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The power of disruptive innovation


By Antares Equities

Innovation is all around us and is constantly changing the world. When a company is considered as an investment, innovation – both current and potential – must be analysed, as it can have a huge impact on long-term investment returns.

Sustaining or disruptive innovation

Technological change and innovation can be either 'sustaining' or 'disruptive'. This distinction is important as the implications are very different.

'Sustaining innovation' occurs when a company improves or updates its existing products or services. This can involve big leaps in technology and significant improvements in the company's market share and profitability, but it only affects their current products and markets, so the market is maintained.

'Disruptive technology' creates new markets or new value networks. This sort of innovation displaces the existing technology and completely disrupts current market dynamics. A disruptive innovation can take years or even decades to become dominant, so there is usually time for existing companies to respond. But history suggests they rarely do. Existing companies often know about the innovation, and in some cases, they've actually invented it! The problem is, they are often so locked into the way things are currently done, that they place insufficient value on new ways of operating. Disruptive innovations are usually exploited by smaller, more efficient or more flexible companies who can see the long-term benefits of significant change.

Disrupting current market dynamics

A great example of disruptive innovation in Australia is the structural decline of Fairfax Media Limited.

Fairfax was the dominant player in classified advertising, which was coined its 'rivers of gold'. Fairfax's problem was that it underestimated the impact of the internet and the way smaller companies like Carsales.com Limited, REA Group (owners of realestate.com.au and more) and Seek Limited would exploit this new technology to create a completely new operating environment.

Chart 1 shows Fairfax's revenue losses since 2008 – around A$1 billion – and the corresponding revenue gains that have accrued to its competitors in the classified space – carsales.com, REA and Seek. These competitors were successful because they had pure play advertising models, they operated online so their advertisements were cheaper to produce and provided more scope for content, and there was better accessibility for those looking to buy their products.

Chart 1: Fairfax's huge loss represents gains for carsales.com, REA and Seek


Source: Antares Equities Research, company data is cumulative since 2008-2015.
Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.

Opportunity or threat

From an investment perspective, analysing the potential for disruptive innovation has to be an important part of the research process as it has such far-reaching implications. For example:

The Innovator – do they choose to exploit the new technology or undervalue its potential and miss out on the opportunity?

The Beneficiaries – which companies can leverage the new innovation and will they do it successfully?

The Losers – which companies stand to lose the most from the new innovation and will they respond fast enough to avoid being left behind?

These questions are important as they highlight that disruptive innovation doesn't just create investment opportunities, it creates investment risks as well. Working out which companies stand to lose from a new innovation is just as important from a portfolio perspective as investing in those companies that have the potential to gain. 

Table 1: Disruptive innovations and the ASX

This table provides a couple of examples of the views held by Antares Equities on the potential opportunities and threats of some current disruptive innovations.

Disruptive
innovation
Some potential beneficiaries Some potential
losers

Internet of Things – the increased connectivity of devices and everyday items to the internet and cloud based applications.

Telecoms with networks (Telstra, TPG, Vocus Communications/M2 Group), data storage (NEXTDC) – significantly increased data downloads and internet usage. 

Private health insurers (Medibank Private, NIB) – software enabled medical devices should make diagnosis easier, enabling earlier treatment and shorter hospital stays.

Electricity generators and distributors (AGL, Origin, Ausnet, Spark Infrastructure) – smarter homes, grids and cities should have lower base load energy demands.

Private hospital operators (Ramsay Health Care, Healthscope) - software enabled medical devices will make diagnosis easier, enabling earlier treatment, and potentially less demand for hospital beds.

Gene therapy
– the ability to replace faulty genes in cells without the use of medication. Potential to eradicate certain genetic illnesses.

Companies that develop the technology successfully.

Companies that treat existing genetic conditions (eg Cochlear – genetic deafness; CSL – genetic haemophilia).

 

Securities mentioned in this article are not recommended as an investment by, and may not be held by Antares Equities.

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