Harvard professor Clayton Christensen, founder of the disruptive innovation theory, recently passed away. Although his ideas have been adopted mainly in the field of management strategy, they are also highly relevant for investors.
Innovation in business is a continuous process. In most cases, existing products are gradually improved through improved technology and/or materials. Well-known examples are the constant increase in the number of pixels in digital cameras and the ever-increasing computing power of computers. Christensen calls this ‘sustaining’ innovation. The top red line in the graph shows this process.
A crucial observation of Christensen was that in most cases, product performance improves faster than consumer demands (represented by the blue lines in the graph) are ratcheted upwards. As a result, the product increasingly meets the requirements of its most demanding customers.
In general, high-end customers are willing to fork out for that enhanced functionality and therefore make up the most profitable segment of the market. By listening carefully to their best-paying customers and aligning their product innovation accordingly, over time companies almost inevitably move up to the highest and most profitable segments of the market.
The downside is that the needs of low-end customers, who want to pay little or even nothing at all for increased functionality, are ultimately 'overshot'. This creates space at the bottom of the market for a lower-priced product that performs less well but meets the needs of the most easily satisfied market segment.
This leaves an opening for companies that are able to seize these low-end opportunities using new, cheaper, albeit inferior, technology or materials to find footholds. Established companies usually do not feel threatened because this doesn’t encroach on their most profitable market segments . So far, no disruption.
However, once the new technology starts its own improvement trajectory of sustaining innovation, this changes. Then companies employing this new technology, in turn, gradually move into higher market segments with more attractive profit margins. Established companies are increasingly forced to be on the defensive, because their better but more expensive technology makes it difficult to compete.
Out of necessity, they seek their salvation in increasingly higher market segments where they are still competitive. This process continues until the companies with the new technology become the new established order. The former champions exit the industry or get stuck in the very highest but very small market segments. This displacement process is what Christensen labeled ‘disruptive innovation’.
Some examples of disruptive innovation are LED lighting displacing the light bulb, music and video streaming displacing CDs and DVDs, and Wikipedia displacing the leather-bound encyclopedia. The power of Christensen's theory lies in the way it at least partly explains the competitive dynamics we see around us, and the associated rise and fall of companies and industries.
It is important for investors to recognize potential cases of disruptive innovation in time, not only to anticipate the rise of potential new market leaders and invest in them, but certainly also to be aware of the possible decline of apparently successful market leaders.