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Profits Kill Businesses
Before going into the article, something personally important. I’m studying for an MA Degree in Finance and Economics, in Boston. I’m about to start my second semester and, after the third one begins, in January, I’ll be legally allowed to do an internship. I’m looking for an asset management firm that might be looking for someone that performs equity research, preferably in Boston or New York. If you happen to know of anything, I’d be really grateful if you let me know.
New information has entered my scope. I haven’t read much of The Innovator’s Dilemma this week as I’m starting to feel mentally exhausted. This book might be the most important one I’ve come across with regards to investing, I need to internalize it. Therefore, I’m only reading it when totally lucid. Nevertheless, I’ve been listening to all conferences and lectures Clayton gave and found so many gems it’s unbelievable. I think he’ll be at the core of this newsletter for a while.
We have covered what the two types of innovation Clayton believed are out there. I don’t know if I missed it on the book or if it’s something that came up after the writing, but there is a third type of innovation. Efficiency innovations are those that make existent products more productive, keeping output and reducing the input. These are the ones that help drive margin expansion and, consequently, eliminate jobs.
The innovator’s dilemma
I haven’t yet properly articulated this idea, but it is vital for both of us to understand it. I will try again.
Companies are built up from nothing. New technologies are a zero to one move. The problem with this is that, because you are creating something that has never existed, you have no idea how to optimize this product for profitability. Furthermore, initial iterations of the new product have little addressable market and close to zero applicability.
Most new technologies will, at some level, compete with old ones. They have some overlap. It’s not like a new technology creates an entire new market without destroying at least part of a previous one. Hence Thiel’s idea that the history of business is a story of new monopolies replacing old monopolies.
When a firm gets to successfully create a product, it then proceeds to make infinite sustaining and efficiency innovations so that margins and productivity continuously improve. It then becomes the leading company, the one with the spotlight. Management has three options to invest in:
Sustaining technology. Improving the productivity of an old product will be close to a guarantee that you remain leading in your market. It helps build brand value as customers see that you are working for them to get better results. It might allow you to charge a premium for the enhancement and, with costs being the same, drive margin expansion. Moreover, returns on capital are high on sustaining technologies, which, combined with margins, it’s the magic formula for investors. Your business will attract capital, who wouldn’t want to invest in a business with high returns on capital and expanding margins?
Efficiency technology. Making a product more efficient means it requires less resources for it to be manufactured. Consequently, less costs are implied in its creation. Because efficiency innovations are done on existing products, it is very likely that you don’t need a ton of investment to find potential innovations in this regard. Therefore, returns on capital are high, margin expansion is guaranteed, and the probability of success is very high. Capital will flood into your business and customers will be happy if you charge them less for the same product. Fantastic.
Disruptive innovation. You already have high-paying customers, you own the market and sell at very high margins. Investing for a disruptive technology implies for you to do a zero to one move, with all context provided above. No guarantee of success, the initial product will serve almost no one and it will be sold for much smaller margins than the ones you currently offer. Investing in disruptive innovation will depress your margins and returns on capital. Investors will criticize you because you are wasting money and customers will find no use in your new technology.
The pursue of profits
That is why good managements fail. It is impossible to logically arrive to the conclusion that investing in a disruptive technology is the best path forward. It’s utterly counterintuitive. Option A and B are the ones that promise the best results, which is capital. It makes investors and customers happy. Nevertheless, it has always been the case that new technologies displace old ones.
Clayton believed (I think) that the problem is in how we measure success. It makes sense for managers to look for high operating margin products and high return on invested capital. However, doing so indefinitely will inevitably condemn you. So why do we measure success in this manner?
Crazy idea and I’m barely scratching the surface. I wasn’t kidding when I said this is a deeply insightful book. There is a lot yet to cover, in the line of this article, the previous one of things that don’t change, and many more I yet have to learn about this man. Hope you enjoyed the article!
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