Capitalising on opportunities created by disruption is, in our view, a key investment theme in the 21st century as technology advances the pace of change, but the concept of disruption itself is not new – it is simply a modern-day term for the change to a longstanding phenomenon that has underpinned economic development for a period of time.
From an economic standpoint, disruption leads to efficiencies by reducing costs and introducing new goods and services, as well as fast-tracking and improving business outcomes. Society has benefited substantially from the competitive and innovative forces upon which disruption is founded, helping to raise living standards.
From an investment perspective disruption is simply a structural change in the economy derived from some form of product, process or service innovation that expands an existing market or creates a new one. Often it disrupts an existing value network or profit pool and can displace established market-leading firms who often become the donor of economic rents to the disruptor.
But investing in disruption alone is not a recipe for success.
Winners and losers
It is important to remember that for every winner of a profit pool shift there must also be a loser and herein lies the explanation for why, as investors, it is crucial to understand structural shifts. Being on the right side of a structural shift can be a useful tailwind to profit growth, while being on the wrong side can be very painful – as many offline retailers (and their shareholders) have discovered to their cost.
Nevertheless, being positively exposed to structural shifts (or disruption) does not in itself define a sound investment. Far from it, it is perfectly possible to be an unprofitable disruptor with disastrous outcomes for shareholders. The graveyard of would-be disruptors is very large indeed.
The importance of cashflow
Ultimately, long-term share price performance is almost entirely explained by the trajectory of cash flows, thus successful companies (and successful investments) are those that can be relied upon to generate a persistently high and sustainable cashflow from their assets over many years and expand those cashflows well into the future. High risk-adjusted compounding of cashflows are a useful measure to define a great company and a potential long-term investment opportunity.
The question is what determines above-average, risk-adjusted cashflow compounding over the long-term at a corporate level, and where does disruption enter into the equation?
Turning disruption into long-term competitive advantage
Structural shifts aided by disruption can provide important tailwinds to growth that can help reduce demand cyclicality and allow cashflows to expand over a long period of time.
We belive investors should consider companies that have a growing market for their products and services as a result of facing into a positive structural shift and avoid those that are negatively exposed to growth headwinds as profit pools shift away from them (the disrupted). But this is only the first stage of being a successful wealth creator. The most important requirement of all is to be able to generate high and sustainable returns on capital persistently over a very long timeframe and this is a function of possessing a substantial and enduring competitive advantage; strong capital allocation decision making; and certainty of demand. Only when all these components are aligned is an investment genuinely great, while failure of any of those fronts can have significant and costly consequences.
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