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 KnowMichael 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.

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:

Subscribe to receive email updates and my quarterly newsletter by clicking here.

Follow me on Twitter: @awealthofcs

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

The Compound Media, Inc., an affiliate of Ritholtz Wealth Management, receives payment from various entities for advertisements in affiliated podcasts, blogs and emails. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. For additional advertisement disclaimers see here:

Please see disclosures here.

What's been said:

Discussions found on the web
  1. Matt Downing commented on Jun 05

    what are your thoughts on the Schwab Intelligent Portfolios? this could be good to look at as a way for technology to impact investing . . . . would appreciate your input.