The Essential Mental Model for Understanding Innovation

The other day I came across this excellent video interview on the Harvard Business Review blog with Clayton Christensen discussing “disruptive innovation.”  As some of you may know, Christensen wrote The Innovator’s Dilemma.  This is one of the most important investment books for everyone to read.  It is essential for understanding the paradigm of innovation and disruption in business.  If there’s ANY tech CEO (or even non-tech CEO) who has not read this book I would have to seriously question their judgment as an executive.  This book is that important.  

Charlie Munger has told us investors that we need to have “mental models” upon which to build our world view and investment strategy (brief aside: there’s a really cool site called Think Mental Models which honors this investment credo.  I fully subscribe to this belief and as this blog develops, will look to share the models that are core to my investment philosophy).  The Innovator’s Dilemma, along with Porter’s Five Forces, create the lens through which to understanding the competitive landscape of any business, whether new or old.  Although the Innovator’s Dilemma tends to appear more relevant to the technology sector, as that is the home domain for the most high profile innovation in our economy, it is equally relevant to all industrial and service businesses alike.

The Dilemma

The crux of the dilemma is that there are outstanding businesses, highly attuned to their customers’ desires, outstanding at driving their product’s evolution forward, and supremely efficient at operating their businesses profitably, which ultimately succumb to failure.  Christensen labeled this a “dilemma” because these dominant market leaders fail precisely because of their managerial strengths.  This is so, because the smaller, innovative upstart competitors are willing to accept lower margins and lower product quality initially in order to break into niche segments beneath that of the dominant leader within the marketplace.  

By operating in this way, the young upstart is able to profitably grow a business while refining and developing the product until it eventually is a cheaper, better and eventually a replacement for what the dominant market leader has to offer.  Meanwhile, the market leader, in an effort to protect their market position and profit margins, and to cater to the needs of their largest customers, never enters into the new level to their core market because they refuse to take part in driving prices, margins and profits lower in the short-run.  Christensen narrates this phenomenon and develops the theory primarily through an analysis of the disk drive market, where these innovations tend to transpire at a far quicker pace than other arenas.  

Mark Suster, a “2x entrepreneur turned venture capitalist” wrote several outstanding posts on the Innovator’s Dilemma and how it not only impacts, but is a core element of his own personal investment strategy.  I highly recommend reading both The Amazing Power of Deflationary Economics for Startups and Understanding how the Innovator’s Dilemma Affects You. One point that I would add to Suster’s analysis is while the new firm accepts lower margins, they do so for particular products, not on a firm-wide scale.  These disruptive technologies are able to sell each unit of their product for a lower margin; however, their technology affords them the advantage to spread the fixed cost element in a much more beneficial way such that the firm-wide margins are far greater than the incumbent technology.  Typically the firm-wide advantage comes via the capacity to support enormous scale on a smaller operating structure.  This is particularly true in the Internet age.  And in this fact lies the ability to compete on price on a per unit basis.

Steve Blank is a pioneer in entrepreneurial theory, professor at Stanford and author of Four Steps to the Epiphany.  His impact is visible throughout the many innovative powerhouses born in Stanford.  He wrote an excellent post that relates the Innovator’s Dilemma to how large enterprises can cope and prosper in such an environment called The Search for the Fountain of Youth: Innovation and Entrepreneurship in the Enterprise.  This too is a must read.  

Investment Implications and the Mental Model 

Because these issues are so fundamentally important to companies both new and old, the connection to any investment strategy is important.  The s-curve model is the visual translation of the impact of the Dilemma.  (H/T to Your Brand is Showing for the graph)

 

 

As it pertains to market disruption, we look at the S-curve of the current technology relative to that of the emerging technology.  With every market leading technology, the product initially started off on a relatively slow growth trajectory.  Once it achieved a critical mass of adoption, the growth takes a parabolic trajectory; however, after adoption is ubiquitous, the growth plateaus.  Meanwhile, the young, emerging technology starts on a path beneath the current technology and crosses above the current in terms of both growth and efficiency (not necessarily quality just yet) at some point on its own parabolic phase of growth.  

These points are crucial for every investor, whether one focuses on growth or value.  For growth, the importance is obvious (invest in companies on the parabolic part of their growth trajectory), yet for value it's less so.  Understanding the Innovator's Dilemma is instrumental in determining whether some companies with solid track-records are experiencing a temporary blip, thus creating the value opportunity, or whether they are in fact being disrupted from beneath.  I look forward to sharing some anecdotal examples over time.

Is Stock Picking Dead?

In these times of macro-volatility, it’s a line heard more each day: “stock picking is dead.”  The reasons listed are plentiful, but all focus on the increased correlations across the stock market and various asset classes today.  There is certainly an element of truth to the notion that in these volatility storms, everything moves closer together, but the claim that stock picking is dead is not a necessary outcome of the idea that correlations are higher.  There are factors that go beyond just what is happening in today’s market that have led to this misguided conclusion that stock picking is dead, so let’s take a deeper look at what’s behind this financially harmful directive.

