As we discussed in yesterday’s “Markets” section, Q1 2022 has been a rollercoaster ride for global equity markets, and nowhere more so than in Technology stocks:
- The S&P 500 Tech sector was down 19 percent from the start of 2022 to the lows on March 14th; now, it’s only down 6 percent on the year.
- The ARKK ETF started 2022 by dropping 46 percent to the March 14th lows; it has rallied back 29 percent from there, although it remains down 25 percent on the year.
- China Big Tech, using the KWEB ETF as a proxy, fell 43 percent from December 31st through the March 14th lows; it has come back 48 pct from those levels, even if it is still down 14 pct YTD.
It is a perfect time, therefore, to go back to fundamentals and discuss exactly what constitutes “disruptive technology”. Its meaning is very specific. We rely on the work of Clayton Christensen, who first coined the term, for the most useful and concise explanation of the concept. There is a link below to an excellent 2015 Harvard Business Review article by him on the topic, but here is the highlight reel:
- “Disruption describes a process whereby a smaller company with fewer resources is able to successfully challenge established incumbent businesses. Specifically, as incumbents focus on improving their products and services for their most demanding (and usually most profitable) customers, they exceed the needs of some segments and ignore the needs of others.”
- “Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable functionality – frequently at a lower price. Incumbents, chasing higher profitability in more-demanding segments, tend not to respond vigorously.”
- “Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offering in volume, disruption has occurred.”
Simply put, disruption starts with a new company using a fresh approach that can make money offering cheap products or services to an overlooked customer base. Incumbent companies ignore the upstart. It’s not worth their time and capital to fight over low-end segments and less affluent customers given their existing business model. But, over time, the same edge that gave the upstart its entrée into the market allows them to offer improved products and services and climb up the value chain.
Now, you might rightly say, “Wait a minute… Tesla is a disruptive company and it started by selling expensive cars, not cheap ones… And Apple’s first iPhone was $499 in 2007 … That wasn’t cheap either …” Very true, but there was no competition for electric vehicles when Tesla launched the Model S in 2012 or for mass market smartphones when Steve Jobs announced the iPhone at MacWorld in 2007. Neither Tesla nor Apple had to start with a low-end product; Musk and Jobs were inventing new product segments with dramatically different attributes from existing offerings. And, let’s face it: Musk and Jobs are exceptions to almost every business rule anyway …
Put another way, true disruptive innovation starts at the low end of a market, but not all successful tech innovation needs to start with a bargain-basement offering. If an upstart is coming into an existing market with deep-pocketed incumbents, however, they do stand a much better chance of success if they can be profitable at the low-end due to a tech-enabled competitive advantage. Existing competitors will be much more likely to cede this less-profitable segment of their market, after all.
Now, if disruptive innovation is such a well-marked path, then why are the stocks of many disruptors so volatile and often outright money losers? The simplest answers are 1) management makes a mistake and 2) the business environment changes. Those issues can plague well-established companies as well; building and maintaining a business is hard and not everything works. But here are a few issues that are unique to disruptive tech companies:
- Many public disruptors have tried to skip the “make money” part of Christensen’s paradigm of “make money at the low end of a market”. That leaves them to the vagaries of capital markets for incremental funding and, in the worst-case scenario they simply run out of cash.
- The enabling technology to address the low end profitably is not ready for prime time. Imagine where Uber’s stock would be if they actually had cracked the code for autonomous driving. But … They haven’t. Which is why the stock trades below its IPO price even today.
- Customers are also citizens of a country, and not all governments like disruption. Chinese Big Tech stocks have taken an absolute pounding over the last year because the national government felt the industry’s pandemic-fueled growth was bad for the country and stepped in aggressively to curtail their powers.
- Valuation matters. This is true everywhere in capital markets, but disruptive tech companies are more easily mispriced thanks to the binary nature of the potential outcomes. Either they will succeed, beat incumbents, and create global franchises, or they will not. The first is worth $1 trillion, the second is worth zero.
Takeaway: disruptive innovation is a very specific concept, and both companies and investors are best served when they understand exactly what it is and why it works. As with any playbook, experts can take some liberties and still achieve a good outcome. For the rest of us, Christensen’s paradigm is worth understanding.
Christensen HBR article: https://hbr.org/2015/12/what-is-disruptive-innovation