We hear a lot of discussion about disruptive companies and their products. The media overuses and often misuses the term in its strictest sense. Companies that are being promoted as disruptors may be merely very talented and competitive. The confusion around what a disruptive technology looks like can be exacerbated by news stories that promote the 50 most disruptive companies. Their innovation may be radical, but not truly disruptive.
The ability to differentiate between the two distinctive versions of innovation, Sustaining Innovation and Disruptive Innovation, can be critical in identifying products and companies that could be either big winners or big losers.
Sustaining Innovation vs. Disruptive Innovation
We are all familiar with sustaining innovation because we see it every day. It is the improvement, refinement and increased performance of established products in major markets. Sustaining innovations can be incremental or they can be more radical in nature. Radical innovations are often mistaken for disruptive innovation. However, it is important to understand that even radical sustaining innovation rarely leads to the destruction of established companies. The vast majority of product innovations are sustaining in nature.
Characteristics of Disruptive Innovation
Disruptive products consist of generally known technology, packaged in some sort of unique architecture that enables the use of the product in applications that were previously uncommon, technically complex or prohibitively expensive for mass markets.
1) They are comprised of generally known technologies.
2) They have a unique configuration or architecture.
3) They typically underperform existing products.
4) They are cheaper, simpler and easier to use than existing products.
5) They target areas of non-consumption. (i.e. a market for this product is not readily discernible because current products are too expensive or too complicated).
6) They often lead to the destruction of known products, markets and companies.
Disruptive Innovation is subversive by nature and will have a devastating cause and effect on products, markets and companies including their total destruction.
How identifying or failing to identify Disruptive Innovations can affect your Portfolio
Identifying the distinction between a disruptive product innovation and a sustaining product innovation is very important for your investment decision. A company that creates a truly disruptive product innovation will over time enjoy outsized gains. Their competitors, if they do not address the disruptive threat, will likely experience the demise of that product category or even the entire company.
Early in their life, disruptive products will under-perform established, mainstream products but they will have features that are attractive to some customers. I recall reading George Gilder's reviews of the early CCD chips and wondering, who would ever use these? They were very cheap and getting cheaper, you could integrate them into almost any electronic device but the images they created were nowhere near the quality of a 35mm SLR. Today Kodak is out of business, a film based 35mm SLR is difficult to find and almost every cell phone has a quality camera included in its feature set.
Investing in Disruptive Companies
From an investor's point of view, it is important to observe that a truly disruptive technology can provide asymmetrical gains, offering upside potential in the disruptive company and short gains in the falling shares of established competitors that fail to address the threat these disruptors pose.
Apple's creation of the iPhone in 2007 using existing technologies created a severe disruption in the cell phone market. From the June 2007 announcement until its high in September of 2012 Apple (AAPL) stock doubled over two times. Over that same time period Hewlett Packard (HPW) declined from a high of about $53 to less than $15 per share while Nokia (NOK) stock declined from $45 to about $2. Palm, among others, is out of business and Blackberry (BBRY) may be another casualty.
Smartphone sales also started the erosion in the PC market. This erosion accelerated with the introduction of the iPad in 2010. IDC now predicts that tablets will out-ship portable PCs in 2013 and all PCs by 2015. We have already mentioned the decline in HP. Dell is another PC manufacturer that failed to respond to the disruptive effect of wireless computing.
Understanding and applying the principals of Disruptive Innovation can help you amplify your trading results on the long side, on the short side or with your pair trades.
The final take-away I would like to leave with you is that non-consumptive markets and disruptive products and companies exist in all areas of our economy. Don't think of this as a technology phenomenon. Tesla's (TSLA) electric car could be a disruptor in the automobile market and Uber (private) might be a disruptor in the transportation services market.
If you would like to learn more about Disruptive Innovation, study the works of Clayton Christensen of Harvard University. His many years of research on this subject have been documented in a number of books, papers and blogs.