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Disruptive business models & technologies


scorpioncapital
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I was watching this amazing video -

where he describes the problems of RONA & IRR and how there is a tension between efficiency and disruptive innovations. As investors, we love free cash flow, but paradoxically, this sows the seeds of too much money and the end of growth over time. So I was thinking, either we are happy with low growth or we look for disruptive companies. Yet the new disruptors are unlikely to make money right away. What do you guys think? Should one look for the biotech or disruptive tech stock or go for the free cash flow or maybe the middle ground, no innovation but at least some place to put your capital back to work (e.g. reinvesting in capital intensive industries where government guarantees a decent return)?

 

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Own some rock quarries.  It's hard to disrupt a business where you sell a whole ton of crushed rocks, sand, aggregate whatever you want to call it for $10.  But it cost $0.15 cents per ton mile to truck it.  So, if someone from 50 miles away wants to compete with you, he's got a $7.50 per ton cost disadvantage against you.  It's hard for me to imagine that this cost advantage to be disrupted by Silicon Valley.  The business is cyclical.  But it seems like rock quarry owners tend to be able to pass their wealth down many generations.  In an ideal case, your quarries are located in a desirable location.  Once depleted, they can be re-purposed into higher value added real estate projects. 

 

 

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It's interesting question. You can probably make a fortune selling life rafts to people on the sinking Titanic. Only problem is, what do you do with the cash when the ship goes down? Now the economy is far more complex and lots of moving parts and everyone looks after their self interest - especially in finance, but I wonder if this, in the aggregate, leads to low growth which taken together means more zero sum activities instead of real growth. If real growth comes from disruptive innovations, some will lose money for sure, but some will gain big for themselves and society. That's why it feels so strange as a value investor who wants to stay away from losing money. My solution has been to try and find businesses that are balanced between disruption and profit making. Some may argue they are not as creative as they could be, but having one foot in both doors so to speak and maybe some department in one of these companies will hit upon something as a fluke :)

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Own some rock quarries.  It's hard to disrupt a business where you sell a whole ton of crushed rocks, sand, aggregate whatever you want to call it for $10.  But it cost $0.15 cents per ton mile to truck it.  So, if someone from 50 miles away wants to compete with you, he's got a $7.50 per ton cost disadvantage against you.  It's hard for me to imagine that this cost advantage to be disrupted by Silicon Valley.  The business is cyclical.  But it seems like rock quarry owners tend to be able to pass their wealth down many generations.  In an ideal case, your quarries are located in a desirable location.  Once depleted, they can be re-purposed into higher value added real estate projects.

 

These quarries might be vulnerable to disruption by Amazon!  I remember reading on the AMZN thread that somebody was buying SAND to put in his child's sandbox and AMZN was shipping 50 lbs. bags of sand to his house for FREE, as he was a "prime" member.

 

If AMZN will ship sand, why not pebbles & rocks & such?

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If AMZN will ship sand, why not pebbles & rocks & such?

 

Amazon doesn't have some magical device that generates whatever you desire in their warehouse and then ships it to you. They still need to obtain their sand or aggregates from somewhere, that somewhere will likely be a local quarry. If the quarry doesn't have to pay for a dump truck and a driver's salary because AMZN wants to handle that - great.

 

As to the original question, I think picking disruptive tech companies is a lot more difficult for investors than it may seem at first glance. Early stage investment funds that focus on tech startups often build a large portfolio of companies where they expect most to fail with hopefully one or two being home runs that offset their losses in the rest of the portfolio. It's a different style of investing from the concentration found in high conviction value investments where there's a reasonable margin of safety - putting a significant percentage of your portfolio in a pre-cash flow startup just doesn't fly in terms of risk management, no matter how disruptive it may be.

 

As an example let's broadly look at how Google invests internally. They have their advertising business that makes the vast majority of their revenue and produces a lot of cash flow they can then invest in a bunch of cool, possibly disruptive, ideas. From Project Loon to self driving cars to robots to whatever else their brightest engineers can think up. Is there a reason why your own portfolio couldn't be structured similarly? A core of relatively stable cash flow generative companies that then provide cash to invest in a number of potentially disruptive startups.

