Disruptive innovation – Unequal growth in a changing world

Technological advances and innovative business models are transforming the size and structure of entire markets. New technologies are being adopted more rapidly than ever before, bringing benefits to customers, along with huge but unequal shifts in corporate earnings. This acceleration of market disruption has important implications for global equity investors.

“The reason why it is so difficult for existing firms to capitalise on disruptive innovations is that their processes and their business model that make them good at the existing business, actually make them bad at competing for the disruption.” - Clayton Christensen (1950 – 2020), Professor of Business Administration, Harvard Business School, developer of the theory of disruptive innovation (1995)

This four-part series investigates key structural trends identified by Axiom Investors - known as the 4 D’s - which are driving long-term equity returns:

• Deglobalisation
• Disruptive innovation
• Demographics
• Debt

We previously published an analysis of the economic effects and investment implications of deglobalisation. In this article we consider the impact of disruptive innovation on investment returns.

What is disruptive innovation?

Investopedia defines disruptive innovation as:

“The innovation that transforms expensive or highly sophisticated products or services - previously accessible to a high-end or more-skilled segment of consumers - to those that are more affordable and accessible to a broader population. This transformation disrupts the market by displacing long-standing, established competitors.”

Disruptive innovation is frequently driven by rapidly advancing technologies that are catalysts for new growth opportunities. These often evolve within an environment of structural change, such as labour shortages, time poverty of professionals, sedentary lifestyles, and consumption shifting to align with values.

Which markets are experiencing disruption?

Technological advancement and disruption often go together. Amazon disrupted the retail book market through an online platform which removed the need to visit physical bookstores, before expanding into many other markets. Uber disrupted the taxi market by providing a cheaper and more user-friendly transportation option. Netflix used technology to disrupt first the video rental and then the pay television markets by delivering televised content on demand, free from schedules. Lockdowns accelerated adoption of many such business models.

However, not all disruption relies on technological progress. Costco’s business model serves grocery shoppers with above average incomes and storage space for bulk items, but who are searching for a bargain. Cosmetic brand e.l.f. Beauty markets ‘affordable luxuries’ to digital native millennial/gen Z females who are concerned about the ethical sourcing of products. Both have recently seized market share from larger, well-established businesses.

Increasingly sedentary lifestyles have expanded the size of the weight loss market which has traditionally comprised of diet and exercise programs. Novo Nordisk and Eli Lilly’s GLP-1 obesity treatments have repurposed existing pharmaceuticals to offer much more immediate results, leading to rapid sales growth.

What does the wave of disruption mean for corporate earnings and share prices?

Disruption is getting faster; this graphic shows how the adoption of new technology is accelerating:

The speed of growth reflects faster information flow and the increasing willingness - especially of tech savvy younger demographic cohorts – to change their media consumption and buying habits. It also reflects the immense capital investment that established technology groups and others can quickly allocate to disruptive projects. This creates significant barriers to entry once a very limited number of participants are entrenched, providing space to further enhance their technology and rapidly scale revenue.

Advanced computing power supports a wide range of generative AI tools which facilitate disruption across the global economy. Those businesses who are ‘selling the shovels in the AI gold rush’ such as leading fast semiconductor developer Nvidia and the ‘big three’ cloud computing providers Google Cloud, Microsoft Azure, and Amazon Web Services are delivering rapid earnings growth.

What should investors do now?

Disruptive innovation is reshaping the global economy and the earnings growth of companies within it. However, not all companies will be impacted equally. The concentration of earnings growth within a limited number of companies – often not the pre-disruption market leaders - may well continue. This environment favours investing in a select set of quality stocks aligned to shifting consumer behaviour rather than the whole market.

US-based Axiom integrates more than a million data points into its proprietary database Axware. These insights identify business models which deliver outsized earnings growth before the next wave of innovation reshapes industries. This requires a robust investment process to determine which companies meet the criteria for disruptive innovation and can deliver superior earnings growth through the economic cycle.

The macro environment remains uncertain, which may bring further volatility at the market level. Astute investors may do better by targeting companies able to grow earnings regardless of interest rate and consumer spending cycles.