27 Aug Beware of Creative Destruction

The process of natural business and technological evolution and destruction was appropriately labeled “creative destruction” by economist Joseph Schumpeter. The forces of creative destruction, especially during economic downturns, tend to speed the passing of older, less efficient businesses and technologies (especially without the intervention of policymakers – as exemplified by U.S. automakers). The dot.com bust hastened the demise of legacy phone switching technologies, independent bookstores, and the Oldsmobile, not to mention thousands of Internet applications that probably served little to no economic purpose. As a result, corporate investments, which aren’t so safe to begin with, become even riskier in a crisis if producing legacy products and services vulnerable to change.

These forces can be obvious or subtle, and technology evolutions are easy to confuse with business cycles; indeed many fall to that temptation. Many thought the interurban railway – or rail travel in general – would come back after the Great Depression; in fact it began a slow and inevitable decline because of the automobile. Now, it’s the automobile itself that’s in question; some wonder whether demand for SUVs or even traditional gasoline-powered cars will ever resume previous levels – or will future demand shift permanently towards hybrids, alternative energy and smaller cars? Similarly, many are now wondering whether the standalone PC will survive the advent of cloud computing, and in what form. PC sales may decline because of the business cycle; every time they do people wonder whether the change is temporary or more permanent. The wealth sustaining investor must make these calls, remembering Joseph Schumpeter’s “creative destruction” occurs more rapidly these days and often with little advance warning.

Likewise, the solid stars of the last decade, best exemplified by Microsoft with its near monopoly and gigantic cash margins from low production costs seemed unassailable, and investors treated it so. But now with Linux and Ubuntu community-enhanced freeware threatening its operating system monopoly, cloud applications and free alternatives like StarOffice threaten its Office applications, and Mozilla and Google are knocking at the Internet browser door. As a result, the Microsoft fortress doesn’t look so formidable.

On the other hand, Apple is running on all cylinders today, although it already endured one decline. But now the company has realized other-worldly success from the digital music business. That said, this level of success is hard to project even two to three years down the road as digital music and smartphone competitors sharpen their offerings. To be sure, no business or business model is safe. One might even question the long term viability of electric utilities in these times. What if solar panels got simple and cheap, so you could buy them and install them simply in just one day, replacing two-thirds of your electricity purchase from your electric utility? That would signal huge and disruptive change for the electric utility business.

Solid and regular cash generators like Coke and Procter & Gamble have had their ups and downs and have endured competitive threats but nothing is guaranteed even there. Technology isn’t the only thing that changes – consumer tastes change, too, and Coke has been forced recently to introduce whole lines of new products to stay in front of the shift towards healthier drinks. As a result, any investor in any business, or any investment dependent on a business, must take these risks into consideration. Those who thought, for instance, that the industrial demand for silver would be forever supported by the photography industry were in for a surprise.