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Should one look for the biotech or disruptive tech stock or go for the free cash flow or maybe the middle ground, no innovation but at least some place to put your capital back to work (e.g. reinvesting in capital intensive industries where government guarantees a decent return)?

 

Disruptor versus cash cow is probably the wrong way to look at this. You remember Buffett's famous "short horses" speech:

http://archive.fortune.com/magazines/fortune/fortune_archive/1999/11/22/269071/index.htm

 

Most "disruptive" tech stocks aren't great long-term investments. But there is a combination of economic castle, moat, and reinvestment opportunities that is very powerful. You are better off looking for the next Copart or Costco or McDonalds or Starbucks or Precision Cast Parts rather than speculating on biotechs. Why? Because these "boring" companies generate enough cash flow to sustain their growth. Their growth is fairly predictable. They are less susceptible to disruption.

 

To rephrase, focus on business model innovation rather than technical innovation.

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I dont think it has to be that difficult.  In the late 1990s we witnessed it in real time, in Canada, and the US at least.  There were hundreds of local companies that started up with a few servers that provided internet access.  It looked as though the telecom incumbents were done for: Bell, Rogers, Telus, ATT, Verizon.  The incumbents moved into the business with their deep pockets and now the bulk of our home internet is provided by the big incumbents.  Without missing a beat, they ate the little guys lunch. 

 

Then came cell phones and mobile data.  Again the big guys ate everyones lunch.

 

Obviously, overlaying this are the Googles, FB, and Amazons as well, which I guess were the disrupters.  But they are still using the pipe provided by the incumbents. 

 

Fracking was a big disruption, of a different sort.  Here the pipelines remained the biggest long term winners.  Had you bought Chesapeake or Sandridge, you got wiped out, but the pipelines, and refiners keep on racking up ever growing profits. 

 

Alternate energy providers are the latest disrupter.  And guess what, they are being eaten by the big guys: Berkshire Energy, Algonquin Power, Enbridge, etc.  The whole carbon trade game has given the incumbents a huge leg up.  In fact, it starts to look like there is an 85 year old dude from Omaha who has given this a huge amount of thought. 

 

Look at the car business.  You have Tesla which gets press for its innovation, in severe disproportion to its size.  Does anyone really think the Hyundais, Hondas, Toyotas, GMs, and Fords of the world are going to let Telsa take the entire car business from them.  It seems unlikey.  As much as I would like to see Tesla succeed, they have a long way to go.  I think Elon knows this, and this is why they have invested in the periphery with the battery packs.  Teslas are a showcase for the propulsion system.  I would never likely invest in the car business directly.  Its is too fickle for my taste. 

 

Buffett has been at this successfully for 55 years.  He has seen dozens of disruptive technologies in his time.  To my mind he has invested successfully most of the time.  He even gets caught with his pants down from time to time (Washington Post).  And what are his major holdings outside of insurance?

He owns the pipes: energy production and transmission, part of the transport infrastructure (an oligoply), parts makers for everthing, snacks amd beverages, etc. 

 

His portfolio is pretty mundane and allows Berkshire to build up endless cash.  Conversely, Everyone of the businesses he holds makes us of disruptive technologies, and some are at the forefront in using this technology. 

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One message I got from this professor is that the low real growth environment (not nominal padding) may be due to coming to the end of sufficient new innovations and reliance on sustaining innovations which lead to low productivity growth.  Although I'm not convinced this is a permanent situation, it may be a a temporary plateau.

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Guest longinvestor

Much of what people have in mind for disruptive technologies are better for consumption rather than an investment. Like Buffett, investors as a whole would benefit by avoiding putting their investment money in them. Buffett seems to put his money into things that are needed rather than wanted. If the disruptive technology (internet) helps the business run its business better (Geico), that goes into the cost side which (surely) reaches investors pockets. My favorite disruptive technology is VOIP since that has reduced my monthly communication budget by an order of magnitude over the past two decades. ($300 to $500 down to $45 per month). This is real savings. Thankfully I've no investments in Vonage, MagicJack etc.

 

My sense is that the hype surrounding disruptive technologies is based on outlandish top line growth projections, which is seldom realized. Taking down investment dollars with it. 