Just the other day, Jason Zweig, in his Wall Street Journal column, took a look at whether “index funds are complicating the market,” and if so, what the consequences are.   This is an important conversation, and relates directly to whether stock picking is in fact dead, or not.

Who makes the claim:

There are several different groups behind this claim, and they are important.  In terms of economics, one of the core arguments for the efficient market hypothesis (EMH) is the notion that there is no alpha (outperformance), as prices reflect all known information, and therefore it is nearly impossible to beat the broader indices.  In a rational and efficient world, where information is ubiquitous, why would anyone sell to another with exactly the same information?  Or so the EMHers ask.  

In the stock market, indexers are a direct outgrowth of the EMH. Burton Malkiel’s Random Walk is probably the most visible bridge between the intellectual economics community and actual asset allocators.  Indexers carry out the theoretical consequences of the efficient market theory in buying broad baskets of stocks designed to mirror the performance of the economy at large. 

Next up are the class of speculators that call themselves technical analysts.  There are many kinds of technical analysts, and I use technicals as an important tool myself for timing and scaling into positions, as well as a basic risk management tool.   I do not mean those types of technical analysts.  More particularly, I am speaking of the technicians who use technicals as their one and only metric through which to buy a stock.  Stock picking doesn’t matter to these people, because they believe that charts rule the market and therefore only charts matter.  They buy the best looking lines on charts, and sell the worst, without “picking” a company based on its own intrinsic metrics.  Their intellectual ancestors are Charles Dow and Roger Babson.

Last are the perma-bears.  They believe that correlations are high, because volatility is here to stay as a direct result of some sort of serious global economic malady that will lead to the “end of the economic world” as we know it.  You’ll know these people based on their zealotry for gold as an asset class, complete conviction that they know exactly why everything is going to shit when markets are crashing, and ongoing claims that the market is “inflated, manipulated and rigged” whenever prices are moving higher. To them, everything is on its way to zero, so why bother?

Taking the other side:

The EMHers like to ask what information one person could possibly possess that the other does not, leading to the belief that buying Company A’s stock is worthwhile for oneself, while selling Company A’s stock is worthwhile for the counterparty?  The problem with this question is that there are far more reasons why one type of market participant would sell a stock than just a question about the known information pertaining to the value of a particular business. 

This is a crucial point in why the efficient market theory breaks down.  It only works in an environment when people are buying and selling based on the same information, focusing on the same companies, and thinking about only factors related to the underlying businesses.  There are plenty of people who don’t base their decisions on “information” at all, and are acting based on emotion like sellers in a panic or buyers in a bubble.  There are other examples outside the emotional realm: Indexers, macro-traders, technicians, and short-term speculators.  Importantly, in practice, indexing itself is a major source of company-specific inefficiencies, rather than a factual outgrowth of the EMH.  Legendary value investor, Seth Klarman, has specifically referenced his affinity for investment opportunities that directly arise out of inefficiencies during index rebalancing (Hat tip to Distressed Debt Investing), and this is but one example.

Beyond styles, there are many reasons that people may sell (or buy) stocks that have nothing to do with company-specific beliefs.  This list includes, but is not limited to, young workers’ deposits into 401(k)s, retirees selling savings to live off of, and mutual funds that are forced to sell shares in a spin-off which is worth a price below the fund’s mandated minimum capitalization.  All of the above transactions have nothing to do with what the person inspiring the purchase (or sale) of an equity thinks about that one particular company.  Again, this is important.

Why we have markets in the first place:

While financial headlines swing from "the end of the financial world" to dramatic rescues, it's necessary to take a step back and think about what investing in markets is all about.  Stock picking is precisely it. 

When we look to the essence of the stock market, we realize that it is an arena for companies to sell fractional ownership interests in exchange for the capital necessary to build, grow and/or maintain a business (forget for a second that most IPOs today are to cash out early investors).  This is not a transaction based on the belief that one person is wrong and the other right, nor is it a situation where one person must lose at the other’s expense.  It’s really supposed to be a win/win for the buyer and seller—the buyer gets an ownership stake in a company, and the seller gets the capital they need to deploy in order to increase the value of the buyer’s ownership interest.  At the end of the day, unless people are in markets to invest in companies themselves, then everything else is illusory, and that’s not really the case.

Somehow, the meaning of markets has been so greatly abstracted by the proliferation of types of participants that this existential fact ends up forgotten.   In many ways, it’s thanks to actual inefficiencies in markets that people learned ways beyond just investing in businesses in order to make substantial sums of money in capital markets.  This is why they say that “stock picking” aka investing in companies is dead.

Pulling it All Together:

These other strategies have made money for periods of time, but the most consistent through all time periods is investing in strong businesses for the long-term.  This is not to discount the efficacy and importance of other types of analysis.  In some ways, it is the generalist who is most adequately equipped for long-term investment, for knowledge of macroeconomics, technicals, etc. are invaluable tools for an actual company-specific investor.  It’s important for any kind of investor to understand who the market participants are, and why happenings play out as they do.  Use these other strategies as tools to maximize the returns from investing in really solid long-term businesses, not as ends in and of themselves. 

