A loyal reader pinged us after last night’s Disruption section, where we outlined Ben Evans’ 2021 year-end lookahead presentation (link below). “Technology”, he very rightly pointed out, is a term we can apply to any innovation that fundamentally changes how humans live. The wheel, the internal combustion engine, air travel … All were disruptive technologies for decades, if not centuries.
But, as the loyal reader went on to say, innovation always runs its course in terms of excess return on corporate capital. To our thinking, this occurs for 2 reasons:
- First, markets reach saturation and become largely cyclical. For example, from 1950 to 1970 US demand for light vehicles (passenger cars and light trucks) grew at a steady pace due to rising incomes and suburbanization. American car companies made reliably high profits. Then, the 1973/1979 oil shocks/recessions came along and the business of selling new cars and trucks became much more cyclical. It has been thus ever since.
- Second, new competition enters the market. Carrying on with the auto industry example, first Japanese and later South Korean makers started selling modestly priced, fuel-efficient vehicles in the US. They ran the classic Christensen disruption paradigm of entering at the low end of a market and growing upwards into more expensive, value-added products. Domestic US carmakers lost market share and earnings power as a result.
- Combine the two and you get a post-innovation end stage of hyper competitive market where few (if any) companies can earn a decent return on capital. That leads to lower valuations and, eventually, financial distress for the weaker players in a recession. One need look no further than the auto and airline industries to see how once-powerful, disruptive companies can end up troubled, a tiny shadow of their former selves.
Against this time-proven paradigm, it can be easy to dismiss the current crop of disruptive companies and future technologies like the metaverse or virtual currencies as simply faddish investment themes. Easy, but in our view, wrong …
Putting aside for one moment whether US Big Tech is a “Buy” or “Sell” here, the humble cassette tape is an excellent example of why disruptive technologies are worthy of investor attention:
- Cassette tapes were invented just after World War II and became popular in the 1960s as the first convenient, low-cost way for users to record music and the spoken word. (Again, disruption happens most easily and pervasively at the low end of a market.)
- In the 1970s, an exiled Iranian cleric by the name of Ayatollah Khomeini began recording anti-government sermons. These quickly found their way back to his home country where they were copied and played at Friday services.
- You probably know the rest of the story: in 1979 the Shah fell to a revolution and Khomeini returned to Iran to become its first clerical supreme leader.
- Where, one might wonder, would oil prices be today without the cassette tape? What would US foreign policy have been from 1980 – present? Would there have been a Gulf War I or II? Perhaps the Shah was destined to fall, but recording tape housed in a cheap bit of plastic certainly hastened his demise.
The bottom line is that disruptive technologies change the course of history. Yes, Sony generated huge financial returns from the Walkman but that is not the most important thing about why cassette tapes were an important technological innovation. One can, of course, make a similar observation about social media today.
Now, as far as why Apple or Google or Microsoft are not directly analogous to, say, General Motors in its heyday in terms of being at risk from the classic reversion to the mean of corporate returns on capital, three thoughts:
First, there’s Moore’s Law (semiconductor speed/$ doubles about every 2 years), which allows tech devices to do more over time and (importantly) do those things more cheaply. Yes, there are those that say we’re about to reach an end state due to physics (there’s only so small you can make circuits before atoms can jump haphazardly between them) or cost (making cutting edge semis is expensive). The work-around is to specialize chips around specific functions and optimize the software that runs on them. NVIDIA’s success on this front is proof there’s still room for Moore’s Law to run even in the face of the constraints we just noted.
Automobiles have seen no such improvement in utility since the 1950s, and the one feature that has gotten better – reliability – actually dampens demand since it allows for incrementally more used cars in the system. That feeds into the cyclicality problem we outlined earlier. Yes, cars have become measurably safer, but that does not add to aggregate demand.
Secondly, there is global mobile internet access. According to GSMA, a mobile operator trade group, 51 percent of the world’s population uses mobile internet, some 4 billion people. Also, 94 percent of the world lives in areas with access to high-speed mobile internet. The difference between the two percentages represents potential future growth. Even with current market penetration, however, this market is vast and open to new products and services. Fintech, ecommerce, social media… All can scale efficiently into a globalized market.
Light vehicles, by contrast, both have a smaller addressable market (since they are more expensive than a mobile phone) and have always faced challenges entering new geographies. On top of that, selling a car is largely a one-and-done transaction with little opportunity for reliable follow-on revenues outside of service parts. That leaves return on capital to the vagaries of economic cycles.
Lastly, there’s market dominance due in part to network effects. No need to expound on this idea: we all live it every day, Googling on iPhones and using social media or downloading a PowerPoint presentation. The moats in Big Tech are beyond anything the auto industry could ever hope to have. Switching between Chevy and Ford or BMW and Mercedes is dead easy, but imagine a world where you couldn’t use Google or an app store to download software you knew would work at least reasonably well.
Summing up: the point here is not that Big Tech is immune to the age-old pattern of eventually commoditized returns on capital, but rather that it sits atop commanding heights with few historical precedents. This position allows them to grow longer than traditional business models and remain in a central spot to collect excess returns. Will there be some new mega-disruptor in the next decade that might supplant an existing giant? We certainly hope so. The only thing that has made US large caps a better investment than the rest of the world over the last decade is companies that create and profit from scalable disruptive innovation. We don’t really care where the next leg of growth comes from (new or old players); we just care that it occurs.
Sources: Ben Evans’ 2021 presentation (highly recommended): https://www.ben-evans.com/presentations/