What Does Disruption Mean For Investors?
The Investment Perspective – February 2021
Peter Flannery CFP AFA
“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business”
For us as investors, this is businesses that see a gap in the market whether it be outdated practices and new ways of doing things or a technological advantage that incumbents have yet to develop.
These are businesses that reset what is thought to be common practice and take market share from the tired mature corporates that have become bureaucratic monoliths and lost the innovative streak that helped set them up, back in the day.
There is quite a bit going on in the disruptive space. Examples that are well-known would include 3D printing, electric motor vehicles and banking.
3D printing has revolutionised manufacturing in some areas but is still only in it is infancy.
Electric motor vehicles are all the rage with Tesla taking pole position in terms of branding.
Banking has been undergoing a somewhat slow change in the past from person-to-person servicing to ATMs and website servicing along with the closure of branches and scaling back of staff. The restructuring for banks has only just begun with the advent of digital wallets that have been around for a while but now starting to develop some real momentum.
It is possible that mainstream banks that have taken decades to grow to their current size, could be undercut by mobile apps that allow people to borrow money online electronically. More specifically, the growing space appears to be unsecured lending which traditional banks do not like.
For example, if I am over age 50, I may want to walk into the bank and have a chat with the nice girl at the desk who pretends to be my best friend and promises me that she has giving me the best deal possible etc., etc., etc.
I would also want to leverage my assets to secure a cheap interest rate.
If I am younger than 30 I will not be interested in even talking to some ‘idiot’ at the bank but rather go where I always go. That is online to Google the different options to find a website that has good ratings and appears trustworthy so that I can then make an enquiry. Long story short, I will have likely secured a loan without too much hassle in no time at all.
These are simplistic examples but they represent the shift, driven by digital technology that is been around now for some time.
The thing is, it takes time for us to work out how to use this technology and I believe we are pretty much at day 1 with regard to the advances that are coming our way over the next 10 years. That of course is where the opportunity lies with disruptor style investments.
However, they are not all winners. Some are abject failures and will cost investors who aren’t careful – lots of money.
When analysing a disruptor, we are using some of the matrix we always use (e.g. the economics of the business) whereas other traditional financial analysis just simply does not provide a true picture.
The classic is the P/E ratio which compares the trading price with the earnings. When we are looking at small young growing businesses, the chances are, there is no profit and so the P/E ratio gets a N/A.
Although there is more to it, these businesses are measured by the number of new customers, turnover growth and other metrics, such as how they benefit from the network effect.
In simple terms, the network effect is where new customers joining a business create more customers. Facebook is one example, Google is another. Basically the network effect is created when users share their knowledge and experience about the product, service or content with their friends and others. This occurs because the service or product delivers better value than is obtainable elsewhere. Where would we be without a search engine on the internet!?
Does traditional analysis no longer matter anymore?
Yes it does.
In overly simplistic terms, at one time or other you would have heard about the game called “musical chairs”. When the music stops everyone has to sit down but of course there is one less seat than there are people. Somebody misses out on a chair.
We live in a global economy that is swimming in liquidity (previous easy money conditions, central bank fiscal and monetary stimulus …… you know the story). In this environment start-ups or young companies have a better chance of getting up and running, growing and staying alive until they can sustain themselves.
In a less liquid environment, markets are not so free and easy with their money and therefore innovation to some degree is held back.
Certainly the funding of businesses is carried out through a different set of eyes and a different perspective in each of those very different environments. At the same time, it appears difficult to stop an idea whose time has come.
Back in the day, electricity at first was believed to be very dangerous and indeed there were campaigns against the adoption of electricity. Eventually though, the idea won over.
Same with (petrol) motor vehicles. At one point there was a law in some States in the US where a person had to walk in front of a motor vehicle to signal to people that a motor vehicle was coming! How things have changed.
There have been numerous internet search engines over the last 20 years or so but a lot fewer now. Baidu from China and Google are the standouts.
Electric motor vehicles have captured the imagination of the motorised world and this industry is in full swing. Watch the competition in this space become quite intense in the future. Right now there is obviously Tesla (that everyone in the world has now heard of) and Nio out of China (that is becoming more mainstream but not as widely known as Tesla). There will be others …
The above is just a brief overview and is not financial advice or a recommendation to buy either Nio or Tesla (talk to your advisor first!).
On balance both appear to be worthy contenders in the EMV space with Tesla perhaps looking like a somewhat better business due to it is ownership structure and Elon Musk at the helm.
Nio has some awkward ownership issues, being owned by an investment company that could exert control over management if things do not go too well in the future. This may never happen and is a contingent risk that is worth knowing about but may not be one that actually eventuates.
Nio can be innovative too e.g. offering purchasers the opportunity to lease the battery at $US150 per month and therefore lowering the cost of their cars, making them more competitive.
Tesla looks promising with Elon Musk working his magic although I would regard Nio’s opportunity being based in China, in the Chinese market as potentially greater than Tesla’s.
Tesla can achieve great things but will have to work harder in that market. Nio has the advantage of being a Chinese business in China – home turf.
The American Elon Musk is a formidable entrepreneur although William Li also has a solid track record in China. As they go ‘head to head’ it will be interesting to see who takes market share and who becomes increasingly more profitable. Time will tell.
Nio versus Tesla
In simple terms I favour Nio’s opportunity with a much larger market in it is home turf but remain cautious about the ownership structure. The company benefited from government support in a recent bail out and also is partly owned by an investment company that, if things did not work out too well for Nio, could see this investment company have more say than the management of Nio might like and therefore, more control over the company should conditions become difficult.
I like Tesla the business for a number of reasons over Nio although they will face competition but they have a good opportunity in China. There is one significant risk, the so-called asymmetrical risk (unlikely to happen but if it does it is a game changer). This risk is the star performer Elon Musk. Basically he is Tesla. Unfortunately he is only human.
He is an awesome human in many respects and has achieved massive success. If he is taken out of the company there is a real question mark over where that company gets to in the future. You can imagine the competition being “all over it” if that were to occur at some point for whatever reason.
Disruptor investments and your portfolio
Should you invest in disruptors?
This depends on your investing strategy.
In general terms, if your investing strategy is Balanced or Growth, disruptor style investments would be considered too risky.
If your investing strategy is Towards Advanced Growth or Advanced Growth then some exposure to disruptor investments maybe appropriate.
That said, there are some examples where even businesses with disruptor tendencies that are highly profitable could be considered by those that are perhaps ‘less advanced’ in the way they prefer to invest. PayPal comes to mind as it is a ‘share of wallet’ disrupter and their payments technology is a direct attack on the banking system.
Carefully selected disruptor businesses offer growth for some investors.
Perhaps predictably, I would say that we need to be cautious about chasing the share price as it races upward. We do not want to be left standing when the music stops.
“There is a tremendous bias against taking risk. Everybody is trying to optimise their ass covering”