The best horseman in Europe will be your guide

It’ll go down as the greatest mistake in investing history. Buying stocks in companies which have already fulfilled their potential. Companies that won’t grow like they used to.

And yet, almost all investors do just that.

Ever since the government’s promise to take care of you in retirement came up short, and the corporate pensions started struggling too, investing for retirement has become the norm. People plough some portion of their paycheque into the stockmarket, almost automatically.

Because there are so many of us with so much money being saved, that deluge gets dumped into large companies. The FTSE 100, the S&P 500, the ASX 200 and so on. Few pension funds bother with smaller, less liquid stocks.

A certain famous fund manager’s recent debacle put on display precisely what can go wrong if funds take on more risk in smaller, less liquid assets.

But sticking to large liquid stocks is like buying the horse that won the race. You’re probably overpaying and past performance is no guide to future success. Holding has-beens is a poor way to win the cup in any sport.

To cover up this obvious flaw, the phenomenon of passive investing has become popular. Attempting to find opportunities is supposedly a mug’s game. You’re better off sticking with the herd. Mediocrity is good enough. Don’t worry, you won’t get trampled.

And so most people stick to their blue-chip stockmarket index. It is easier, after all.

But investing is supposed to be about uncovering potential. About growth and the future. If it isn’t, you’re punting on how much time is left in a company’s life cycle before decline. Before competition catches up and diminishes profits, or the industry becomes obsolete altogether. That’s not very inspiring, is it?

Even if stockmarket indices supposedly go up in the long run, the companies in them gradually die off and fall out of the index, reducing your returns. They are replaced with new upstarts that you didn’t own until they grew big enough to get into the index. Until it was too late to make big gains, in other words.

The sort of decline I’m pointing out is top of the news cycle right now thanks to climate change. Coal stocks, oil stocks and other unethical companies are all in the firing line. Get out before they become obsolete – that’s the mantra you’ll hear.

Strangely enough, the impressive performance of tobacco stocks and other politically incorrect companies is not mentioned. Then there’s Japan’s plan to build 22 new coal power plants. But let’s leave all that to the side for today.

Surely you’re better off investing in companies with potential to boom? Companies that haven’t boomed yet, in other words.

I suppose that’s part of the premise of Exponential Investor. I’m preaching to the converted… But after two weeks on paternity leave, I’m just warming up.

If you agree with what I’ve said so far, then you’re probably not particularly interested in economics. After all, it’s boring. And not very innovative. It doesn’t feature the sort of booms that Exponential Investor is all about.

But there is one economist you should know all about. He’s practically the patron saint of exponential investors.

Joseph Aloïs Schumpeter’s three goals in life were “to be the greatest lover in Vienna, the best horseman in Europe, and the greatest economist in the world.”

But that’s not why you need to know about him. It’s his theory of creative destruction – the lifeblood of exponential investing. At least, as I see it.

The idea is all about how innovation also destroys parts of the economy. But what makes the creative destruction theory interesting is that such destruction is required for innovation and that it must happen first. This is what sets Schumpeter apart from the basic idea that innovation is disruptive. It’s creative destruction, not destructive creation.

As Schumpeter sees it, for capitalism and innovation to evolve, it requires turmoil. Labour market turnover, bankruptcies, unused resources, crises and defaults.

Many of the US’s most successful companies were born during the Great Depression. People who get fired are often the ones who start companies.

Corporate America loved the idea of creative destruction as a justification of downsizing. It’s a validation for spinning off business parts that aren’t profitable because it implies that future innovation and growth should be using those resources for more productive purposes.

In other words, if it isn’t making money, it should be owned by someone else who would use it to make money. Failure is part of that reassignment.

When mechanisation and automation left the luddites unemployed, the creative destruction enthusiasts would’ve celebrated this. Quietly. Because they see it as part of the next phase of growth.

If machines can do what textile workers used to, then the textile workers should go on to produce something else instead. This increases the total amount of stuff being produced, making living standards better. Without the textile workers being laid off, the next phase of economic growth would not be possible. The destruction comes first. And it is part of the process of future creation.

Farming employs a tiny proportion of the labour market compared to 100 years ago. And yet we’re not exactly running out of food. Instead, we have far more other stuff as well as more food.

But what does creative destruction mean for investors? Well, if you see destruction in an industry, what does it suggest?

An opportunity, if you ask Schumpeter. Something is about to be created with those resources.

A similar way to think about all this is called the S curve. Innovations have a habit of being adopted by society at a certain speed. There are the innovators, the early adopters and so on. Things start slow, speed up and then the stragglers take a long time to opt into the new tech.

Michael Felton of the New York Times and Harvard Business Review plotted the S curve phenomenon for us:


Source: Harvard Business Review

As you can see, it’s not a perfect fit. But the general idea holds.

Now ask yourself, where should you invest in such tech trends? What was the optimal time to buy into the companies that are part of these industries?

Many innovators fail. And the tech bubble of 2000 is a nice example of what happens when a promising technology is turned into a dangerous investment fad. The price must be right, no matter how promising a technology is.

Invest too late and you’re joining a trend when profits are being squeezed by competition and the gains are already baked in. That’s what most investors do when they invest in the stockmarket index, which includes companies after their success has played out. When will they be the destruction that begets creation? It’s only a matter of time. And the losses will be painful for shareholders.

As far as I can tell, the best time to invest is when the process of creative destruction has begun. When Uber began causing trouble for cabs, Dell began causing trouble for IBM, Amazon for retail and airlines for ocean liners.

Why?

Because that’s when cash flow begins its shift. And investors should pay attention to cash flow.

Do you think Schumpeter would’ve agreed? Which industries are struggling for cash right now? Which industries are preparing to take their place?

Let me know here: nickolai@southbankresearch.com.

Hint: I just got my first online grocery delivery…

Until next time,

Nick Hubble
Editor, Southbank Investment Research

Category: Technology

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