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Disruptive Innovation: Investing in the Right Side of Change

The next decade could be the most technologically innovative in history. However, investors still need to be cautious, as record-breaking technological advances are creating not just exponential growth opportunities, but also black holes in global economies and financial markets.

The Opportunity

Since the Dot-com crash in the early 2000’s, index funds, such as the S&P 500, have outperformed the vast majority of actively managed mutual funds. Now, Wall Street’s algorithms have finally caught on, and bankers are moving vast amounts of money into index funds, with increasing volume. This is great for the average investor because they can diversify their portfolios relatively cheaply. However, this passive investing strategy does not discriminate. It rewards every company in the index regardless of their brilliant strategy or their outstanding executive leadership - you just have to be one of the index companies. This is because their stock prices increase as money flows into the index funds, thus making equity offerings more lucrative to the company as they can raise more money by giving less shares away.

This has created a situation whereby innovative and potentially disruptive companies in the public markets, not yet included in the major indexes, have been overlooked by asset managers, who at the same time are searching for these similar types of companies in the pre-IPO space. In the past decade, the cautious investing attitude has led to investors staying away from small-cap innovative stocks. This has caused these stocks to remain undervalued, not in the traditional sense, as value investors would highlight, but in the sense that investors are not realising the true exponential waves of demand that will be unleashed once these companies are ready to hit the marketplace.

What is Disruptive Innovation?

Disruptive Innovation refers to a technology whose application significantly affects the way a market or industry functions. An example of modern disruptive innovation is the Internet, which significantly altered the way companies did business and negatively impacted companies that were unwilling to adapt to it.

Technology is seeping into every sector and blurring the lines between them. Instead of analysing different sectors, we need to identify innovation platforms that cut across different economic sectors. Investment Management firm, ARK Invest, believes that; artificial intelligence, energy storage, robotics, genome sequencing and blockchain technology are the innovation platforms leading the global economy into potentially the most transformative period in history. These platforms involve 14 technologies, this includes gene therapies, 3D printing, cloud computing, big data analytics, and cryptocurrencies. ARK Invest expects these innovation platforms to create trillions of dollars of economic activity and market capitalisation.

Figure 1: Estimated impact of innovation platforms on economic activity

Source: Ark Invest

A great example to illustrate how stock analysts are still looking at companies in terms of sectors rather than innovation platforms is the case of Tesla. Tesla has been analysed by auto analysts, who are focusing on a very mature industry. They are value analysts, looking at price to book ratios, P/E ratios and dividend yields. They find it difficult to analyse a company that is not simply an auto manufacturer, but also an artificial intelligence chip designer, autonomous taxi platform and energy storage developer. To put into perspective how important the autonomous taxi service will be for Tesla’s future profitability, gross margins for autonomous vehicle taxi services are in the 80% range, whereas for vehicle manufacturers, gross margins are in the 20-30% range. Analysts do not seem to understand how Tesla will evolve into these platforms, therefore, are finding it difficult to comprehend the current market capitalization. Thus, we constantly hear comments of Tesla being overvalued and due for an imminent price correction, a correction that never materialises.

Whilst traditional analysts may have been sceptical about buying Tesla, retail investors have been the complete opposite, driving Tesla’s price up by 700% in 2020. This is possibly due to retail investors using less fundamental analysis of the stocks financials and focusing on the future vision of CEO Elon Musk. Tesla could be the first of many examples, as investors realise the true potential of companies looking to disrupt stagnating industries.

Wright’s Law

Pioneered by Theodore Wright in 1936, Wright’s Law aims to provide a reliable framework for forecasting cost declines as a function of cumulative production. Specifically, it states that for every cumulative doubling of units produced, costs will fall by a constant percentage.

When the costs associated with one of the five previously mentioned platforms drops to a low enough level, we should expect demand to rise exponentially for these new technologies. To illustrate this, we can use the example of DNA sequencing. In 2019, DNA sequencing costs went below $1000, and the number of whole human genomes sequenced in that year was 2.6 million, more than half of all whole human genomes sequenced ever before. ARK Invest forecasts this to grow to over 100 million by 2024. As cumulatively more genomes are sequenced each year, the cost to sequence a human genome should drop to less than $100 in the next five years.

Figure 2: The Growth of Genomic Sequencing (Log Scale)

Source: ARK Investment Management LLC 2020 | Sequence volume is measured in whole human genome data equivalents, which is defined as 96 giga-bases of genomic data (3.2 GB genome at an average coverage of 30X)

The decreasing cost of DNA sequencing technologies will greatly impact the healthcare industry. Scientists will more easily be able to identify the ‘needle in the haystack,’ meaning that they can pinpoint specific disease-causing mutations in genes. Whilst gene sequencing allows us to understand where mutations are occurring within the DNA of a patient, CRISPR, a powerful genome-editing tool, allows us to precisely and relatively inexpensively correct the mutation. Therapies utilising CRISPR technology have the potential to revolutionise healthcare by curing monogenic diseases such as sickle cell anaemia, cystic fibrosis, paediatric blindness. Researchers are hoping the scope can be widened to more complex diseases such as cancer. CRISPR has the potential to generate $75 billion in global revenues per year. In addition, CRISPR’s one-time addressable market for individuals already living with monogenic diseases would be up to $2 trillion.

The companies in the public markets, pioneering these disruptive technologies, are not included in the traditional benchmarks and so do not receive the fund flows that we would expect. Any investor with a 5-to-10-year time horizon should definitely be taking a look at the companies associated with these technologies.

The Risks of Disintermediation

Among the sectors at risk of disintermediation are energy, industrials, consumer discretionary, communication services, healthcare, and financial services. As autonomous transportation evolves, the combination of robotics, energy storage, and artificial intelligence will collapse the cost structure of transportation, capitulating auto manufacturers, rail, and maybe even airlines. Traditional healthcare is likely to give way to the convergence of next generation DNA sequencing, artificial intelligence, and gene therapies. Meanwhile, traditional financial services are likely to commoditise, due to the rise of digital wallets and blockchain technology that will enable the convergence of consumer and business transactions, disintermediating the middlemen dominating the financial ecosystem.

Broadly defined, the sectors at risk of disintermediation account for more than half of the S&P 500. With the exponential growth trajectory, innovation is evolving at such a rapid pace, that traditional equity benchmarks are being populated with value traps, stocks that are “cheap” for a reason. These value trap stocks normally have attractive financial metrics; however, they are not investing enough into their businesses to keep up with the rapid changes to come in this next decade. Instead, they satisfy shareholders in the short term, via share repurchases and high dividends. What will be crucial for investment success in this next decade will be moving to the right side of change, avoiding industries and companies in the crosshairs of disintermediation.

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