What should investors know about the accelerated rate of change in business, industry and the markets?
In chapter 21 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Michael Mauboussin wrote, “Just as scientists have learned a great deal about evolutionary change from fruit flies, investors can benefit from understanding the sources and implications of accelerated business evolution.”
What he called the “most direct consequence” of this acceleration is that the amount of time an average company can sustain a competitive advantage (aka a moat) is getting shorter. That, he noted, has important consequences in areas such as valuation, portfolio turnover and diversification.
To make his case, he began by citing a book by Charles Fine entitled “Clockspeed: Winning Industry Control in the Age of Temporary Advantage.” Fine defined clockspeed as a measure of cycle time on at least two main levels:
- Product clockspeed: This refers to how quickly an industry can launch new products and how long those products survive. For example, at about the time this book was published in 2013, the Technology Review periodical reported that General Motors (GM, Financial) had cut the time it took to develop and build a new vehicle from 48 months to 21 months.
- Process clockspeed: This is the time required to create and deliver a good or service, i.e. average asset life. According to the HOLT database, the average asset life of the top 1,800 companies in the U.S. had declined from 14 years in 1975 to less than 10 years at about the time Mauboussin’s book was published). It means companies have to generate returns on assets in shorter amounts of time.
Average clockspeeds vary by sector, and not all sectors face an accelerating pace of change. However, there has been a change in the composition of indexes; according to Eugene Fama and Kenneth French, the number of public firms in the Compustat database jumped by 70% in the twenty years between the mid-1970s and mid-1990s. A majority of those new companies were smaller and faster growing than already-established firms. The profusion of these new companies affected the clockspeed of the whole market.
Mauboussin also brought forward the research of Robert Wiggins and Timothy Ruefli, who did empirical work on the sustainability of excess returns. The drew up and tested four hypotheses:
- “Periods of persistent superior economic performance are decreasing in duration over time.” Their results showed this hypothesis to be true.
- “Hypercompetition is not limited to high-technology industries but will occur through most industries.” Generally, the evidence supported the hypothesis.
- “Over time, firms increasingly seek to sustain competitive advantage by concatenating a series of short-term competitive advantages.” The data showed support for this idea.
- “Industry concentration, large market share, or both are negatively associated with chance of loss of persistent superior economic performance in an industry.” The research did not support this hypothesis, with Mauboussin observing that neither a concentrated industry nor large market shares are consistent with sustainable competitive advantages.
What all of this confirmed for the mauboussin was that an accelerating rate of innovation was leading to faster clockspeeds. Further, he argued that an increase in information technology will continue to have speed effects, and that the shift from physical to knowledge assets will lead to greater flexibility in the allocation of resources, meaning allocations can be made more quickly.
Of course, increasing clockspeeds have implications for investors. First, the value of historical multiples will be reduced as sustainable excess returns have shorter life cycles. Overall, Mauboussin thought investors are involved in a trade-off when clockspeeds increase: higher economic returns for a shorter time are replacing smaller economic returns over a longer time frame.
Second, faster clockspeeds may force changes in the terminal growth rates of discounted cash flow models. DCF models generally presume that growth will continue through the terminal phase, but that may no longer be a valid assumption.
Third, there is the matter of portfolio turnover. The author proposed that portfolio turnover of less than 20% per year may not be flexible enough for changes in the market. At the same time, he continued to believe that high rates of turnover, as seen in recent decades, were too high.
Fourth, the need for more diversification grows as clockspeeds increase. Since competitive advantages come and go more quickly, investors need to “cast a wider net” to improve their odds of finding and holding stocks that can deliver excess returns.
Finally, this accelerating pace of change in the world of business means investors need to spend more time studying the dynamics of organizational change. Mauboussin added, “Success and failure at fast-changing companies may provide investors with some useful mental models for appreciating change at the slower evolving companies.”
Conclusion
In chapter 21 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Michael Mauboussin has dug into the phenomenon of accelerating changes in the business world.
He has made a case that “clockspeeds,” aka the rate of change in products and processes, have been speeding up, especially in technological industries.
For investors, this means competitive advantages may become more fleeting than they have been in the past. To compensate, they may have to reconsider their approaches to valuation, especially the terminal rates in discounted cash flow analysis. Greater speed may also force more diversification and faster portfolio turnover.
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