In 2015, Clayton Christensen – who coined the term “disruptive innovation” – wrote in The Harvard Business Review that as incumbent businesses became preoccupied with improving their products and services for their most demanding (and usually most profitable) customers, an interesting trend emerged. One by one, these businesses would soon exceed the needs of some segments and completely ignore the needs of others. This made them ripe for disruption.
As smaller companies with fewer resources began to successfully enter the market, a fundamental shift in power would occur as the newer entrants contested and successfully challenged the business models of traditional market incumbents. They would target those previously overlooked segments in the market. What’s more, they would be much more disciplined and nimble in delivering suitable functionality quicker, more efficiently and at a lower price point.
This universal truth about disruptive innovation extends to the competitive landscape of Australia’s established ASX 300 companies, the “old world” facing the rising tide ahead.
At Hyperion Asset Management, our ethos has always been to invest like business owners, taking a bottom-up approach that aims to produce superior investment returns for our investors over long-time horizons. According to our research this year, approximately 77 per cent of ASX 300 companies are ill-equipped to navigate the storm ahead: they are not growing and are at risk of being disrupted.
When we look at the majority of these “old world” companies, we see a lot of risk to their business models. This is because of an inability to produce sustained organic growth and remain relevant to the next generation of customers. Many of these companies are likely to experience a decline in their intrinsic value over time as more innovative businesses start to emerge. These incumbents are the “old guard” businesses that are highly reliant on economic growth which, right now, is abundant. In Mr Christensen’s words, they are “chasing higher profitability in more-demanding segments” but equally they have become complacent. In other words, they are at a higher risk of being left behind.
Over the next 12 months, growth will become scarcer, making it much more difficult for your average business that is relying on the economy for its earnings. Investors are torn between factoring in transitory or persistent inflation, and the jury is out while the data emerges. And, the threat of technological disruption is suddenly much more real.
Inflation has started to rise in economies such as the US, where the consumer price index surged in April to a level not seen since 2009 on a headline basis. Core CPI was even stronger, rising the most since 1996. But these surfacing signs of inflation are really just a function of the cyclical recovery in the economy from the COVID-19 lockdowns.
At Hyperion, we maintain short- and long-term outlooks for inflation and the headwinds that this represents for Australia’s current crop of ASX 300 listed companies – seeking those with solid fundamentals, a global outlook and structural growth opportunities. As the market continues to evolve, it’s important to remind investors that the current pick-up in inflation is cyclical. We still believe inflation is likely to stay low over the longer-term.
Cheaper energy in the form of renewables and better battery technology is an integral part of this investment thesis. Solar, wind and batteries are all on technology cost curves, so they are likely to get cheaper at double-digit rates over the coming years, and that will feed through into lower prices for most goods and services and that will be disinflationary.
Investors in today’s climate must continue to maintain a longer-term investment horizon, as we see a variety of factors emerge that will suppress inflation, starting as early as 2022, and having a flow-on effect on Australian listed companies. Ageing populations, high debt levels, a hollowing out of the middle class and globally integrated product and labor markets are powerful structural forces that are here to stay and have kept price pressures subdued across advanced economies.
New technology will undoubtedly replace traditional models and it’s critical to be able to selectively buy the businesses that are disrupting the rest, avoiding those lower-quality businesses that have left themselves too geared towards economic growth in the short-term.
Needless to say, low growth and low-interest rates are here to stay and it’s going to be a much harsher environment for investors. Only a disciplined approach that can continue to identify winners – those with structural tailwinds, large addressable markets and a sustainable competitive advantage – will help provide comfort and clarity to investors facing the storm.
Mark Arnold, chief investment officer, and Jason Orthman, deputy chief investment officer, Hyperion Asset Management
