While creative disruption is nothing new — machines have been replacing human workers for centuries — today’s technology is disrupting long-entrenched business models such as infotainment, advertising, retailing and enterprise information technology faster than ever. Creative disruption has enormous implications for investors, particularly in the current environment where active investors have been challenged by persistently high price correlations among stocks for several years. Low volatility has compressed price dispersion, making it difficult for active managers to realize alpha or to outperform benchmarks, as prices have largely moved in lockstep for many years. We believe, however, that the climate is changing and that investors may be able to profit from alpha opportunities that are present in the market. Identifying the disruptors and those most at risk from them can provide compelling alpha opportunities, allowing investors to potentially prevent return shortfalls in portfolios.
Disruption and the stock market
Investors don’t need to look far to find examples of creative disruption and the potential for outperformance — or obsolescence. A quick scan of 2015 equity returns reveals that some well-known disruptors outdistanced the pack. Performance of the so-called “FANGs” (Facebook, Amazon, Netflix and Google) ranged from 34% to 134%, far outpacing the 1.38% performance of the S&P 500 Index (see Exhibit 1). Without those four stocks, the index would have been negative for the year.
As these four companies have shown, disruptors are growing fast and large while supplanting some older, legacy businesses. Large-cap companies are moving in and out of the S&P 500 Index at a faster rate. In 1965, for example, the average amount of time a company was listed on the S&P 500 Index was 33 years, a figure that narrowed to 20 years in 1990 and is forecast to fall to 14 years by 2026.1 At this rate, half of the index will turn over in just 10 years. Having insight into which companies might thrive in this winnertake-all environment can be a powerful source of investment returns and growth over the long term.
Identifying opportunities on the S curve
While much time is spent dwelling on the relationship between stocks and macro factors such as productivity, interest rates and even presidential elections, earnings and corporate profits are what tend to drive share prices over time. This also holds true for today’s ambitious disruptors, as well as for potentially disrupted companies. One of the keys to identifying the winners and losers in this climate is determining where a company’s product, service or technology falls on the “S curve” life cycle (see Exhibit 2). The S curve illustrates the path a company’s product or service takes as it evolves from high-cost, low-adoption to low-cost, mass usage. There’s a period during this lifecycle when tremendous growth may occur. When companies reach the peak of the curve, growth wanes and future viability becomes less certain. Some companies evolve, innovate and experience new S curve growth, while others become disrupted themselves and their margins decline. Where a company is on the curve or in a life cycle has major implications for its profitability and is ultimately where its return potential lies, either positive or negative, for investors.
Finding inefficiencies in growth stocks
Predicting tectonic shifts in a market or industry — such as technology companies supplanting auto manufacturers — is extremely difficult. This is where active management can add value. We believe there are inefficiencies in large-cap growth stocks that can be exploited, because investors tend to overpay for yesterday’s profits while undervaluing tomorrow’s. Most analysts, for example, are focused on quarterly and annual growth projections, while very few forecast earnings beyond those short-term windows. The “out years,” or the time horizon extending beyond those periods, is where we believe the inefficiencies lie because it requires a trait largely absent in capital markets today: patience
The landscape will likely look much different three years from now, which is why it is critical to sort through these secular trends and identify the companies poised to capture market share and margin versus those most at risk for giving up profits. Disruption is occurring across industries and sectors more than ever, creating both opportunities and risks. Media, for example, is becoming a digital and direct-to-consumer proposition. “Over-the-top”, which is the delivery of content over the Internet, has given consumers the option to “cut the cord” and move to subscription-based models, disrupting the entire media landscape. Online shopping platforms, to cite another example, are disrupting the traditional brick and mortar retail model. The Internet has effectively shifted the supply of goods for sale at a rate that has dramatically outpaced demand, resulting in a supply/demand imbalance that has deflated pricing to the obvious benefit of the consumer and to the detriment to the traditional retailer. Retailers at risk have been, and we believe will continue to be, those whose goods can be sourced by consumers online, offering greater convenience or better pricing. In yet another example of disruption, IT departments continue to shift their budgets away from legacy equipment and services to Web-based platforms that offer both cost and convenience advantages. The traditional IT “stack,” which consists of computers, data storage, and services is being disintermediated by more efficient and cost-advantaged online platforms.
Seeking to avoid underperformers for better return potential
There’s no guarantee that a fast-growing company will experience explosive growth and redefine an entire industry. This is why having a sound risk management process is also critical in a growth strategy. Disruptors need to be risk weighted, based on valuation, in the event that they themselves become disrupted. However, what makes today’s market environment so unique is that the universe is littered with companies that are at risk of losing substantial market share and profits. Business, like most things in life, isn’t linear. Today’s stalwarts are by no means guaranteed to continue on a steady, upward trajectory. Yet many investors invest that way. We believe there exists an abundance of yet-to-berealized alpha by owning disruptors, but perhaps the best opportunities to outperform are to avoid the vast and growing number of disruptees. That’s why we think understanding what a company does and its potential to disrupt — or to be disrupted — is critical to making investment decisions in this landscape.
1 Innosight Executive Briefing, 2016.
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