The Era of Disruption - November 2022 Update
It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change
Issues to be addressed in this paper
“Business platforms have been disrupted for hundreds of years. Ever since the industrial revolution when innovations first gathered momentum, it has happened fairly regularly, but the advent of digital technology has had the effect of accelerating the pace quite dramatically.”
That’s how I started the megatrend paper on disruption in September 2019. Now, you hold the first update of that paper in your hands. Before I begin, allow me to make a few important points. First and foremost, it is a misconception that entrants are disruptive by virtue of their success. Some disruptive businesses succeed, whereas others don’t.
Secondly, disrupters tend to build business models that are very different from those of incumbents, and it takes much longer to disrupt than generally perceived. Disruption is a process and, because it takes time, incumbents frequently overlook disrupters until it is too late.
Thirdly, disruption takes place across the economy and, as you will see later, technology is not the ultimate driver of disruption. Having said that, there can be no doubt that new technologies such as advanced robotics, artificial intelligence and blockchain have accelerated the pace of disruption.
In the following, I will repeat the most vital points made in the 2019 paper, I will update you on the most important, new disruptive technologies, and I will share with you the opportunity set, investment-wise, which has arisen as a result of the ongoing disruption process.
The root cause of disruption
Harvard Business Review has provided a very descriptive definition of disruption, which I wholeheartedly subscribe to. It is described as a process whereby “… a smaller company with fewer resources is able to successfully challenge established incumbent businesses. Specifically, as incumbents focus on improving their products and services […], they exceed the needs of some segments and ignore the needs of others. Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more suitable functionality – frequently at a lower price. Incumbents, chasing higher profitability in more demanding segments, tend not to respond vigorously. Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred.”
From this definition, it should be obvious that technology is not the ultimate driver of disruption. In the vast majority of cases, it is indeed a very important tool in the disruption process, but it is not the root cause. Thales Teixeira, professor at Harvard Business School, makes some very interesting observations in his book, Unlocking the Customer Value Chain. He uses Uber as an example and argues that, while technology has definitely helped the company to grow quite fast, it wasn’t technology that got Uber off the ground in the first place. As professor Teixeira puts it:
“It is not that Uber has a technological ability to summon a car. When I did research and I look back at the early days of Uber, when you wanted to call an Uber, you would text message or call them. At the other side of the line, there was an Uber employee who picked up the phone or looked at the text message and tried to call car operators to send a car your way.”
In other words, in the case of Uber, the ultimate driver of disruption has been the changing needs and wants of the customer, and I believe other case of disruption are no different. Changing behavioural patterns are almost always the root cause and the technology behind the disruptive innovation merely a tool.
The role of technology in the disruption process
If technology is not the root cause, how important is it to disruptors? There is no simple answer to that question because, sometimes, it is very important and sometimes it isn’t. Going back to the Uber example, the company initially became a success because of changing consumer habits. Taxi customers were increasingly frustrated by the poor service provided by conventional taxi firms and found that Uber had something else to offer. Uber, on the other hand, didn’t have access to a technology nobody else had. They simply responded to changing behavioural patterns, and they did so better than anybody else.
Another example worth mentioning in this context is Amazon. It has responded to a rising desire to shop online, which is the result of changing lifestyle patterns. As a result of those changes, many households struggle to find the time to shop the conventional way. Technology allowed Amazon to develop a business model that would suit those lifestyle changes, but it was changing consumer habits that created the opportunity in the first place.
In other words, technology may not be the root cause behind the recent wave of disruptive innovations, but it has most definitely played a very important role in many instances and will probably continue to do so. In our 2019 paper on disruption, I went into great detail on a number of disruptive technologies. In no particular order, I discussed AI, advanced robotics, driverless cars, Internet of Things (IoT), streaming and blockchain. I shall not repeat myself, but at least a couple of the technologies I discussed have undergone so much progress since 2019 that an update is warranted.
The Internet of Things
For new readers of ARP+, I should probably spend a minute to explain what IoT actually is. Essentially, IoT is about embedding a digital technology into the real (physical) world. Effectively, you use the technology to connect various physical objects. For example, IoT allows your local supermarket to communicate with your refrigerator to find out what’s missing. So, when the kids get out of bed the next morning, there is fresh milk outside the front door. And the car park that you plan to use this afternoon at the local airport will tell your car if it is full. There are literally billions of opportunities if the IoT technology were to be rolled out worldwide. McKinsey provides plenty of value-added information on IoT. If you find the topic of interest, I suggest you take a look at this website.
There is a problem, though, which is why the early estimates from McKinsey proved overly optimistic, as far as the economic impact is concerned. For IoT to work efficiently worldwide, millions of IoT workers who are well versed in IoT security, cloud computing, data analytics, automation, embedded systems, etc., must be found, and all those people simply do not exist today. That doesn’t mean IoT will never happen. It will just take longer than projected.
