Investing in technology disruptors

I’m not usually a “thematic” investor, but as one who is constantly looking for the next set of growth opportunities I strongly believe companies that successfully invent or employ a disruptive technology have the potential to provide investors with superior and sustainable long-term returns.

The McKinsey Global Institute published what I believe to be an extremely influential and timely report entitled “Disruptive Technologies: Advances that will transform life, business, and the global economy”, released in May 2013.

This report identifies 12 potentially economically disruptive technologies. They are (in order of economic impact):

• The mobile internet;
• Automation of knowledge work;
• The internet of things;
• Cloud technology;
• Advanced robotics;
• Autonomous vehicles;
• Next generation genomics;
• Energy storage;
• 3D printing;
• Advanced materials;
• Advanced oil and gas exploration and recovery;
• Renewables.

Arguably there will be others but what these 12 have in common, says the McKinsey report, is “they share four characteristics: high rate of technology change, broad potential scope of impact, large economic value that could be affected, and substantial potential for disruptive economic impact”.

Quantifying the economic effect of these technologies is difficult, but by measuring and valuing the numbers of people affected, outputs and market size estimation, McKinsey believes the aggregate additional economic value of adoption is between $US14 trillion to $US33 trillion per annum by 2025! I believe that in itself is a significant investment opportunity.

For a potential investor, what is striking about the disruptive technologies is that they now transcend the traditional technology sector and include a large number of industries and sub-industries encompassing healthcare, biotechnology, industrials, materials, telecommunication, media, and energy.

This means that a portfolio can be intelligently constructed with a view to return and risk given that it can be somewhat diversified in terms of industry and market capitalisation. It also means the investable universe is of a reasonable size and contains companies of sufficient liquidity.

As well, since disruptive technologies and innovation are NOT driven by macroeconomic variables it could be argued that there is a countercyclical bias to many of these companies. And while their stock prices will on a daily basis be affected by equity market levels, their long-term potential will be determined by the strength of the innovation itself, not the underlying economy.

For example, in the early years of this century, the Indian outsourcing companies (Tata Consultancy Services and Infosys) flourished in an extremely difficult economic environment. Companies and government agencies out of necessity migrated their back offices to offshore providers that had superior technologies and pricing. The share prices of Tata and Infosys have increased in excess of four to fivefold since then.

Three ways to leverage disruptive technologies

In order to participate in the disruptive technologies phenomenon, I believe one should concentrate on three types of companies;

1. The first category is established successful companies that have grown by possessing or using disruptive technologies and continue to innovate. Good examples would be Google, Amazon, Ebay, Microsoft, Salesforce.com, VMware, Comcast, Gilead, Celgene, Sun Pharmaceuticals. Tata Consultancy Services, Baidu, Alibaba, Schlumberger, and FMC Technologies. You’ll notice Apple is not on the list as I believe that it may have lost that innovative edge. I say “may” because companies like that can always surprise you, although in my experience companies and industries that lose it usually don’t get it back due to the power of those pesky disruptive competitors. A few past examples include IBM, Hewlett Packard, Eastman Kodak, Xerox, Borders Books, the US automobile industry, department stores etc.
2. The second category is the most interesting (and requires the most work). They are the “early disrupters” – companies that have gone public in the last 12-24 months, have a powerful disruptive technology and are growing their top line at a high rate, beginning to generate cash and produce earnings. Some are household names, while some are not. For example: Facebook, Twitter, Tesla, Fireye, Splunk, Proofpoint, 3D Systems, Pandora Media, Netflix, Asos, and NC Soft. I have been an investor in most of these names over the past two years and they have provided some spectacular returns.
3. The third category is the so-called “neophyte disrupters” – companies that have not yet come to the market, are still private and may be still receiving venture capital funding. Some examples would be Uber, Dropbox, Cloudera, Airbnb, Palantir, Spotify, Pinterest, Box, Warby Parker, Line, and SpaceX, to name a few. They all have seemingly promising technologies and products and may be turning the industries that they operate in on their heads, but as yet they are unproven as public companies. These companies will be identified at the pre-IPO funding stage and followed closely after they become public.

Waiting for the IPO dust to settle

I should mention that I am not a fan of buying IPOs (Initial Public Offerings), no matter how attractive or interesting the company is. It is truly a “mug’s game” and individual investors and even most institutions don’t stand a chance given that the price is not determined by what the company is worth but rather by the perceived demand for the shares. Many of these neophyte disrupters will be overhyped by the financial media and the brokers, with the result that the share price will have a huge run on day one. Some will be up 25-50% on the opening bell. That is NOT the time to buy them. I normally let them become “seasoned”, to pick up some analyst coverage, and report a quarter (or two) as a public company. Then I get interested. By waiting there is always the risk that you might forego some upside, but in my experience many “hot” IPOs revisit the original offering price (or lower) at a future date.

For example, in 2012 I looked at Facebook prior to its IPO and could not get my head around a $US38 issue price in spite of the company’s ubiquity and obvious potential. Based on the value of subscriber metrics it was about 50% overvalued. Sure enough, over the next few months the stock disappointed investors and ended up at $US19 or so in late 2012. That was a buying opportunity! Shortly after, Facebook CEO Mark Zuckerberg admitted that he had erred in not targeting the mobile user space but would be concentrating on it going forward. Sentiment and numbers improved. The stock then rallied and eventually climbed into the high $US60s where it is now.

Looking for disruptive opportunities

Over the next weeks and months I intend to drill down into each of McKinsey’s “12 disruptive technologies”, discuss their impact and hopefully provide some actionable investment ideas. It’s a truly fascinating concept and I’m sure it will generate some exceptional ideas. I also hope to create a concentrated investable portfolio that investors can replicate and be managed in real time.