Active Investing in the Age of Disruption. Evan L. Jones
—Joseph A. Schumpeter, economist
The question for investment managers is,
Why is the faster pace of creative destruction more important to active investing today?
What Schumpeter could not have had much insight into was how these waves of innovation would change in length of cycle and the amplification of their effect on economic development and disruption. There are two major factors that determine the speed of new innovation and their speed to mass use: technology and capital.
Many leaders in the technology field believe the nature of recent technologies themselves are shortening the length of innovation cycles. New technologies and discoveries are building on themselves to quicken the pace of innovation and adoption. Gordon Moore of Intel formed the hypothesis that the number of transistors in an integrated circuit would double every two years, and this theory has held in the electronic circuit industry. It may not hold for all technological innovation, but the core of the idea is that technology compounds on itself, and whether it will double every two years or four years, there is an amplification process.
At least 40% of all businesses will die in the next ten years… if they don't figure out how to change their entire company to accommodate new technologies.
—John Chambers, Cisco Systems
Figure 3.1 provides a simple chart demonstrating recent innovations and each innovations' time in years to adoption by 25% of the US population. In an analysis done by Ray Kurzwell, the famed futurist, it took 46 years for 25% of the US population to have electricity in their homes, 26 years to put a television in 25% of US homes, and 7 years to get 25% of US homes on the web. The speed of adoption is clearly accelerating. The tipping point for investors is that the time of adoption is now within one business cycle. Disruption and paradigm shifts occurring faster than business cycles leave investing with a contrarian or mean reverting thesis open to large losses. When there is a higher probability that an industry is being disrupted, reversion to normal is less likely to happen.
FIGURE 3.1 Innovation adoption: Number of years to 25% US population adoption
Source: Ray Kurzwell, “Singularity Is Near” (2005).
Innovation adoption tipping point
For fundamental investors, this quickening pace of disruption is problematic. As the model in Figure 3.2 conceptually demonstrates, innovation has driven the speed of adoption and therefore disruption. In the 1940s, innovation-driven change took on average 28 years, which is the span of four average economic cycles. In the 1990s, innovation change took on average 14 years, or two economic cycles. Today innovation-driven change takes less than seven years to disrupt an industry. Disruption within that time period, the average length of a historical business cycle, opens investors to the higher probability that their cyclical investment will actually be a paradigm shift.
Faster paradigm shifts call into question all mean reversion–based strategies in a way they never were before. This is very evident in deep value-based mean-reversion strategies, but any strategy that has an underlying assumption that we return to a prior status quo in the next economic cycle is under pressure.
Investors for decades have generally been able to rely on which sectors will outperform during different stages of an economic cycle. The difficulty in achieving your expected return revolved around being correct on time horizon, avoiding excess leverage that might bankrupt the company before the next cycle upturn, and managing the position well through market volatility (avoiding behavioral mistakes). These are not simple challenges, and only a minority of managers progressed through these challenges with positive alpha. However, the biggest risk to mean reversion investments and contrarian investments is a paradigm shift. There is no mean reversion if the industry changes.
FIGURE 3.2 Pace of innovation in business cycle terms
As a value manager you live in dread of a paradigm shift—something changes and leaves you high and dry forever.
—Jeremy Grantham, investor
Although Figure 3.3 is overly simplistic, mean reversion is the primary theory for a number of multibillion-dollar investment management firms. Investors may have very complex strategies and mountains of research and data backing up their strategy, but often strategies boil down to a few core investment beliefs, and mean reversion is one of them. This confluence of capital and disruption has had a significant effect on the concept of mean reversion and must be recognized by investors.
To further pressure mean reversion strategies, the economic cycle has been extended longer than ever before (as we surpass ten years), and the cycle of disruption (paradigm shifts) has shortened significantly. This one change alone will hurt many active investment manager returns significantly.
FIGURE 3.3 Economic cycles and mean reversion
Innovation and Financial Capital
The second major factor in driving innovation is risk capital. Entrepreneurs and researchers can move only as quickly as access to capital allows them to take losses. By definition, early innovation is not profit producing and needs development and growth capital. Access to risk capital driven by investors' appetite for risk is the number one factor in the pace of innovation. Whether that innovation be a start-up in Silicon Valley or new projects at Amazon and Google, the appetite for risk capital by investors is a determining factor.
This is where the confluence of central bank intervention and the accelerated pace of technology compound to dramatically increase disruption. Almost every industry is being disrupted in some fashion, and companies no longer stay within their industry verticals. Google is disrupting industries from autos to medical devices. Amazon is no longer just threatening retail but has moved into everything from health care to cloud computing. The competitive environment can no longer be narrowly defined by industry. This would not be possible if investors were demanding earnings. It would not be possible if money were not moving aggressively into private equity, and it would not be possible if interest rates were 400 basis points higher than they are today.
Venture capital is the clearest indicator of investor willingness to finance innovation and accept losses in a quest for growth. More US venture capital has been invested in the last five years than the previous ten years combined. Figure 3.4 illustrates venture capital investing since 2004 and the huge growth in the last five years. Pre–2008 financial crisis investing levels that were considered high at the time have been surpassed every year post–financial crisis.