That said, it is not as if nothing is happening. For IoT to work effectively all over the world, we need billions of so-called LPWAN connections. This is a technology that allows all physical objects to communicate – supermarkets with refrigerators, car parks or traffic lights with cars, etc.. Furthermore, it is a technology that offers relatively simple and cost-effective communication. In Exhibit 1 below, you can see that the number of LPWAN connections worldwide is growing very fast. By 2025, we should have more than two billion of those connections up and running.
It is almost impossible to overstate the impact of IoT, once fully implemented. McKinsey definitely underestimated some of the early hurdles, but the opportunity set is virtually endless. One could argue that the biggest winners will be all those companies that take part in building the LPWAN network. One could also argue that, eventually, the biggest winners will be those companies that are going to use IoT to improve their productivity. However, I would argue that the true winner is society itself, i.e. all of us. IoT will free up so much time that quality of life can only get better.
Blockchain is best known as the technology behind cryptocurrencies. To begin with, it was indeed developed as the technology to support Bitcoin but has since taken a life of its own. In essence, it is a tool to maintain transparent ledgers that verify transactions with minimal third-party involvement. Those ledgers are not held in a central location (typically in a bank) but are spread across a network of computers. And it is transparent in the sense that every transaction is made public for all to see.
Blockchain's unique characteristics address many issues companies have to deal with every day. The ability to share data in a secure way without any one entity having to take responsibility for safeguarding the data or facilitating the underlying transactions is one of the biggest benefits according to techtarget.com. In no particular order, other benefits include improved privacy, reduced costs, speed, visibility, traceability and improved security.
Blockchain has the potential to do to banks what online retailers like Amazon have done to brick and mortar retailers. Banks, at least the most forward-thinking of them, are aware of this risk and have begun to implement blockchain in their own systems, but does that offer them a meaningful level of protection? Will there be any need for commercial banks, once the blockchain technology has been fully implemented?
From the corporate sector’s point-of-view, one example as to how blockchain can lead to massive cost savings is cross-border payments, most of which are transacted to facilitate international trade. About $1Tn of B2B cross-border payments were transacted in 2021 (source: fineksus.com) – a number that is expected to grow to $2.5Tn by 2030 – at an average cost of more than 2%. Blockchain could cut that cost to virtually zero, saving more than $20Bn annually, but that is a saving to the corporate sector. To the bank, blockchain becomes an opportunity cost. From the bank’s point-of-view, the biggest saving from blockchain is likely to come from a reduction in the number of fraud cases. You can learn a lot more about blockchain on this website.
How to invest in disruption
For every megatrend we have identified, we have uncovered a number of investment themes. In the case of the megatrend in question, we have identified no less than five themes so far, namely:
- The Digital Revolution;
- Electrification of Everything;
- The Death of Fossil Fuels; and
- The Rise of Populism.
50 years ago, only one-third of all people on Earth lived in urban areas. That number is now up to 55% and is expected to reach 66% by 2050 (source: The Open University). Nowhere is urbanisation happening at a faster pace than in Asia (Exhibit 2).
Urbanisation is the result of people seeking a better life. All over the world, a city life offers more job opportunities than a rural life does. Even in the most mature countries in the world, young people continue to move to the bigger cities in search of a job, once they have completed their education. At the other extreme, millions of Africans migrate every year in an attempt to escape the poverty trap.
The biggest wave of urbanisation is currently unfolding in Asia. Younger, educated people migrate to the cities in search of a job, and the poor underclasses migrate to the cities to escape poverty (which doesn’t always work to plan). The implications are numerous. City-life affects the environment, and it affects health. Living in Delhi, one of the most polluted cities in the world, is akin to smoking no less than 44 cigarettes every day (source: CNN).
From an investment point-of-view, the healthcare industry stands to benefit from this trend. So does the water industry. As you may suspect, urbanisation has a massive effect on water – both quantity and quality. I suggest you read our recent research paper on water, Swimming in Troubled Waters, if you want to learn more about the topic. Another investment opportunity is the agricultural industry. City-life almost always leads to higher per capita meat consumption, and we are currently looking into this opportunity, so stay tuned.
The Digital Revolution
So far, robots have disrupted the auto industry more so than any other industry, but this is only the beginning (Exhibit 3). Workers in many other industries will soon find that their employer prefers robots to humans. Robots don’t get sick and never go on holiday. Most importantly, they don’t demand a 10% pay rise when higher food prices require it to maintain their living standards. Therefore, the introduction of advanced robotics is one of the most disinflationary trends I can think of.
Earlier, I mentioned the rapid expansion of the LPWAN network to facilitate the rollout of IoT. Unfortunately, virtually all LPWAN companies are private, which dramatically reduces the investment opportunity set (see here for details).
The Digital Revolution has also affected the service industry. Let me give you an example of how impactful technology can be. In a growing number of airports around the world, you can now check in, hand over your luggage, go through security (assuming you are not carrying anything suspect) and all the way to the aircraft without having to deal with a single human being. This will increasingly become the norm and, given the bleak demographic outlook, we shouldn’t look at this as a risk to job security but as a solution to a very serious problem.
