Book Review: The Innovator's Dilemma 01/05/2005

Book Review

THE INNOVATOR'S DILEMMA
Disruptive Technologies: Investment Opportunities in the Digital Age
by Joseph Dancy
LSGI Advisors, Inc.
January 5, 2005

The Innovator's Dilemma
by Clayton M. Christensen
320 pages, HarperBusiness (January 2003)
List: $17.95; $12.56 at Amazon.com

Book Cover Disruptive Technologies: Investment Opportunities in the Digital Age

Industry leadership, good management, and the rational allocation of corporate resources will not keep a company competitive in the face of disruptive technological change according to Clayton Christensen, Harvard professor and author of an interesting book entitled "The Innovator's Dilemma."

In fact, in the face of technological change one of the most powerful reasons a company may lose market dominance is that it is successful, has good management, and has a well-organized process in place to rationally allocate capital.

Sustaining Versus Disruptive Technological Changes

According to Christensen, there are two types of technological change - and each has a substantially different impact on the companies subject to such changes. Most technological change is "sustaining" in nature. Sustaining technological change will improve an existing product's performance, increase margins, and take the product up-market in an existing, well defined, market.

Occasionally, however, "disruptive" technologies emerge. Disruptive technological change generally creates products that are cheaper, simpler, smaller, more convenient, to be sold in a market that is not well defined. These products usually offer lower margins, and are down-market. Most existing clients initially express little interest in these products.

For example, the transistor was a disruptive technology to the vacuum tube, smaller size disk drives were a disruptive technology to the previous generation of drives, and off-road motorcycles were a disruptive technology to the over-the-road machines. Christensen does an excellent job of using actual case histories of several industries - the hard disk drive industry, the excavation industry, retailing, motorcycles, and steel mills - to illustrate his points.

When technological change is sustaining he concludes well-managed companies excel - they allocate their capital in a manner to obtain the best return on investment. But when such changes are disruptive, capital and other resources are not allocated to these disruptive technologies until it is too late - and the company stands at a substantial disadvantage.

Large Firms at a Major Disadvantage

Large, successful firms, in particular have problems with disruptive technology. Their cost structure and capital allocation process does not work well where the market is not well defined, the margins are thin or uncertain, and where flexibility and innovation are needed to make the disruptive technology useful. The more successful a company, the harder it is for it to enter a disruptive technological market - and the more vulnerable it is to smaller, more nimble, competitors.

Christensen claims that regardless of management theory, customers and investors actually dictate how capital will be spent because companies that don't serve their customers and investors well don't survive. The highest-performing companies, in fact, are those that are the best at this - that is, they have well-developed systems for rejecting ideas that their customers don't want.

As a result, these companies find it very difficult to invest adequate resources in disruptive technologies - lower-margin opportunities that their customers don't want - until their customers want them. And by then it is too late.

Small markets served by disruptive technologies also don't address the growth needs of large companies. Disruptive technologies typically enable small niche markets to emerge. There is strong evidence showing that companies entering these emerging markets early have significant advantages over later entrants. And yet, as these companies succeed and grow larger, it becomes progressively more difficult for them to enter the small markets destined to become the large ones of the future.

Disruptive markets that don't exist also can't be analyzed. Sound market research and good planning, followed by execution, are hallmarks of good management. When applied to sustaining technological innovation, these practices are invaluable. When disruptive change occurs, these practices tend to produce the wrong decision.

Disruptive Technology Not Always Profitable

The Internet - one of the ultimate disruptive technologies - represents the greatest transformation of economic life since the railway. There was "extravagant excitement" as the railways were built, much like the current enthusiasm for the Internet. Like the railroads the Internet will be the central nervous system for commerce. Companies that exploit these opportunities will reap untold wealth.

But if the Internet is like the railways, it "could produce extremely mixed rewards for its financial backers" according to London Financial Times columnist Peter Martin. Even with massive "land grants" of acreage to developing companies, "the profitability of railroads was still mixed" notes Martin, "continuous expansion and the depressions of the 1870s and 1890s prevented many from rewarding investors."

What are the lessons for the internet investor? Martin concludes that "investment in the construction of the internet infrastructure will be pushed beyond the limits of profitability - leading to ruinous price wars as managers exploit the low marginal costs of their sunk investments."

But all is not lost. The internet has its own equivalent of the "land grant" - "portals" or frequently visited sites that give easy access to the rest of the internet's facilities, are like the free acreage according to Martin. "But the great majority of the land grant acreage never proved of much value; the profits came from the relatively small proportion that contained minerals, or turned out to be the downtown areas of newly developed cities."

Similarly, "of the millions of dollars being ploughed into creating internet land-grant acreage, some will be valuable and most will be worthless. Distinguishing between the two will not be easy."

Last, he notes that "the real profits of the railway boom were made not by the heroic engineers or even the enthusiastic developers. They were made by the promoters, the stock-waterers, the exploiters of bankrupt lines, the manipulators of freight rates, . . . . There is lots of money to be made from the birth of new global nervous system. As with the railways, however, it is unlikely to accrue to those who take the long view."

Disruptive Technology Tends To Be Developed By Small Companies

Companies that thrive with disruptive technology are generally flexible, quick to respond, and have leadership positions in the disruptive technology. Smaller companies, not the dominant leaders in their sector, are generally where the disruptive technologies are developed. They have the flexibility to perfect such technologies in smaller, downscale markets, that the industry leaders ignore.

Leaders in the development of disruptive technology have a significant advantage - even if the company is small - as long as the company has the resources, and the flexibility, to change strategy as required to get the disruptive technology into these markets.

Dangers of Investing in the Technology Sector

Given that technological change will occur, excellent companies with good managements and decision making processes will fail when faced with disruptive technology. It is also a given that while some companies will tap untold riches created by the disruptive technological change caused by the Internet, profits may be "unlikely to accrue to those who take the long view."

For those interested the pitfalls involved when investing in the technology sector, the impact of technological change on the allocation of capital, and challenges to management in the technology sector, Christensen's work is well worth reading.

Contact Information
Joseph Dancy, Adjunct Professor
Oil & Gas Law, SMU School of Law
Advisor, LSGI Market Letter
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