How Innovation is Affecting Market Valuations

This week I had the chance to listen a talk given by the CEO of an aerospace company that ships products all around the globe. He walked the audience through the company’s different transformations over the years and ended his discussion with a short video that demonstrated how their state of the art warehouse works.

What used to take hundreds of hands-on employees now takes just 10 engineers as the entire process is automated by robotics. It was amazing to watch these robots move parts throughout the warehouse and assemble everything with no human intervention. To stay competitive, the company’s options were to either ship the jobs off to places like China or Mexico or build out their own innovative system.

He described how pace of innovation in the industry has exploded over the past decade or so which basically gave them no choice but to make these changes. It’s a huge risk if the company doesn’t keep up with the latest trends to sustain their competitive advantage. Some competitors have already fallen by the wayside while new ones have entered the space.

Innovation should matter to investors because it can affect a company or industry’s sustainable competitive advantage. And it’s happening at a much faster pace these days. The life expectancy of a Fortune 500 company in 1955 was 75 years. Today the life expectancy is just 15 years.

In his book, More Than You Know, Michael Mauboussin discusses competitive advantage as it relates to the concept of clockspeed. Clockspeed is the rate at which industries are changing from a product and process standpoint. Mauboussin makes the argument that technological advances are shortening the duration of corporate life cycles, which can have an impact on valuation metrics (emphasis mine):

Faster clockspeed affects investors in a number of ways. First, shortening periods of sustainable excess returns have important implications for valuation. Shorter product and process life cycles undermine the usefulness of historical multiples (especially price/earnings, which aren’t very useful to begin with), because the basis of comparison is different. I believe there has been a trade-off: higher economic returns for shorter periods are increasingly replacing lower economic returns for longer periods. Whether or not I am right, simplistic valuation assumptions invite danger.

This is an interesting theory, one in which I’m sure the initial push-back from many investors would be, “So you’re saying this time is different.” But the way I take this is that single variable analysis is useless if you’re unable to put it into context. It’s very difficult to make comparisons across historical market environments if you’re not willing to put things into perspective. No two periods are ever the same.

I think many investors have learned this lesson the hard way by trying to figure out a simple formula that will tell them “every time A has happened, B has followed.” If only the markets were that easy. There also has to be some context around which companies and industries this will affect the most. There are still going to be very slow changing sectors in the economy and certain companies will build natural barriers to entry as they always have.

But we’ve witnessed old school fundamental investors try to apply their historical models to value companies in the initial growth stage over the past few years who have been way off on their assessments. You can’t value companies like Tesla, Facebook or Uber in the same way that you would model Coke, GE or Johnson & Johnson.

My takeaway from the potential for continued faster clockspeed and innovation is that it’s going to be much harder to have conviction or certainty in your investment views, especially when it comes to individual companies. Mauboussin says this means there will be a greater need for diversification because of this:

In addition, faster clockspeed suggests the need for greater diversification. If competitive advantages are coming and going faster than ever, investors need to cast a wider net in order to assure their portfolios reflect the phenomenon. (Ideally, of course, investors would focus on the winners and avoid the losers. This is practically very difficult.) The data shows evidence for this increased diversification.

It takes a heavy dose of humility on the part of an investor to admit that you can’t always pick the winners and the losers. It’s possible that this will only get more difficult in the years ahead as the cycles continue to become shorter and faster.

Source:
More Than You Know: Finding Wisdom in Unconventional Places

Further Reading:
What if the future is better than we think?
Is technology speeding up market cycles?
The shrinkage effect in the stock market

Now here’s what I’ve been reading this week:

• How to think about risk (Dash of Insight)
• 3 characteristics of good financial advice (Kris Venne)
• There’s a reason markets have risk premiums (Aleph Blog)
• Jim Simons on building an investment firm (Alpha Architect)
• The best doctor gives the least medicine (Malice For All)
• A dozen lessons from Seneca (25iq)
• There are more choices in ETF land but that’s not always a good thing (Reformed Broker)
• Ignore the margin debt alarm (EconomPic)
• The maleficent 7 behavioral biases (Above the Market)
• Wall Street doesn’t need to brainwash you (Bloomberg View)
• A 99 year old advisor who’s never lost a client (Investment News)
• Chris Sacca on how to improve the Twitter user experience (Lowercase Capital)

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