From an investment point-of-view, there are opportunities at both ends of the liquidity spectrum. If lack of near-term liquidity is not an issue for you, you may choose to invest in either venture capital (VC) or private equity (PE). Many VC and PE funds (particularly the former) are very active in this area and have, on average, delivered quite attractive returns in recent years.
As a footnote, I have to point out that the recent rise in interest rates may cause certain problems for the PE industry. I suggest you read this paper, if you haven’t already done so. At the most liquid end, there are plenty of listed companies around the world that stand to benefit from the digital revolution. Even better, if you haven’t invested yet, many of those technology companies trade at much lower multiples than they did earlier this year.
Electrification of Everything
Following months of absurdly high energy prices and an exceptionally dry summer, the desire to skip fossil fuels is bigger than ever. The consensus is that the solution, in principle, is quite simple. Assuming we only use electricity to fuel our cars and heat our homes, ‘all’ we need to do is to make sure that the electricity we use comes from renewable energy forms. By going 100% electric, the argument goes, we can arrest the ongoing climate change problem. I disagree with that, and here is why.
Apart from the fact that the average temperature is not a function of current CO2 emissions but of cumulative CO2 emissions since the early days of the industrial revolution – i.e. the damage has most likely already been done – there is another and potentially insurmountable problem, as we go green. There is quite simply not enough green metal available to go 100% green any time soon.
Admittedly, some metals are well supplied, but a handful of them are not. Proven copper reserves, for example, only make up 20% of the amount required, and nickel reserves are even smaller. We only have 10% of what is needed. Lithium is about the same (10%), whilst cobalt, graphite and vanadium all suffer a gigantic shortfall. Proven reserves of those three metals are less than 5% of what is required (Exhibit 4). Therefore, an obvious way to invest in the drive towards Electrification of Everything is to invest in a basket of those green metals that will be in short supply.
The Death of Fossil Fuels
This investment opportunity is closely aligned with the previous one (Electrification of Everything); it is effectively the antithesis. Global warming is driving governments all over the world to introduce new laws and regulations that will force fossil fuel users to switch to alternative sources of energy. In the 2020 edition of the annual Energy Outlook from BP, the company conceded (for the first time) that global oil demand will never regain the levels seen in pre-COVID times. 2019 is now considered to be the year of Peak Oil – something which wasn’t expected to happen for another 15 years or so (Exhibit 5).
From an investment point-of-view, there is a twist in the tail, though. The desire to go electric has dramatically reduced the amount of capital available for exploration. Over the next few years, that will almost certainly lead to both oil and gas being in short supply. This again will most likely lead to a very attractive, tactical investment opportunity despite my long-term (30 years+) expectation that all fossil fuel prices will eventually go to $0.
The Rise of Populism
Populists always prevail when ordinary people struggle. In the last 120 years, we have only experienced two big spikes in the Populism index as compiled by BridgeWater (Deutsche Bank does a similar index). The first spike was in the dark days of the 1930s, when Adolf Hitler – the most notorious populist of the 20th century – took advantage of desperately poor living conditions in Germany after years of despair. The second one is now (Exhibit 6).
With a rise in populism follows plenty of misallocated capital. The classic populist agenda is to promise the electorate things they want rather than things they need or can afford. A good recent example is Liz Truss, the ex-Prime Minister of the UK, and the promises she made (which led to her downfall) despite the country being in poor financial health and thus not in a position to support the tax cuts she promised.
As the gap between rich and poor has grown, populists have found it easier and easier to win the electorate over by making silly promises, as Liz Truss did. The problem from an economic point-of-view is that there is only so much capital available. If much of it is used non-productively, there is not much left that can be deployed in productivity-enhancing projects. Therefore, the rise of populism is bad for economic growth and bad for equity markets.
Final few words
As we learnt from the attack on brick and mortar retailers orchestrated by the growing army of online retailers, when the ball starts rolling, it rolls pretty fast. Having said that, despite the fact that going short banks could potentially be the single biggest opportunity in front of us, it is still premature to enact such a strategy. Bank stocks perform quite well at the moment, as higher interest rate margins benefit the profitability of the industry.
Therefore, from an investment point-of-view, your attention at the moment should be on other disruptive opportunities. In this paper, I have, in addition to blockchain, only touched on IoT, but that doesn’t mean that nothing else has caught my attention. One of my favourite shorts of all time was, for a long time, Tesla. Tesla common stock peaked in November 2021 at about $407 per share, making the company worth more than the rest of the car industry combined, which was ridiculous.
Tesla can now be acquired for about $187 per share. Thus, it has more than halved in price over the past year, making the company worth about $585Bn today. By comparison, Toyota – the most valuable conventional car company – is valued at about $232Bn or 40% of Tesla. Would I short Tesla at these levels? No, I wouldn’t. One could argue that it is still overvalued, and that the Twitter acquisition will distract Elon Musk but, given the army of religious Tesla followers, the stock price will probably recover a meaningful share of the last 12 months’ losses in the more positive environment that is the likely result of the upbeat US November inflation report.
Niels C. Jensen
17 November 2022