How to Spot Innovative Companies

Many of the companies that keep showing up as recommendations in The Motley Fool's stock-picking services are disruptive -- companies that totally change the status quo of their industries, that meet needs their markets hadn't even known they desperately wanted.

In this week's Industry Focus: Tech, host Dylan Lewis talks with Million Dollar Portfolio analyst Simon Erickson about five principles that investors can use as guidelines to identify disruptive companies, based on Clayton Christensen's book The Innovator's Dilemma. Also, they explain why once-disruptive companies often lose their game-changing luster with time, why it's so hard to predict future markets, what Facebook (META -2.28%) and Netflix (NFLX -2.52%) did so right, and more.

A full transcript follows the video.

This podcast was recorded on Sept. 2, 2016.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Sept. 2, and we're talking innovation and disruption. I'm your host, Dylan Lewis, and I'm joined in the studio by Fool premium analyst Simon Erickson. Simon, how's it going?

Simon Erickson: Great, Dylan. Two of the finest words in investing right there: innovation and disruption. I love it already.

Lewis: Have you tried to reach out to people at dictionary.com and get your face directly next to those definitions?

Erickson: I really need to. That's a great idea.

Lewis: Yeah, one of these days. This should be a really fun show. We're basically going to go through the Fool's introduction to disruption, like Disruption 101 class. Thankfully, I have Professor Simon Erickson to help me out. Simon, when I say this is a class, I'm not kidding. This is something we've institutionalized a little bit.

Erickson: That's true.

Lewis: You gave a presentation a couple months ago to Fools, whoever wanted to show up and hang out and listen, check it out. This discussion we're going to have is also a part of what the analyst development program on the investing team side, what those people go through as cohort when they come in and learn how we invest, and become part of our program. So, this is kind of a look behind how our investing team thinks about some of the stuff, and, I think, a cool thing to be able to share with listeners.

Erickson: Yeah, and it's really a neat field. It's all based on a book called The Innovator's Dilemma written by Clayton Christensen back in 1997. We incorporate it into our investing process. You see it a lot in our Rule Breakers service, our Supernova premium service. It's basically an understanding of, why do these huge companies, like the IBMs and the Ciscos of the world not just keep getting bigger and bigger and more efficient and taking over the world eventually? There's something that changes along the way, and disruption, to a very large extent, explains what's happening.

Lewis: Yeah, and it's something that's near and dear to the Fool's heart. Like you said, a lot of the very successful stock picks from our newsletters have been highly disruptive companies. We've been able to benefit from having folks identify these hot spaces and the companies operating in them fairly early on, and hopefully helped out investors along the way. Listeners, the idea with this show is, we're going to outline, basically, what it truly means to be disruptive. There may be a little bit of a misconception out there. Also, why investors should care, and some of the principles that Fools use to identify disruption and some of the companies that are leading the charge in some of these spaces. Simon, to kick it off, what is disruption as you define it here, and as Christensen defines it?

Erickson: Disruption is based, first, off of technology itself. Technology, the definition of that is really just a process that changes labor, money, materials from something of a lower value to a higher value. You see examples of this all the time. Apple takes radios and processors and compiles them all into an iPhone, which is of much higher value for somebody than all those pieces together. Wal-Mart does the same thing. They take a world-class inventory management system and can work with vendors all over the globe to put those products into a discount retailer. Technology is how you bring something from a lower value to a higher value.

The interesting part is that technology changes over time. We call that innovation. There's really two types of change in technology. One is sustaining innovation. That's basically, we're doing something kind of similar to what we did before, but it's a little bit better and a little bit higher tech. So, when Apple comes out with the iPhone 7, probably in September --

Lewis: Hopefully, fingers crossed.

Erickson: -- it's probably going to look a lot like the iPhone 6. It's going to have, probably, a better camera, better processors, stuff like that, but still based off the way Apple packages products.

