natural that shareholders commit capital only if they expect to recoup it as quickly as possible.
Various metrics, such as return on invested capital, have been developed and institutionalized in line with the objective of being able to measure how quickly capital can be recouped. Such metrics have become what is expected and sought by investors. This explains why dividend increases and share buybacks generally make investors happy.
Margins and Competition Layers
When a company reaches the level where it generates the high metrics it is expected to deliver to shareholders, it is the result of a long process of adapting and moving up the margins layers from the bottom activities deemed non longer desirable to pursue. It does not make sense to allocate capital to compete with new entrants on a level playing field where margins are less attractive or where the competition does not answer by conventional metrics.
The process repeats itself until the company’s focus shifts entirely on the high-end segment, at which point it has improved its existing products and services which it can sell to its best customers only (the more sophisticated and well-off) at high margins and high return on capital.
Investors are pleased, but in the long term, new entrants, or disruptors, will continue their ascension to the top, pushed by even lower entrants, collapsing prices and margins relentlessly.
Sustained Innovation
This has major consequences. Companies develop a relatively finite time horizon as they must adopt a strategy around returning capital quickly, which at the same time kills innovation and, eventually, the business. The incumbent innovates only so much as to move up to the higher end of its market scale by incrementally improving and perfecting existing products and services to sell to its best customers, where it can maintain high return on capital. This is referred to as sustained innovation, not disruptive innovation. When they reach the ultimate level, incumbents are left in a corner in which they painted themselves.
Efficiency Innovation
For each layer of competition, incumbents face disruption risks from the entrants at the lower level, forcing them to compete among themselves on operational efficiency. When a company operates on efficiency only, it has no durable competitive advantage. When price competition intensifies, prices collapse, and businesses get killed or zombified. This is what happened to the steel, personal computer, and car industries to name a few. It is also arguably what has Japan witnessed because of their lack of robust venture capital markets.
The assailed incumbents can not just “re-invent” itself or try to compete head-to-head with disruptors. It has not evolved in a way to survive that environment and the mere attempt to do so would scare away investors accustomed to the returns that fit the accepted metrics they understand and were taught to believe in.
In answering by the metrics that they are expected to by business schools and investors, many great and highly performing businesses create their their own demise.