Technology equities portfolio manager Denny Fish explains why, as long as data and networks continue to be valuable currency, today’s leading tech companies may face less of a dilemma than the generation of titans they displaced.

  Key takeaways

• In the past, once-innovative companies faced a dilemma as they grew larger: the considerable capital investment required to protect what has become the status quo meant less money for R&D to remain competitive.
• Today, that theory has been turned on its head as the secular themes that have propelled the tech sector now may reinforce the positions of leading companies rather than contribute to their eventual demise.
• In our view, certain tech companies’ graduation to mega-cap status may now reinforce their ability to innovate with ever-expanding networks and ample cash flow to fund R&D.

Many investors may have been forewarned that the most expensive words in the English language are: “it’s different this time.” But with respect to the challenges posed to large enterprises in Clayton Christensen’s ‘The Innovator’s Dilemma’, it really may be different this time. Over 20 years ago, Mr. Christensen – a Harvard professor – described the dilemma faced by once-innovative companies as they grow larger. The scrappiness and out-of-the-box thinking that once defined them is replaced by a need to protect what has become the status quo: the ever increasing need to reinvest into the business and service more clients. Typically, that requires considerable capital investment which, in turn, leaves less money to allocate to the research and development (R&D) necessary to stay a step ahead of the competition in a dynamic marketplace.

Since its publication, Mr. Christensen’s theory has served as a warning for growth-oriented investors across all sectors including – well, perhaps especially – technology. Looking ahead, however, we believe that the innovation-driven secular themes that have propelled the tech sector over the past several years may actually reinforce the positions of leading companies rather than eventually contribute to their demise. What is different this time, in our view, is how the complementary forces of the cloud, artificial intelligence (AI) and the Internet of Things (IoT), have enabled market leaders to leverage flywheels fuelled by powerful network effects to continue to out-innovate would-be challengers.

Avoiding the dust bin

Perhaps the most elemental force of a competitive economy is the unending demand to meet customer needs faster, better and often cheaper than the next guy. The history of business is littered with once mighty companies that failed to rise to this challenge. Erstwhile leaders across all sectors of the economy have fallen prey to faster-growing peers offering novel products and more effective business models. And with the pace of innovation having accelerated over the past decade, the risk of disruption has only increased. Losing one’s market position is often not due to strategic oversight but to the inability to both maintain an existing, large-scale business model and also deploy capital to search for the next generation of products and services.

While technology has been a vehicle of disruption across all sectors, it has also seen its fair share of fallen giants. Mainframes have given way to on-premises servers and personal computers, which have more recently been usurped by the cloud and mobile computing. Similarly, Software as a Service (SaaS) applications have grabbed significant market share from legacy software providers that failed to see the threat presented by updateable, subscription-based competitors.

The commanding heights

This process will no doubt continue, but for certain tech businesses, we believe that their graduation to mega-cap status may now reinforce their ability to innovate rather than tie their hands. The two powerful tools they have at their disposal are ever-expanding networks and ample cash.

We believe that where the themes of the cloud, AI and IoT meet is data. Business decisions tend to be much better informed when managers have large data sets at their disposal. Whoever can collect the most data – often derived from IoT – and make sense of it via the massive computing power available on the cloud – utilising AI with greater frequency – will find themselves in the enviable position of more effectively delivering value to customers while also optimising their own operations.

The most notable exemplars of this development are the large internet platforms that have commanding positions in digital advertising and e-commerce. Magnifying these platforms’ prowess in collecting and analysing data are powerful network effects that draw in additional users, thus further strengthening the value proposition of the ecosystems of these platforms.

The hyperscalers

The other factor leading tech companies have in their favour in the pursuit of innovation are large cash war chests. Innovation is an expensive proposition with lots of trial and error, and one where the few successes must pay for the many misfires. Having to allocate substantial cash flow toward maintaining an existing business model leaves less to fund R&D. But due, in part, to their strong network effects, large internet platforms and other tech leaders have been able to generate cash flow at rates unmatched not only by their tech peers but many other large-cap companies.

One subset of the sector has come to be known as the ‘hyperscalers’. This select group of companies is responsible for a disproportionate amount of the capital expenditure across the corporate sector. Much of this investment is channelled toward cloud-enabling servers and the devices powering IoT. The data-driven solutions that are the result, further increase these companies’ value proposition to clients, thus increasing the allure of their platforms and networks.

Well positioned – but not carefree

Today’s mega-cap internet platforms find themselves in strong positions. Yet, despite their size and impressive recent history, they may still be able to generate growth rates higher than smaller competitors with less expansive networks and ability to fund new initiatives. That does not mean these tech leaders do not face risks. They are clearly in the sights of regulators concerned about their size, power and the privacy of their customers. Furthermore, as in past instances, market leaders often fail to identify possible threats before it’s too late. But as along as data and networks continue to be valuable currency, today’s leading tech companies may face less of a dilemma than the generation of titans they displaced.

 

Glossary

Saas: Software as a Service lets users connect to and use cloud-based apps over the internet.

IoT: internet of things; a network of internet-connected objects that can collect and exchange data.