In 2010, I conducted an interview of Justin Fox (now the editorial director of the Harvard Business Review Group) shortly after he wrote The Myth of the Rational Market, a comprehensive review of the history of the competing types of investment theories and how they came together to form competing bases of economic theory.  Fox concludes that Benjamin Graham-style value investing is the only conssitent strategy through all time, but asserts that t is psychologically draining to consistently instill a sense of discipline on oneself, and therefore people tend to float dangerously towards alternatives. The book is an excellent read that traces the history of investing and economics from Irving Fisher to Benjamin Graham to Eugene Fama all the way through the physics-drive Santa Institute.  In my interview with Fox, we had the following exchange that I think very aptly sums up the problem with the question "is stock picking dead" and why the answer is conclusively no:

Elliot: Now, correct me if I’m wrong but one of the concepts that I took to be a semi-conclusion in “The Myth of the Rational Market” was the idea that the Benjamin Graham model of value investing has withstood the test of time, that people who are able to take the information and come up with what they think is a fair value and have the ability to ignore what “Mr. Market” is telling them on a daily basis have an edge over time.  Do you think that’s a valid interpretation?

Justin: Absolutely – I completely think that’s true.  And I think one of the interesting things that is sort of common sense, but that finance scholars have finally started studying and recognizing, is that one of the big reasons for why it’s really hard for a professional investor to stick it out as a value investor is that it requires being unfashionable and going against the crowd.  And unless you’ve either built up this incredible reputation—although even that doesn’t really help you that much in investing as people forget your reputation and a year or two if you fail to beat the market—or you get a situation like Berkshire Hathaway where it’s actually not the investors’ discretionary money that you’re investing, but the cash flow from Berkshire.  There’s really no way anybody can discipline Buffett except over maybe a really long period that gives you the freedom to do it.

The flip side of that is that as an investor you have a situation where there’s such little control over the investment decisions.  That’s the difficult situation that our investors fear. There’s a reason why people invest in mutual funds.  They like the flexibility of being able to take their money out.  But the very fact that they do that, and that if you’re some value fund and it’s 1999, everybody wants to take their money out of your fund regardless of your own performance; that’s exactly why it’s hard to be a value investor, and a good economic reason for why value investing works.  Beyond that is the individual as a value investor.  Obviously, you don’t have to worry about customers but you just need a pretty strong constitution and maybe a different psychological wiring than most people to be able to stick that out.

New RGA Investment Advisors Market Commentary

It's official, I'm Managing Director at RGA Investment Advisors!  Here's our first commentary with some of my input, be sure to check it out:

RGA 2011 in Review and a Top Down Plan for 2012

For years many professionals in finance have been touting the benefits of diversification, however there remains a long-standing debate about how best to pursue the objective—should investors have a concentrated yet diverse portfolio, a diverse portfolio, or should they just index and buy as broadly as possible?  2011 was a year in which we saw all kinds of problems with  the pursuit of diversification and it highlights exactly how and why we like to approach this problem a little differently.  First, the important math.  The theoretical reason behind diversification is to eliminate single-stock risk to the point where a problem with one portfolio company or holding does not overly infect the entirety of the portfolio.   Joel Greenblatt, a Columbia University professor, hedge fund manager and author did some interesting work to quantify this factor of risk. Owning two stocks eliminates 46% of the risk associated with individual stocks, eight stocks eliminates 81% of the risk, sixteen stocks eliminates 93%, and thirty-two stocks eliminates 96% of the risk.  In order to mitigate 99% of the single-stock risk one most own 500 holdings.  The clear point here is that mathematically speaking, the benefits to diversification continually diminish when the portfolio holds more than sixteen total stocks.

Why do we bring this up now?  Well in 2011, correlations were as high as they ever were.  In other words, every stock, and just about every asset class moved in the exact same direction.  This implies that what was a risk to one stock, was also a risk to another.  While in aggregate that statement appears to be true, it’s not entirely true.  Directionally, stocks moved consistently in tandem, but in terms of magnitude of the move, there were vast differences.  Plenty of stocks finished the year up nicely, while others finished the year down badly.  Many diversified portfolios took substantial hits and the key factor lies in how diversification had been pursued. 

Simply diversifying holdings is not enough.  Importantly, 2011 highlighted the fact that people need to diversify their correlations.  That means that investors must expose their portfolios to as many different catalysts as possible.  It means buying quality companies in a variety of sectors, with a variety of strengths and weaknesses, which should overlap as little as possible in aggregate.  Some might say, well why not just index then and achieve ultimate diversification?  And that question, while a legitimate one, further confirms the initial point.  An overly broad, diversified portfolio is exposed to nothing other than just economic growth.  Without economic growth it’s nearly impossible for the market in aggregate to move higher, but that’s not entirely true for a well-selected, diversified basket of stocks, bonds and cash that are rebalanced tactically with layered and stratified correlations.