The Taylor Frigon Advisor: Clayton Christensen, disruptive technology, and your portfolio recovery plan

The above image of Harvard Business School Professor Clayton M. Christensen is a link to a r ecent interview in EE Times with Professor Christensen.

The interview, and the work of Professor Christensen, is noteworthy on many levels, and contains important insights with which all classic growth investors should become familiar.

Professor Christensen's 1997 bestseller, The Innovator's Dilemma, introduced his thinking on the concept of "disruptive technology" and its importance in explaining the perplexing phenomenon by which firms at the top of their industry almost inevitably fall out of the top tier altogether.

As he explains in that book, illustrated by extensive data from the business world and numerous examples from recent business history, it is not that these companies simply failed to continue to improve or to innovate, in a world that never stands still.

Instead, it is that companies tend to improve their existing products (a form of innovation that Professor Christensen calls "sustaining innovation") beyond the requirements of even their most demanding customers, even as new entrants introduce technologies that he calls "disruptive innovation."

These new technologies are typically cheaper, and previously were not practical for the mainstream customers, applying perhaps to a small niche, but as they improve they become good enough, and upend the industry, toppling the former leaders who have been focusing on improving the old technology to levels that nobody needs anymore. You can see a short clip of Professor Christensen explaining the distinction between "disruptive innovation" and "sustaining innovation" at his website at this address.

Professor Christensen's work dovetails nicely with the important concepts from Joseph Schumpeter (also a professor at Harvard) concerning "Creative Destruction" and the insight that industrial progress and business progress "is a history of revolutions."

As we explained in our previous post on Schumpeter, the crucial role of innovation is completely ignored by the mathematical models that underlie "modern portfolio theory" (as well as by most of the mathematical models that underlie Keynesian economics, leading to the idea that you stimulate an economy by stimulating consumption, rather than by removing government barriers to production and disruptive innovation).

Instead of focusing on charts of the "efficient frontier" and formulas that purport to tell them how much "beta" and "R squared" they have in their portfolios, investors should focus on the concepts of innovation articulated by Schumpeter and Clayton Christensen.

We have said that investing should be looked at as providing capital to innovative companies. If the investor is providing equity capital, he is hoping to participate in the rewards of adding value through innovation. If the investor is providing debt capital, he wants to be sure the company is not going to be put out of business by a stubborn adherence to "sustaining innovations" in the face of a new disruptive innovation.

In previous posts, we have explained how this crucial concept of "disruptive innovation" or "Creative Destruction" can be practically applied to investing. See for example the posts relating to "paradigm shifts," the "topple rate," and the discussion of what growth-stock theory innovator Thomas Rowe Price called "fertile fields for future growth."

Finally, note carefully what Professor Christensen says in the recent video interview about the current environment and what businesses are probably doing during the economic downturn. He explains that adverse circumstances can be "framed" as either an opportunity, or as a threat. Those who perceive them as a threat typically "hunker down," become defensive, and hope they survive. On the other hand, he predicts "strong companies kind of using this piece of down-time to really aggressively prepare for when the economy turns around."

This insight applies to companies, but it is equally applicable to investors, who can themselves choose to "frame" the current environment as a threat, or as an opportunity.

For all these reasons, it would behoove investors to become familiar with the work of Clayton Christensen.

For later posts dealing with this same topic, see also: