How Innovation Can Improve Your Investing

Like rocket fuel, innovation can help power a prosperous American future -- or blow entire industries to smithereens. Even as it drives growth, innovation can also cannibalize companies in any industry, insidiously stealing their market out from under them. Toyota did it to General Motors, Canon did it to Xerox, and Sony did it to RCA.

This concept, known as "disruptive innovation," was coined by Harvard Business School professor Clayton Christensen. The author of The Innovator's Dilemma, and the foremost expert on innovation in the U.S., visited Fool HQ recently to share his thoughts on the power of new ideas.

Disruptive innovation: Good for consumers, bad for companies
Christensen defines disruptive innovation as any development that transforms an industry whose products historically were complicated and expensive into something that is affordable, simple, and available to a much larger population. According to him, disruptive innovation generally occurs when a company comes in at the bottom of the market with an inexpensive product, and proceeds to clear out that whole market.

Consider the automotive industry. Toyota entered the U.S. market not with the pricy Lexus, but with a small compact model called the Corona, back in the 1960s. From there, it progressed to a Tercel, to a Corolla, to a Camry, to an Avalon, to a Forerunner, to a Sequoia, and then to a Lexus.

Meanwhile, GM and Ford (NYSE: F  ) , who were manufacturing large cars at the time, looked down at Toyota and said, "We ought to compete against them." Both U.S. automakers began to make smaller cars to compete with Toyota -- until they compared the profitability of compacts with that of the Ford Explorer or F-150 pickup.

"They found it didn't make sense to defend the least profitable end of the business when they have the privilege of making even bigger cars to sell to even richer people," said Christensen. "Now it makes sense that the Japanese were coming from the bottom, but the game is basically over for them."

Now, Christensen said, Korea's Kia and Hyundai have stolen the subcompact end of the business, and they're moving upmarket very quickly. "It's not because Toyota is asleep at the switch, but rather, why would they ever invest to defend the least profitable end of the business when they have the privilege of competing against Mercedes and much more profitable products?" he said. Christensen predicts that GM's and Ford's fates will eventually be Toyota's as well.

"There's no stupidity on either side of the equation," said Christensen. "The mechanism that drives companies to move up market is the pursuit of profit."

The key to sustainability
How does a company like Apple (Nasdaq: AAPL  ) , widely considered an incredibly innovative business, sustain that over the next 10-20 years? Christensen says the only way companies have ever kept their core business healthy when a disruptive business surfaces is if they set up a completely independent business unit, and gave it the charter to "kill the parent."

"A business unit with its own business model wasn't designed to evolve," Christensen said. "It's designed to give a particular value proposition to a particular set of customers. But a corporation can evolve by creating new business models underneath the corporate umbrella."

Christensen points to IBM (NYSE: IBM  ) as the poster child for sustainability. IBM set up completely independent business units for each new product or service. Whether it was jumping from making costly mainframe computers to minicomputers, or moving from software and hardware to services, those separate business units enabled the company to slash overhead and costs to boost margins and volume.

"So the individual business units haven't evolved at all, but IBM as a corporation did," Christensen said, "by shutting down dead ones and opening the new disruptive business, and it's a rare thing."

Who is about to be disrupted?
We asked Christensen whether Apple, Amazon.com (Nasdaq: AMZN  ) , or Google (Nasdaq: GOOG  ) would be disrupted first. He picked Apple, followed by Amazon, and then Google.

At the bottom of Apple's market, Christensen says that music-playing cell phones, primarily from China, are disrupting the iPod. "My prediction is that they'll get driven out of the iPod business in the same way they were marginalized in computers, become an iPhone company, and try to keep shooting up market as Samsung and Nokia come after them," he said.

Christensen puts Amazon in the middle, because he says he thinks Amazon has interesting disruptive opportunities in the publishing business. But he worries about Amazon's model because of the history of disruption within retailing. At the beginning of every wave, he said, the initial business model is a portal. In the past, once people figured out where to go to get what they needed, they didn't need a portal anymore. For instance, Marshall Field's was the portal for department stores. "But once it matured, independent retailers like Abercrombie emerged and people knew where to go," he said. "They didn't need the portal."

Christensen says Amazon is the portal for online retailing. If the historical pattern holds, people will flock to smaller outlets where they know they can buy what they need -- knocking Amazon from its perch.

He puts Google last, because he doesn't see a disruption coming at the search giant yet. "They haven't developed another truly profitable growth business after the ad business," he said. "But you see [rival search sites] trying to compete head-on, and that always loses. So I think the current model has good legs for a long time."

Innovation as investing thesis
Christensen has put disruptive innovation to work through investing, and so can you. His strategy is simple: Invest in disruptive companies while they're small, and when they hit the high end of the market, sell. He works from the premise that the disruptive companies will consistently surprise the market. "Wall Street's methods of valuing companies systematically underestimate how big the disruptive companies will become," says Christensen.

How successful has his approach been? Christensen started his own personal portfolio with family money in 2002, and the fund has since yielded a compounded annual return of 32%. His portfolio includes salesforce.com, which is disrupting Oracle (Nasdaq: ORCL  ) ; Research In Motion (Nasdaq: RIMM  ) , whose BlackBerry is unseating the notebook computer; and Orbital Sciences, which is shaking up the satellite business.

As Christensen's holdings demonstrate, while innovation can destroy entire companies, it can also be an excellent way to build a strong portfolio.

Further novel Foolishness:

Fool contributor Jennifer Schonberger owns shares of Oracle, but she does not own shares of any of the other companies mentioned in this article. Apple and Amazon.com are Stock Advisor recommendations. Google is a Rule Breakers pick. The Motley Fool owns shares in Oracle and has a disclosure policy.


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