Lewis: And that type of innovation, to me, sounds much more iterative. The idea of being like, "OK, we can kind of project where this is going." It's easy to see what the next phase of this might look like.

Erickson: Exactly. And the other side of that, to answer your question in the most long-winded way I possibly could, is sometimes, we have disruptive innovation, where you do not base it off of an established product or process. It's completely doing something differently. It brings new value to customers through a new technology or a new business model. We can go more into that a little bit later in the show.

Lewis: Yeah, we'll dive deep into that. But, something to keep in mind as you see outlets or podcasts or anyone talking about something that is disruptive, think about whether it's something that slightly changes what we already know, or is truly coming out of a new space. Looking at why investors should care about disruption -- we touched on some of the great Rule Breakers picks, some of the great picks from the Fool universe have been highly disruptive companies. Any color you want to add there, Simon?

Erickson: It's interesting. The sustaining innovations, the improvements that are complimenting existing technologies out there, really benefit the larger firms. They already have, maybe, a plant built out. Maybe they have a huge process that makes them a lot more efficient than smaller companies can be. So, typically, they'll shy away from disruption, which is what makes it so interesting -- disruptive innovation favors the newcomers that have a different set of glasses on, are able to see things differently, bring a new business model out there. 

I think the reason why you should care, if you're a big company, about disruption is ... Let's not forget that Cisco, for many years, was the largest company on the stock market. I believe it had a $500 billion market cap, at some point. And now, it's definitely a shade of that, because the business world changes, and you have to keep pace with those changes, and sometimes disrupt yourself, if you're a big company. So, for big companies, small companies, investors, it's definitely something that we should all be paying attention to.

Lewis: And your point about Cisco -- even if you're not someone who is a highly growth-oriented investor, and you don't like the idea of playing and more nascent spaces, you want to see that some of these stalwart companies that you're invested in are at least considering this kind of stuff. Whether it's a small department that's working on projects like this, or through acquisitions, just, that they aren't going to be passed by by technological change.

Erickson: Exactly. The really interesting part, Dylan, is that these companies aren't doing anything wrong. It's hard to call the managers of these multibillion-dollar segments of these companies -- they're not idiots. They're smart guys that are making great rational business decisions. It's just, disruption looks at, why does that not always work? What is it that they didn't see coming that changes the business out there?

Lewis: And in some cases, there are characteristics of the business that make it tough to really engage in some of these markets. With that said, why don't we look at a couple of the principles that you and some of the investing folks use to identify spaces that are, maybe, ripe for disruption, or companies that are ready to turn the world on its head.

Erickson: Like you said, there's five principles you could look for to predict when disruption is going to hit an industry or a certain company. We can walk through those, for this podcast, one at a time. The first is what Christensen calls the theory of resource dependence. He really says that it's not companies, but it's their customers and their investors that dictate how they're spending their money. Which is crazy, right?

You think about it, companies are always allocating capital, "We're going to do this and that." A lot of times, it's the investors saying, "We want you to make this acquisition to juice your return on equity." Or, your customers might be saying, "We want a slightly better product, that we'll pay a little bit more for it," and that guides your allocation decisions. But the concept is, a disruptive company will look at where the market is headed, and is not as subject to their own customers or their existing investors telling them how to spend that money.

I have an example for it. Is it OK if I throw in an example?

Lewis: Drop an example, absolutely!

Erickson: One of the great examples -- we have a lot of these on our scorecards from The Motley Fool -- it's Netflix. Netflix, as you and I discussed before the show, had a very profitable DVD-by-mail business. Reed Hastings, of course, went out and said, "Guys, I think the future is in online streaming. I'm going to get a lot more data about what shows people are watching and build this recommendation engine." And a lot of people thought he was crazy for spending money on a market that really didn't exist yet. But he, in essence, disrupted his own business, and it's proved very profitable in the long run for Netflix.

Lewis: Yeah, and you hear a lot of businesses talk about how you want to cater to the customer, and deliver what the customer wants. There are a lot of instances where the customer doesn't know that they want something until it's available. Then, it's "How do I live without this? What am I going to watch on Saturday night if I can't stream Netflix?" And that's something that wouldn't have even been a thought 10 years ago. Sometimes, companies have to be willing to anticipate what people want rather than respond directly to it.

Erickson: Very true, both of those. On top of that, what is available in the market at the time? Until people really had high-speed broadband internet, streaming movies over the internet was almost impossible. When that enabled digital streaming, Netflix really took off. It was in the right place at the right time.

Lewis: I see No. 2: Small markets don't solve growth needs. You want to elaborate on that a little bit?

Erickson: Say that you're Berkshire Hathaway, you're Warren Buffett. Buffett has famously said that he can't go after small fish anymore. He can't go after small-cap companies as investments because they're just not going to move the needle for Berkshire Hathaway. He has multiple hundreds of billions of dollars in divested capital that he has to go after the Coca-Colas and the IBMs as investments. It's the same thing with businesses. If you're wildly successful, doing $100 billion a year, you have to find a market that's existing today that's a $10 billion market for you to grow 10%. A $100 million company just has to have $10 million to do the same thing. 

Disruptive companies, a lot of times, will look at markets that big companies are not looking at. The example for this one is a Rule Breakers' recommendation, Ubiquiti Networks (UI -1.67%), that's setting up wireless access points to get onto the internet. When you think about the internet service providers we've typically had, they lay a lot of cable, they go and want to dominate a market. Maybe if you have an apartment complex in the D.C. area, you're locked into one certain provider.

Lewis: I know that game very well.

Erickson: Huge costs, huge sales forces like to go in and dominate areas. Ubiquiti has no direct sales force, and very little marketing costs. They basically have customers come to them and say, "Hey, I would really like this kind of product spec. Can you build it for me and tell us how much we'll pay for it?!" It's been really successful in universities and sports stadiums and emerging markets. A very, very profitable business.

Lewis: Yeah. Very interesting. No. 3, moving along: Markets that don't exist can't be analyzed. I think this might be one of the most interesting points that we'll raise during this show.

Erickson: It's my favorite of the five, actually. Can I ask you, how did he come up with the name The Innovator's Dilemma? Do you know what that actually refers to?

Lewis: I don't.

Erickson: It's an interesting thing. The Innovator's Dilemma is, if you want to get into something new, you don't have the data to support that decision, necessarily, because it's new. You don't know if it's going to work or not.

Lewis: So, the idea is, you're working on a hunch and not much more, in some cases.

Erickson: Yeah. It would be a no-brainer if all the data told you, "Hey, this new market that nobody's going into is going to be wildly successful." You don't get that. You have to jump out there ahead of the pack.

Lewis: And, in fairness, if the data suggested it, everyone would be doing it.

Erickson: Exactly. So, that's the beauty of The Innovator's Dilemma. It's always forward-looking, it's not looking at financial ratios. A lot of what Wall Street lives and dies by is things like margins, return on equity, return on invested capital. This is always a framework looking forward.

Lewis: Even something like addressable market, which is something that we like to look at when we can, but if you don't even know what a market is going to look like, or what the scale of a technology might be, it's kind of a Fool's errand to even put a number on it.

Erickson: Exactly. And let's go back in time to 2004, 2002 -- social media, social networks, Facebook is the example for this one. This was something that most people didn't understand. You had MySpace and a couple others trying to figure this out out there. But Facebook was so far ahead of the game of the larger competitors in the traditional space that they learned a lot more about what people wanted to do on social networks, then they collected that data and did targeted advertising. Of course, now, it's a more than $300 billion market cap company.

Lewis: I will say, I saw an interview that Zuckerberg did recently with the founder of Y Combinator. He asked him, "What was one of the tougher things you experienced as CEO and in the development of Facebook?" And he said "People not seeing the vision that I see." These weren't external folks. These were people that were internal employees, members of the management team, that were disappointed when Facebook decided to shun early buyout offers.

