The disruption dilemma

Technology change presents risks as well as opportunities. Identifying and valuing these risks is crucial to preserving investor value in both the short and the long term.

‘Disruption’ is the latest technology buzzword of the financial press. The spotlight mostly focuses on the disruptors boasting innovations that will revolutionise the way we consume and interact.

Whilst it can be enticing to focus on the emerging technologies, it’s perhaps more important for investors to focus on the disrupted incumbents left in their wake: these companies represent a far larger portion of the investable universe. This is true for equities but is especially pertinent in fixed income; disruptors typically fund their growth through private equity whilst the cashflows of incumbents often flow back into the debt markets.

The chill wind of Schumpeter's gale

The concept of corporate disruption emerged from the “gale of creative destruction” described by Joseph Schumpeter to articulate the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one”.

It was taken further by Clayton Christensen of Harvard Business School, with a simple premise. A product or service starts small, initially appealing to a limited audience that often isn’t served by the incumbents. As a result, it can be easily and rationally overlooked by established companies unwilling to lower their quality threshold or price points to address the new customer base. Incumbents can therefore be unprepared when the true disruptors mature, increase market share and threaten the status quo by growing into the incumbents’ core markets.

Much as corporate boardrooms can underestimate the risks of creative destruction, investors may struggle to identify the risks posed by new technologies to established blue chip firms – the companies which often form the core of a typical fixed income or equity portfolio, and are cornerstone tenants of commercial real estate.

Correctly identifying and valuing the risks posed by technology change is therefore crucial to capital and income preservation over the long term across all major asset classes.

Look up, look down, look all around

In order to construct and monitor portfolios to reduce technological disruption risk, we try to remind ourselves to look up from the minutiae of the current status quo, look down at the new entrants at the bottom of the quality or price pyramid, and look all around at potential threats from outside the existing value chain.

However, every situation is different, and the market reaction to technology risk can just as easily be overstated as underestimated. It is crucial to continue to apply the cold logic of cashflows against the theories of creative destruction in order to calibrate the risks against the opportunities.