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For context, I grew up in a family that was heavily involved in the information systems, internet, and telecom industries at a very high level. Computing and engineering discussions were standard, everyday things for us and the growth of the internet and many technologies were a first hand experience.

 

I think part of what prevents investors on this board from even trying to differentiate a potentially great technology investment from an unsuccessful one, is they simply don't understand how the system and technologies work and how they might or might not interconnect fundamentally. For them, I think that's sensible and totally rational. Only a fool's going to screw around with something they don't know about.

 

On the other hand, if you've been immersed in the latest technologies as well as programming and engineering discussions your whole life, there's at least a reasonable likelihood the stupid thing to do would be to not invest in your circle of competence. For example, people like Phil Fisher, Don Valentine, Henry Singleton, the Rales Bros, John Malone, and others have all earned excellent long-term returns in high tech industries they knew well.

 

So, I think if you've got no business being there then you should avoid it but someone who combines Buffett's growth thinking (ie. the four filters, Munger's behavioral psych models, the toll-booth philosophy, FCF generation, etc) with all of what Phil Fisher wrote, as well as the best of what numerous others (especially those in the VC world - Don Valentine, Bill Gurley, Fred Wilson, and so on) have said, will have a sound investment paradigm with which too judge technology companies that fall within their circle of competence.

 

 

 

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Guest longinvestor

 

For context, I grew up in a family that was heavily involved in the information systems, internet, and telecom industries at a very high level. Computing and engineering discussions were standard, everyday things for us and the growth of the internet and many technologies were a first hand experience.

 

I think part of what prevents investors on this board from even trying to differentiate a potentially great technology investment from an unsuccessful one, is they simply don't understand how the system and technologies work and how they might or might not interconnect fundamentally. For them, I think that's sensible and totally rational. Only a fool's going to screw around with something they don't know about.

 

On the other hand, if you've been immersed in the latest technologies as well as programming and engineering discussions your whole life, there's at least a reasonable likelihood the stupid thing to do would be to not invest in your circle of competence. For example, people like Phil Fisher, Don Valentine, Henry Singleton, the Rales Bros, John Malone, and others have all earned excellent long-term returns in high tech industries they knew well.

 

So, I think if you've got no business being there then you should avoid it but someone who combines Buffett's growth thinking (ie. the four filters, Munger's behavioral psych models, the toll-booth philosophy, FCF generation, etc) with all of what Phil Fisher wrote, as well as the best of what numerous others (especially those in the VC world - Don Valentine, Bill Gurley, Fred Wilson, and so on) have said, will have a sound investment paradigm with which too judge technology companies that fall within their circle of competence.

 

Rales brothers? Danaher founders? Danaher is in no way a technology investment vehicle. Successful? Yes. Technology, no! My knowledge of them (fairly long stint @ DHR) is that they were real estate investors that ended up owning operating companies. Once they got the operating model tweaked, they grew through acquisitions, most of it opportunistically. There is no core technology competence. The Danaher Business System is the core competence, specifically the ability to apply it to an acquisition and generate mounds of cash flow.

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For context, I grew up in a family that was heavily involved in the information systems, internet, and telecom industries at a very high level. Computing and engineering discussions were standard, everyday things for us and the growth of the internet and many technologies were a first hand experience.

 

I think part of what prevents investors on this board from even trying to differentiate a potentially great technology investment from an unsuccessful one, is they simply don't understand how the system and technologies work and how they might or might not interconnect fundamentally. For them, I think that's sensible and totally rational. Only a fool's going to screw around with something they don't know about.

 

On the other hand, if you've been immersed in the latest technologies as well as programming and engineering discussions your whole life, there's at least a reasonable likelihood the stupid thing to do would be to not invest in your circle of competence. For example, people like Phil Fisher, Don Valentine, Henry Singleton, the Rales Bros, John Malone, and others have all earned excellent long-term returns in high tech industries they knew well.