He saw this huge potential to get beyond colleges, to become this huge platform that connects everybody, and they didn't. And a lot of them actually left when they decided to reject that buyout offer. So, this is not something that's limited to your average investor or mom and pop at home. This is something that even people in the space might not be 100% capable of grasping market size.

Erickson: And just like you said, it has to be the right person. You have to have the right vision, and not somebody that's leading you in the completely wrong path that maybe they think is the future of the business that really isn't. Good point on that.

Lewis: And even beyond the platform itself, we can look at the idea of, markets that don't exist can't be analyzed, or can't be totally grasped -- with Facebook, in the context of its pivot to mobile. A lot of people were pretty skeptical of Facebook's ability to monetize mobile audiences when they saw that that's where the majority of web traffic was going. Clearly, it's worked out for Facebook. They, basically, quintupled in value as they've really successfully pivoted to mobile. Now, mobile makes up, I think 84% to 85% of their total revenue take. So, this is not even necessarily something that is limited to when a company is first starting out. It can be something that, similar to the idea of streaming video with Netflix, happens as a company sees opportunities, and maybe leaves some of the market behind because they don't.

Erickson: Yeah. It turns out, interesting as this might be, that predicting the future is actually pretty hard. It's not so easy to have a crystal ball and say, "We're going to put billions of dollars behind this new market that doesn't exist yet." A story I love to tell when talking about this is back in the year 1980, AT&T hired McKinsey to do a study of how many U.S.-based cellphone subscribers they thought there would be by the year 2000. 20 years in the future. Put yourself back in 1980, say, "There's this new thing called a cellular phone. How many subscribers do you think it could possibly reach by the year 2000?" Any shot on what the estimate was?

Lewis: Do you have any idea what the population was back then, so I can kind of anchor to it? You know, I'm going to say 40 million.

Erickson: Good guess. The actual estimate that McKinsey -- one of the best consultants in the world at the time, keep in mind -- they said it would be about 900,000 people.

Lewis: Wow!

Erickson: The actual number by the year 2000 was 109 million, just in the United States. It just shows how hard it is to look even five years in the future, and predict where the market is going to head. But you do have to look, at some point, at smaller companies that are going in a path that everyone else is not going in.

Lewis: I think that segues very nicely into No. 4 on our five-point principle list here. Capabilities define disabilities. I think this plays into the idea of smaller companies maybe being able to be a little bit more nimble, and there being a certain stodginess with being a larger company, and being a little bit more fully formed.

Erickson: Yeah, that's right. It's kind of an interesting way, how you can define culture in a bunch of different ways. But one way to possibly define culture is how decisions get made at a company. There's typically certain metrics that in the boardroom of a business, managers and bigwigs of the companies, are using to base whether a decision is good or bad. Does this bring in a certain amount of cash flow? Is this a good return on our investment today? Do we have customers lined up that are ready to do this kind of stuff?

That's interesting because those capabilities, how a business is making decisions, its culture, and how it's deciding on things, can actually handicap it in looking at all of the stuff we're talking about today. An example of this is the large regulated utilities. When utilities spend billions of dollars to build a new power plant, they mandate a certain return on equity and a return for their investors that they can pass along to shareholders. It's heavily regulated by the states. That's how business is done. These are huge decisions.

Then, you have this small, scrappy company called SolarCity.

Lewis: Oh, I think I've heard of them.

Erickson: Maybe a time or two before. One of my favorite companies -- apparently Tesla also like them, they're trying to acquire them right now.

Lewis: Yeah, Elon Musk seems to really like them.

