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Disruption and Darwinism


By Pengana Capital

Much was written about the attraction of 'disruption' by investment analysts during 2015. How new technology is enabling smaller, smarter and nimbler start-ups to build disruptive business models by achieving the 'magical trifecta' of better service to more customers at a lower cost.

Buzzwords associated with these concepts:

Collaborative software allows many users to share information by collaborating on a common platform eg Uber and Aconex.

The network effect exists when a rise in the number of users with a common denominator, usually location, creates an exponential increase in efficiency eg Airbnb and Domino's online.

First-mover advantage suggests that the first company to establish critical mass and meaningful scale gains an extremely strong position eg Google Search and carsales.com.

Global operational leverage occurs when businesses can spread their cost base over a global customer base providing a cost advantage over localised competitors eg Netflix, Amazon and Aristocrat's online games.

Investing in a 'ten bagger' by picking the next Google or Facebook is harder than it seems. Survivorship bias means investors remain focused on the few companies that 'make it' rather than the multitude of ones that don't. Furthermore, rapidly growing disruptors carry additional investment risk.. Depending on how hot investor sentiment is at the time, this risk may include a lack of any cash earnings to underpin a valuation as the business grows its way to scale; as well as lofty future earnings or revenue expectations, or whether there is even available market share for the company to capture.

The preference at equities fund manager Pengana Capital Limited has been to find existing companies with proven robust business models and competent management at the right price, who are using technology to either grow their target market, lower costs through efficiencies or strengthen their customer service proposition.

Two pertinent examples

ResMed is a home-grown global medical device company that designs, manufactures and distributes flow generators and masks to treat sleep apnea. By connecting each flow generator through a network similar to Amazon's Whispernet for the Kindle, the company has successfully connected patients, sleep doctors and equipment suppliers to a common database that enhances efficient and effective service at substantially lower cost. First-mover advantage has provided sales momentum in excess of 40% per quarter while simultaneously establishing a closer brand connection with its customers and end-users.1

Tatts Group, the domestic lottery provider, has successfully increased its distribution of products by offering them online. Previously, lottery tickets were sold exclusively through newsagencies. For every $109 spent by the consumer on tickets, $9 stayed with the newsagent as a distribution fee, $60 went to players as prizes, $30 went to the government and $10 remained with the operator to cover costs and profit.2 The online offering has broadened the company's target market without requiring an intermediary or increasing its associated distribution costs; while simultaneously creating a direct interaction with its customers.

The Darwinism of modern capitalism continues to allow the strong players to survive (and even flourish) while whittling away the inefficient. Our challenge as investors is to be able to identify and back the winners while reducing the risk of being led down an evolutionary dead end. Be careful, it really is a jungle out there.

1 Resmed, March and June Quarterly Earnings Report.

2 Numbers as per company meeting notes.Securities mentioned in this article may no longer be in Pengana's portfolio.

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