It is easy to forget how rapid innovation and technological change can be. In 1995, a typical mobile phone seemed to be an amazing device but it had only one application—making phone calls. Ten years later, we marvelled at a new function for our mobile devices—text messaging. Today, there are in excess of 1.2 million mobile applications and the phones of yesteryear, once so useful, have quickly become redundant. Rapid changes, such as those in the mobile phone industry, bring huge rewards for the winners but destruction of value for the losers.
The term “creative destruction” was coined by Austrian economist Joseph Schumpeter in 1942 to describe how every company has to live in a world where new competitors are constantly innovating to displace the incumbents.
When plan sponsors invest passively, they are investing in the incumbent leaders in a variety of industries—creative destruction leaves those companies exposed to the forces Schumpeter identified.
Sectors to watch
Four stock market sectors, representing more than half of the global index, are particularly vulnerable. In the energy sector, U.S. fuel consumption is already falling and regulatory changes in 2016 will encourage auto companies to supply a fleet of vehicles that is 60% more efficient than today. This alone implies a calamitous collapse in demand for big oil companies. If alternative energy and electric vehicles continue their rapid rates of adoption, then their business models could face obliteration.
The huge healthcare industry tends to focus on prolonging life, not on cures. A wave of new technologies, notably sparked by a better understanding of the human genome, holds up the hope of offering cures, prevention and better targeted treatment for individuals, which will pose huge challenges for today’s big pharmaceutical companies.
In the consumer discretionary sector, online retailing is already causing the destruction of traditional brick-and-mortar companies—and the growing adoption of online shopping is much greater in emerging markets, where the formal retail sector is far less developed.
Finally, the biggest sector ripe for disruption makes up nearly one quarter of the global index: financials. In Kenya, a payment system called M-PESA uses mobile technology rather than the banking system, and currently carries transactions that account for nearly one-third of the country’s gross domestic product. Initiatives such as this present major challenges to incumbent banks.
Investing for growth is dangerous, uncomfortable and risky for company executives—but, in the longer term, the cost of not investing is much greater because businesses may not survive. If you own the index, you own industry leaders with numerous new competitors that are willing to spend to innovate.
Short-termism and the increasing velocity of technological change leave incumbent companies vulnerable. Creative destruction does not bring incremental change—it brings exponential change. Plan sponsors need to think carefully about the merits of passive investing in this context, and ask their investment managers if they are investing in the next generation’s winners, or in those that may find themselves in the dustbin of history.
John Carnegie is Client Service Director, Baillie Gifford Overseas Limited