Erickson: That's right. They said, "It doesn't have to be this way. If you can figure out how much electricity one house needs, you can size a solar panel on the rooftop and have that produce all of the electricity you need for that one house. You can size those accordingly." And if people pay on a monthly basis for that power, you don't have to put up the $20,000 to $30.000 to build it yourself. Totally disruptive idea. Didn't have the same metrics they were using to make decisions, because they weren't building these giant power plants. A very disruptive company to the energy industry.

Lewis: Yeah, and that is a little bit of an inside example, one that maybe needed to know the industry a bit better, understand how it works, to fully grasp. I think, to go back to Netflix, they're another example of a company that, even by name, shows that they weren't limited to the business structure that they had when they first started.

I've heard David Gardner make this point before, and it's a very bright one -- they're called Netflix. They were not called MoviesByMailFlix. That would have been redundant. But, they weren't tethered to this idea of being a by-mail company. They were a digital company that pivoted when they saw the opportunity. And their name suggested that. So, that's tougher to recognize, but something to keep in mind. I don't know how many examples will show themselves like that. There are different ways that businesses indicate, I think, their flexibility and how nimble they are. Any indicator you can find there can be helpful in looking for some of these more disruptive companies.

Erickson: And David has many times called Reed Hastings the smartest guy in any room that he's in, which is a telling sign of exactly what you said, that he saw changes in the industry to take advantage of.

Lewis: Yeah, I certainly wouldn't fight that. Our last one here, No. 5: Technology supply versus market demand. You want to dive into that one?

Erickson: Yeah. A lot of times, companies get really excited about their technology, and try to push it to the limit. They say, "We have the greatest-in-the-industry widget that's going to do something 10 times better than you even need it to do in the first place," which sounds great, but it's actually completely inefficient. You want a technology to meet the market's demand, and do exactly what the market is asking you to do. Otherwise, you're probably spending way too much money of your [research and development] efforts on developing something that isn't even needed in the first place.

The trick is to see, what is it that your market wants your industry to do? What is the value that you're bringing to your customers? What are they asking you for, and how can you hit that right in the sweet spot so you're not overspending or underinvesting, but going right after what they're asking you to do?

Lewis: I'm curious what you think about applying that type of approach to Tesla. They started with a very elite, luxury product. The difference is, they went small market first and created an excellent product, reached the high-value markets, then slowly have decided to make it more accessible, build out their scale. Would you say that might be an example of a company being limited in the scope of technology, and maybe not spending as much in R&D as they would have, had they been more ambitious, but doing it in a smart way?

Erickson: Interesting example. Actually, electric vehicles were talked about in Christensen's original book in '97.

Lewis: That's early on.

Erickson: Exactly, right? I think Tesla, early on, was more about the brand than the car and its performance. They really went after the highest end so they could start at the top of the market, and get everybody to want a Tesla, that all the movie stars like Leo DiCaprio had. And if you had a Tesla at the mid-market, or the lower end, one that was affordable, you were buying into a luxury vehicle. I mean, it's a Tesla, this thing is awesome. Even though it might have cost, I think the next one is supposed to be $35,000, the Model 3.

The one I like, Dylan, is actually a company called Splunk (SPLK), that can just look at a ton of data out there and distill it down into a very simple dashboard for their customers to understand. Examples of who they're working with -- the San Francisco 49ers --

Lewis: Oh! I was not expecting a sports example!

Erickson: Yeah! What Cokes and what hot dogs people are buying in different sections, maybe they can market to them. Domino's Pizza uses Splunk to know what, regionally, is selling better. If the jalapeno pineapple pizza is only selling in Cleveland, Ohio, then maybe you go after more marketing there.

Lewis: I have a feeling it's not Cleveland, Ohio, for jalapeno pizza. I know Sean O'Reilly, host of the Energy Industry Focus show, has one of the blandest palates I've come across at The Fool, and he's from Ohio.

Erickson: You might have to ask him if he would eat it, pineapple jalapeno pizza.

Lewis: I'll follow up with him after the show.

Erickson: OK. Probably not the best example on my part, then.

