How to invest in companies with staying power

The credit crunch wasn’t the only development in late 2007 that was to change the shape of an industry forever.

It was in October 10 years ago that the initial concept for Airbnb was created, soon to have a profound effect on the hospitality and lettings industries.

The previous year had seen the birth of Twitter (TWTR) and the arrival of Facebook (FB) in the public consciousness, while 2008 brought us Spotify and 2009 delivered Uber.

These are just some of the brands that, alongside relative veterans such as Amazon (AMZN), ASOS (ASC), Netflix (NFLX) and Tesla (TSLA), have shaken up established business models. Often referred to as disruptors, they have left traditional incumbents trailing in their wake.

Digital innovation

Remember Blockbuster? The digital innovation behind the likes of Netflix rendered it virtually obsolete.

Technological change did for Kodak too, while bookstores such as Borders and Barnes & Noble were among numerous high street retailers devastated by Amazon’s impact.

But some companies and sectors may well prove to be disruption-proof. Not all are ripe for the picking by new entrants.

For all those that would appear to be under threat, there are others with the characteristics to suggest they are well positioned to maintain and even build on their dominance.

Those stalwarts may remain in pole position despite the challenge from technological innovators, or simply because they are in industries with dynamics that offer few opportunities for potential upstarts.

For example, companies involved with infrastructure are to some extent shielded from the impact of technology-driven disruption, particularly where there are assets of a regulated nature.

Rory McPherson, head of investment strategy at Psigma Investment Management, explains: “Economist estimates are for developed economy infrastructure assets to double in the next 15 years, and emerging economy assets to triple in size.

“Many of the cash flows are set (or linked to inflation) by regulators, which allows the companies not only to pay strong, stable dividends, but to still deliver the cash flows in periods of economic stress; hence these companies tend not to move in line with other equities.”

Toll roads and extractives

McPherson nods towards the Legg Mason RARE Infrastructure fund as one offering exposure to such companies.

“This tends to mean a preference for companies involved in the supply of electricity and water, as well as assets such as toll roads; being backed by a hard asset with stable cash flows means these companies can largely chug along, regardless of the near-term impacts of technology.”

There is a similar case in favour of extractive industries, simply because of the limited number of ways in which resources can be removed from the ground.

“The baseline for commodity prices is generally the marginal cash cost of production for the lowest cost producer, and that rule is likely to stand,” says Amanda Forsyth, investment manager at Edinburgh-based Murray Asset Management.

There are also industries in which the development of new ways of doing business has had little impact on the bottom line.

In banking and utilities, for example, regulatory efforts to open up the market continue to be thwarted by ‘sticky’ customer behaviour and the high costs of entry.

“Although it has become ever easier to switch bank accounts and energy suppliers, the simple inertia exhibited by many customers has meant that the freedom has only been exploited to a very limited degree,” says Forsyth.

“Some industries may actually become beneficiaries of disruptors in their supply chain; an example here would be the housebuilding sector. As the likes of Purplebricks (PURP) bring down the cost of selling a home, the liquidity of housing stock should, all things being equal, improve,” she continues.

Stock exchanges may also be at minimal risk of technological disruption. With roots that can be traced back to the 1570s, the London Stock Exchange (LSE) and Deutsche Bourse (owner of the Frankfurt Stock Exchange) can claim to be among the world’s oldest corporations, points out Charles Plowden, joint senior partner at Baillie Gifford and manager of the Monks investment trust (MNKS).

“Over time they have diversified into new asset classes, from foreign exchange through stocks and shares to derivatives, but at the heart of all lies the concept of a trusted marketplace, which is precisely what drives the success of the likes of Amazon or Alibaba (BABA) – and indeed our understanding of the exchanges informed our early investments in such companies,” he explains.

The advantage of exchange and marketplace businesses is that they tend to have largely fixed costs, and therefore high margins and low capital expenditure needs, says Plowden.

“We generally perceive the exchanges to be exploiters and beneficiaries of new technology, rather than its victims; it is always the provider of liquidity who wins in the end. Regulatory change is actually the greater risk, as they tend to be natural monopolies; but the recent trend, especially since the global financial crisis, has been to encourage more trading onto exchanges, to give greater transparency and security.”

Defence against disruption

Established firms have various strategies they can employ to defend against disruption. The automotive sector is an example of one in which market-leading brands that identify the nature of the threat can adapt their business models and try to take the disruptors on at their own game.

The challenge to the traditional carmakers comes from two sources in particular – climate change related regulation (such as new restrictions being imposed by several countries on diesel cars), and the evolution of driverless cars.

A combination of car-sharing and autonomous driving technologies could result in a 60% fall in the number of cars on roads globally, Barclays has estimated.

But while some global motor firms are struggling to evolve, several of the big names have begun investing heavily in their own driverless technologies (including Volkswagen (VOW), as it recovers from the rigged emissions scandal).

Another option for incumbents is simply to buy emerging companies that have become competition and which have shown their model can work.

Some of the big technology and ecommerce platforms have taken this approach, with Google's (GOOG) purchase of YouTube and the 2011 acquisition of Skype by Microsoft (MSFT) both prominent examples.

Chinese tech giants including Alibaba and Tencent (TCEHY) have increased their scale by acquiring the up-and comers with the biggest potential.

For all the newcomers that have taken advantage of technological innovation to change the shape of industries, companies and investment portfolios, there will always be the stalwarts that cannot or will not be disrupted.

It’s never been more important for investors and investment managers to understand what it takes for a company to have staying power.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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