Don't fret about disruption

Disruption is easier to spot in advance than you might suspect. Here we examine a disrupted sector identified ten years ago, and plenty of companies you should worry about now.

Disruption equals death. Or so the doomsayers would have you believe. More than ever, listed companies are being disrupted by new technologies or shifting preferences. If truth be told, though, disruption is often just ‘competition' by another name.

Whether you prefer to call it ‘disruption', ‘structural threats', or ‘secular trends', companies are finding the ground beneath them shifting faster than ever before. As investors, we now need to consider not just cycles, but long-term megatrends that could destroy the companies we own.

It sounds frightening, and to some extent it is. Do you need to be a futurist on top of everything else?

Flashing lights

Well, while you should be alert to potential structural threats affecting companies and their industries, the market is so short-term focused that it often ignores threats until the effects are obvious. In other words, you can often exit before the warning lights start flashing.

Sometimes, fears of structural threats – perhaps combined with other worries, such as cyclical downturns – can provide buying opportunities. The Flight Centre (ASX: FLT) Buy recommendation from 18 months ago is a recent example.

Companies at risk?

Most companies will contend with structural threats eventually. Here are some that are facing disruption now or in the future:

  • Flight Centre (FLT)
  • Tabcorp (TAH)
  • JB Hi-Fi (JBH)
  • Nine Entertainment (NEC)
  • Here, There & Everywhere (HT1)
  • Southern Cross Media (SXL)
  • GTN (GTN)
  • AP Eagers (APE)
  • Automotive Holdings (AHG)

For a real-life example of how you can anticipate looming structural threats before they damage your portfolio, let's jump back to the heady days of February 2007. It was clear to us, in Time to cancel your newspaper sub, that newspapers were structurally threatened. We issued Sell recommendations on every newspaper stock we covered in that review.

It seems obvious in hindsight, but at the time the market was blissfully ignorant of the risks. It was focused – as broking analysts invariably are – on profit forecasts a year or two out. By contrast, we focused on what newspaper industry profitability might look like ten years out.

Paper cut

The evaporation of classified revenues happened just as we expected. All the newspaper stocks subsequently cratered; Fairfax Media's (ASX: FXJ) share price, for example, has fallen by around 80%. And it would have been worse but for the success of Fairfax's real estate spin-off Domain Holdings (ASX: DHG).

Not only can disruption often be spotted early, it can be a ‘slow burn' when it does in fact arrive. Management will usually take evasive action, for example, by cutting costs or making acquisitions.

Fairfax Media's management prevented collapse by selling assets to reduce debt, cutting more than $500m of costs from the publishing business, and investing in the growth of Domain. A more recent example is Tabcorp (ASX: TAH), which bought lotteries operator Tatts Group this year, ostensibly to diversify away from a structurally challenged wagering business.

Buying time

Disruption is never really the issue. Rather, it's that a business fails to adapt to a changing environment quickly enough. While many businesses struggle as structural threats emerge, few just sit there and watch their lunch get eaten. This process often buys the investor time.

Disruption can even benefit the strongest businesses in a sector, sometimes for a long period. As travel bookings have moved online, Flight Centre's strength has allowed it to take market share from independent retail travel agents. In effect, Flight Centre has taken a larger share of a flat or declining market. JB Hi-Fi (ASX: JBH) has done something similar in electronics retailing, although it's now under threat itself.

If it's so easy to spot sectors that are about to be disrupted, what's a current example?

Shareholders in free-to-air television companies like Nine Entertainment (ASX: NEC) should be worried. Free-to-air television's share of advertising revenue seems almost certain to decline over the next decade. With more eyeballs moving online, advertising revenue will surely follow.

But short-term factors are benefiting Nine at present. Strong ratings in comparison to Seven and Ten, a reasonable economy and the abolition of licence fees helped 2018 first-half profit rise 55%. As a result, Nine's share price has almost tripled from its 2016 low.

Silly sausage

In the short term, the market's focus on profit growth can make long-term investors like us look pretty silly. In the case of Nine, cyclical and one-off benefits are obscuring negative long-term trends.

Nine might trundle along for a few years yet. But external factors like recessions can accelerate structural shifts. If advertisers need to ration dollars in tough times, they're more likely to shift them online. We don't cover Nine because of these risks, but $2.2bn seems a lot to pay for the business.

Plenty of other sectors are under more distant threat. Radio companies such as Here, There & Everywhere (ASX: HT1), Southern Cross Media (ASX: SXL) and service providers such as GTN (ASX: GTN) could find themselves in trouble if car ownership trends or radio broadcasting technologies change.

Car dealership companies, such as AP Eagers (ASX: APE) and Automotive Holdings (ASX: AHG) could one day be threatened by autonomous vehicles. In the meantime they must contend with regulatory changes and cyclical threats such as a weakening housing market.

The message isn't to stay away from companies that could be disrupted. Disruptive threats rarely act in a linear way, and ‘company death' is only ever one of many potential outcomes.

Indeed, sometimes great buying opportunities lie in companies that seem threatened. Pay a sensible price, and you might still make excellent returns.

Disclosure: The author owns shares in Fairfax Media and Domain Holdings.

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