The Investor's Best Disruption Defense

It's hard to tell which companies are going to be disrupted. Newspapers once looked infallible but have since suffered low end disruption from free online news. Many traditional brick-and-mortar retailers have lost sales to online retailers who charge less and have lower cost structures. The traditional car industry, which has been fashioned around car ownership and performance attributes like gas mileage, handling, acceleration, and looks is probably going to be disrupted by (1) cheap, ultra-convenient transportation as a service (e.g., self-driving Uber cars) and by (2) electric, self-driving vehicles -- with tightly integrated hardware/software -- that function as mobile offices and living spaces.

Cheap transportation as a service is a form of low end disruption that appeals to people who don't derive additional benefits from car ownership. Electric, self-driving mobile offices/spaces are a new market disruption appealing to consumers who need transportation and a place to work/live -- a mobile work/living space gives these consumers an economical way to "kill two birds with one stone."

The flip side is that many traditional businesses survive disruptive threats. Some brick-and-mortar retailers are doing well, sales of printed books have stopped declining, and newspapers like the New York Times, the Washington Post, and the Wall Street Journal have made successful transitions to online content. It's hard to predict the future.

An investor trying to read the tea leaves can only really protect himself through adequate diversification. If you're a Benjamin Graham disciple, this means holding 10 to 30 stocks. If you're Seth Klarman, it means holding 10 to 15 stocks. If you're Warren Buffett, it means holding five or more stocks and knowing as much as possible about each one. Adequate diversification -- however you define it -- is probably the most reliable way for an investor to protect himself from the catastrophic effects that disruption can have on a single company/stock.

It's also worth noting that incumbent companies trying to address disruption through the creation of a low end or new market product often make their returns and balance sheets worse. Incumbents trying to self-disrupt often leverage up and/or pour money into projects with a poor return on capital employed (capital employed meaning working capital plus net fixed assets). Low end and new market disruptions that initially appear promising frequently fail because margins and/or sales volumes are too small to generate a meaningful return (that's why entrants generally pursue new and low end markets before incumbents do).

It's ironic: from an investor perspective capital expenditures to develop disruptive/promising new products should often be distributed as dividends instead, since new products usually fail and investors are well-positioned to invest dividend income in companies with higher/better returns on capital, while from a management perspective self-disruption through low end and new market offerings is critical to long term corporate survival, even if it means lower overall returns on capital employed.