 

So, I think if you've got no business being there then you should avoid it but someone who combines Buffett's growth thinking (ie. the four filters, Munger's behavioral psych models, the toll-booth philosophy, FCF generation, etc) with all of what Phil Fisher wrote, as well as the best of what numerous others (especially those in the VC world - Don Valentine, Bill Gurley, Fred Wilson, and so on) have said, will have a sound investment paradigm with which too judge technology companies that fall within their circle of competence.

 

Rales brothers? Danaher founders? Danaher is in no way a technology investment vehicle. Successful? Yes. Technology, no! My knowledge of them (fairly long stint @ DHR) is that they were real estate investors that ended up owning operating companies. Once they got the operating model tweaked, they grew through acquisitions, most of it opportunistically. There is no core technology competence. The Danaher Business System is the core competence, specifically the ability to apply it to an acquisition and generate mounds of cash flow.

 

 

When you go to 'About Us' on Danaher.com and it says, in the very first line:

 

"We are a global science and technology innovator committed to helping customers solve complex challenges and improving quality of life around the world."

 

So you're saying your former employer is making inaccurate statements about itself?

 

 

 

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Should one look for the biotech or disruptive tech stock or go for the free cash flow or maybe the middle ground, no innovation but at least some place to put your capital back to work (e.g. reinvesting in capital intensive industries where government guarantees a decent return)?

 

Disruptor versus cash cow is probably the wrong way to look at this. You remember Buffett's famous "short horses" speech:

http://archive.fortune.com/magazines/fortune/fortune_archive/1999/11/22/269071/index.htm

 

Most "disruptive" tech stocks aren't great long-term investments. But there is a combination of economic castle, moat, and reinvestment opportunities that is very powerful. You are better off looking for the next Copart or Costco or McDonalds or Starbucks or Precision Cast Parts rather than speculating on biotechs. Why? Because these "boring" companies generate enough cash flow to sustain their growth. Their growth is fairly predictable. They are less susceptible to disruption.

 

To rephrase, focus on business model innovation rather than technical innovation.

 

" Incidentally, if you think interest rates are going to do that--or fall to the 1% that Japan has experienced--you should head for where you can really make a bundle: bond options."

 

Amazing, he was quite prescient in 1999. I wonder how many investors did the bond option thing if they had thought this was coming. I would love to see an article from him in 2016 what he thinks will happen the next 17 year period.

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Anyway, to answer the original question: I think it's the sort of problem you want, if you're an investor who invests in disruptive technology businesses.

Free cash flow was always the clear priority for Amazon and almost all major successful tech businesses have gone a long way towards emphasizing it.

Net income sometimes not so much, but definitely FCF.

 

For a current example, look at Facebook then look at Twitter. Facebook's FCF growth is excellent while Twitter's is non-existent.

Facebook also ticks many of the obvious boxes you'd look for in a potential technology investment like brilliant management, a proactive approach to solving major problems, and a clear path to future growth.

Twitter on the other hand, constantly introduces ineffective products or products ineffectively, takes too long to address important issues, and has a stock-based compensation problem.

 

To me, it's obvious you want strong FCF growth and the great company, management, plus products. Why compromise unnecessarily?

I'd look forward to a time 10 or 15 years from now when my problem involves tens of billions of dollars on said company's balance sheet, because that would mean my original insight was a smart one.

I think it's best to stay grounded and just making investment decisions based on the common sense things you'd like to see in almost any other company, while remembering to wait for a reasonable price.

Management integrity and capability, FCF growth, within your circle of competence, excellent products, good industry economics, right place in the value chain, an ability to deal with major issues effectively, obvious future growth potential, and so on.

 

Then again, I've already said I'm comfortable evaluating new technology businesses (basically all consumer-related) and scoring them on those characteristics so it'd be irresponsible of me to suggest to someone who isn't that they take that approach.

Invest in a way that makes sense for you based on your skill-set and temperament. That way, you'll be able to sleep well at night.

 

 

 

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Sure, I don't think he meant that FCF should be hugely negative to be a shining example of disruption and a great growth engine. However, I would argue that disruptive growers that start off a small FCF base (perhaps losses in the first few years) are going to have sky high P/E ratios. Those who can see the future 10 years out for some of these companies can indeed do quite well if they are not blinded by the value investing precept of moderate P/E ratio.

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