Lewis: But, the idea being, they're teasing out insights from data, and helping businesses make smarter decisions.

Erickson: Yeah. And if you're in a board room, maybe you're a CEO, you're a decision-making manager, you don't want a whole lot of data that doesn't mean anything to you. You want to say, "OK, what is this going to matter to me?" And Splunk does a great job of distilling all of that down, and saying, "What are you trying to accomplish? Let's look at what the data is telling us, and let's move forward from that." Again, hitting the sweet spot. What is the market demanding? What do they want your product to do? Companies going out with the technology to achieve that.

Lewis: Yeah, I think sometimes you can overdeliver on the tech side or the capability side, and it's just extra. Or, your customers aren't seeing the value, and you've spent all this time and ramp up getting it there and it might not even be a very useful feature or add-on. So, definitely something to keep in mind.

Erickson: Absolutely.

Lewis: So, those are our five points. Anything else on the topic of innovation or disruption that you want to give for listeners here, Simon?

Erickson: I guess, to wrap it all together, Dylan, there's only three points that I try to have as my key takeaways when we're looking at disruption.

The first is, how does the industry define value? What is it important that your company needs to achieve that is valued by your customers? That's a really hard question to answer, especially for markets that don't exist. That's one of the keys of whether your company is successful or unsuccessful -- are you correctly going after the things your customers want you to be going after? If you're achieving them, there's a high likelihood that you will be a disruptive, successful company.

The second one is, what is the position of the incumbents? What is going to be their reaction to what you are doing? Are they going to come in and just crush you and do it better, because they already have an established process? Or, is there truly something that's keeping them from pivoting to what you're trying to do?

And then, the third one, I always say is, who's in the captain's chair? Who's the leader? You were talking about Mark Zuckerberg, or Reed Hastings. Who's making these decisions, and are they valuing the future of the company? Or are they just looking backwards? And that plays a huge role in whether it's successful or not. 

So, those are my three key takeaways for disruption.

Lewis: Yeah. These different principles we outlined are great, but they're only as good as they're eventually being an end customer, or not being an "a-ha" moment from a big company, and then just coming in and squashing them. I think those are good things to keep in mind, and nice caveats to have. Simon, you've obviously drawn quite a bit of inspiration from Clayton Christensen. I understand that you're going to be interviewing him.

Erickson: Yes.

Lewis: Later this month?

Erickson: Next month, October.

Lewis: OK. I know he's written some other books. He has another book coming out. Do you want to talk about that a little bit?

Erickson: He does, he has another book coming out right now. I don't believe it's been published yet, so I don't want to talk too much about it. But keep in mind, he has influenced all of this thinking. I think he's just a real visionary guy, very forward-looking guy, an author, started as a Harvard Business School professor, still teaching there today in addition to writing books and influencing business leaders.

We're really looking forward -- I can't tell you how excited I am about this interview. We're going to be posting it all over our sites. It's definitely going to be influencing our Rule Breakers service and our Supernova services. But really, for anybody that's a growth-minded investor, I think this is something you at least have to keep an eye on and be aware of.

Lewis: So, folks who are looking for some more information on this, stay tuned. I will probably steal Simon again and have him talk about the interview that he did with Clayton Christensen, as a little follow-up, in a month and a half or so. But, if you're interested in learning more, I would certainly read The Innovator's Dilemma, and I would check out his other books. That's another great place to jump off and dive into this topic a little bit more. Otherwise, I think that does it for this episode of Industry Focus. Yeah?

Erickson: Hey, I'm glad to be here. Thanks for inviting me for the show, this was a really fun for me.

Lewis: Yeah, this is like your Christmas morning.

Erickson: That's right.

Lewis: Well, listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out and say, "Hey," you can shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus. If you're looking for more stuff, you can subscribe on iTunes, or check out The Fool's family of shows at fool.com/podcasts.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Simon Erickson, I'm Dylan Lewis, thanks for listening and Fool on!