How can investors best monitor disruption? Challenges to big established companies seem to be business as usual – too readily we believe that scale protects. And the threat of upheaval is often played down by incumbents - challengers are seen as small and unimportant. This faith in past success brings persistent bias to the news we see. Fortunately, there are more independent sources of disruption risks.
Disruption is not new – so rarely makes headlines – but it has a huge impact on investment returns. When the competitive position is finally realised, the impact for a traditional business can be swift. Marks & Spencer, for example, spent years fighting online competition. But the memorable date for investors was 12 months’ ago when a rights issue, dividend cut and deal with Ocado, marked the beginning of a 40% fall in its share price. Just because a company’s response is delayed does not mean that investors should also be blindsided. How can investors better understand the impact of change, and what it means for portfolios?
Investors should keep abreast of innovation; new strategies can scale-up rapidly and quickly challenge big legacy businesses. Finance and retail are particularly vulnerable. For now, major banks might dismiss the impact of challengers – typically picking off areas such as SME lending, debit cards, currency exchange and mobile payments. But these include some of the most profitable niches in banking and challengers are unlikely to stop there.
The upheaval brought by mobile digital technology and big data is still in its early stages. Powerful online brands such as Apple, Facebook and Google could readily turn their attention and marketing power onto other sectors. Investors need to understand the impact on established businesses of new business models and emerging technologies.
It might seem illogical to monitor business developments outside a portfolio, but it can help to bring context to FTSE 100 complacency. New business models can mean that older brands look stale or that capital invested becomes a stranded asset, unable to earn an economic return. Empty units in shopping malls and on the high street point to this destruction of old capital. Much of how a company balance sheet is drawn up depends on management projections of future sales and profitability, typically optimistic. Apparent strength in company accounts can mislead shareholders as much as the enthusiastic statements from company chairs.
The FTSE 100 does not appear to capture the dynamism of the UK economy, shown by many of its mid-cap businesses. Successful businesses can now stay private for longer - with ample private equity finance, up to the size of £5bn and more. Fewer of these big disruptive growth stories are to be found in the FTSE 100. Certainly, the UK’s 20 largest listed businesses are typically oil majors, legacy banks, mining and big pharma. Much stronger sales growth is to be found in the FTSE Mid 250 and in some of tomorrow’s winning strategies that are as yet unlisted. It is in these stories, outside the FTSE 100, where the future is to be found.
Investors may fear the risk of picking winners at an early stage, but there are funds that focus on growth businesses. These can give insight into tomorrow’s trends. Whether young businesses are currently profitable may matter less than their revenue growth rates and unit economics. Those sales typically are taken from someone else – often a less agile traditional business. Until recently, most private businesses were constrained by the growth capital they needed. Now many have powerful backers writing big cheques. As M&S showed, it can then take a big capital-raise from shareholders for an old company to re-engineer its business.
Certainly, many big companies offer comfort and liquidity – but maybe not mean safety. Investors need to think about where growth lies in the economy, and what the winning business models will look like. Then, the focus should be on listening to the right news sources.
At the time of writing SVM Asset Management holds positions in Ocado and Alphabet (Google parent company).
A version of this article was published on Trustnet.com on 03/03/2020.