How Disruption Works

Podcast

A couple of months ago, I started a podcast. It took time and iterations for me to find a product I believe is worth consuming. The thesis for the podcast is to think aloud about the stock market and digest reads. Episodes are a great complement to Sunday articles as they include much more breadth of thought and multiple things I don’t share in these write-ups. I’d appreciate if you gave it a try (last 3 ones have much better audio):

From 0 to 1 in the Stock Market, Podcast

Article

I have been reading and writing about Clayton Christensen’s work for 3 months now and there’s definitely no bottom to it. By itself, his theory of disruptive innovation has an unbelievably profound depth. But, moreover, there are infinite concepts that surround the theory and Clayton’s thinking that also bring layers and layers of knowledge. Among these, we find ‘business models’, ‘interdependence vs modularity’, ‘how industries evolve’, and many more we’ll be covering accordingly.

The reason why I’m placing infinite emphasis on learning these things goes around the following. The definition of a theory. A theory is a statement of causality. And a good one can not only detect patterns from observations, but actually predict a phenomenon’s behavior. The good thing about the disruptive theory is that it is industry-agnostic. There is only one process, which seems to be repeated industry after industry. If correct, it should allow us to leverage it in our companies’ industries and foresee whether there are dangers on this front or, even better, if there are not.

Disruption in the steel industry

In the 1990s, Andy Grove’s acquaintances and partners were talking about this new thing called disruptive innovation. Grove was curious and called Clayton directly to see what it was about. After a short conversation, Andy asked him if he could go to Intel’s headquarters on the west coast to explain his theory to Intel’s team and analyze how could it impact the business. Since there are too many specific pieces of information needed to perform a reasonable assessment over each industry, Clayton always tells the story of how disruption worked in the steel industry.

Integrated steel manufacturers had been leading the industry for a long time and were quite comfortable, but things changed when mini mills became technologically viable in the mid 60s. However, the steel quality they could produce was extremely low, which becomes a problem when trying to compete in the high-end of the market.

Therefore, the only market that would accept what a mini mill could produce was the concrete reinforcing bar market, at the bottom, because there’s almost no specifications for re-bar. Once it’s buried in cement, the quality is unverifiable and non-required as well, if I’m not mistaken.

At the same time, because the quality of the product didn’t matter that much at this bottom end of the market, margins were in the mid to high single digits. Furthermore, it only accounted for 4% of the industry’s tons produced. Curiously, because mini mills had a 20% cost advantage over integrated manufacturers, their margins in this market were pretty nice.

When integrated manufacturers saw mini mills getting into the re-bar market, they just walked away from it. Not only was this a minuscule part of the industry, but it also reported almost no benefit because of the low margins. Integrated producers, because of the high quality of their steel, could compete at the high end of the market (angle iron; bars & rods), where profit margins were higher. One by one, they started leaving the re-bar market, which went on until 1979, when the last integrated manufacturer left it.

In 1980, when there were only mini mills competing with one another, the price of re-bar dropped by 20%. Once the high cost producing companies left, the remaining producers all had this 20% cost advantage. Added to the fact that steel is a commodity, prices very quickly tended towards costs, as there was no meaningful differentiation between products. At this point, mini mill companies started wondering what would they do since they now weren’t making any profit.

In most industries, the higher you go upmarket, the higher the profit margins. Therefore, these new companies had to find their way into higher tier markets. What hadn’t allowed mini mills to move more rapidly upmarket is that, in parallel, the higher you go, the higher quality is required to compete. In the case of mini mills, they weren’t initially optimized to produce something of higher quality than re-bar. But, little by little, the rates of improvement pushed mini mills quality capacity higher and higher.

That’s the time when mini mills entered the angle iron, bars & rods market. When integrated manufacturers saw this, they were very happy in leaving the bottom end of the industry. Gross margins were a mere 12% and it only represented 8% of total tons produced. Moreover, integrated steel producers had the luxury of competing at the high end of the market, structural steel.

It made no sense to invest in protecting the least profitable part of the business when they could reconfigure their fabs to now produce more of the high margin products. One by one, they were leaving this market and, in 1984, the last one had left it, leaving mini mills competing with one another. A year later, prices drop 20%. Now mini mills find themselves with no profit margins, so what will they do? Well, they have to go up market and compete in structural steel.

The same story happened with structural and, as of 2010, when I think Clayton was shedding light on this matter, mini mills now had half of the sheet steel market.

That is how disruption works, industry after industry. The new lower cost player displaces the giant from the bottom end of the market. One is happy entering it and the other is happy leaving it. They don’t see the threat until, market after market, they get competed away and, finally, the disruptor claims the highest end of the market.

Personal commentary

What a fascinating process. I’m unbelievably dazzled by Clayton’s realizations and I hope you see some of that. I honestly think we can find a lot of use in this theory. It is becoming increasingly clear that we can leverage it to find true compounders or disruptors. It can very much help analyzing competitive landscapes. Anyway, hope you enjoyed the article.

Contact: giulianomana@0to1stockmarket.com