The big risk when it comes to investing in disruptors
Invest in an Amazon and the windfall can be huge. But leading the pack is expensive and risky, just look at Uber.
That's the warning from Insync chief investment officer Monik Kotecha.
"Disruption may be providing a short-term advantage to a firm, and the megatrend may be supercharging growth, but history shows only the healthiest firms are enduring," he says.
The oft-touted first-to-market advantage can turn into a gilded cage. Paving the way as a disrupter is expensive and clears the path for other companies to quickly catch up.
"Successful disruptors in the short term have themselves faltered on the back of competition due to low barriers to entry," says Kotecha.
"Look at the malaise impacting Uber since the entry of similar apps like OLA and Didi."
We live in a time when headlines are dominated by tech giants that plow every investment dollar back into the company and sometimes don't see a profit for years.
Kotecha says the trick is to find companies that can generate strong return on investment early.
He points to Disney as a company that has piggybacked disruption in a sustainable and profitable way.
"Disney pivoted from the old world to the new world, but they did it with a library of great content and an intimate knowledge of their customer, and now they're highly profitable. Every dollar they put into the business is generating a very high return."
This is not to say the disrupters can't come good.
"Amazon was a good example where the earnings were coming through but so was the cashflow, and it's testament that the model does work," says Kotecha.
"But the hit rate using that model is very low."
Kotecha instead looks for companies that have a good return on invested capital (ROIC), as opposed to those that need to do capital raising after capital raising.
"We examine high-quality firms who are very profitable given there is substantial research supporting that these firms overwhelmingly remain so, and even improve that profitability over 10 years," says Monik.
"The marriage of quality businesses with megatrends provides the perfect mix for growth. But factors such as Reinvestment Rates within a firm helps retain competitive advantage and lifts barriers to entry for competitors, and underpins the sustainability of that growth."
For this reason, Kotecha largely ignores price to earnings (P/E) ratios, one of the most common metrics for determining the value of a stock.
"P/E ratios only look forward 12-24 months. A lot of companies generate growth through research and development, brand promotion and its people - all those things get expensed in this year's expense statement, but they contribute towards growth in the future."