All investors know there are stocks that rise and fall. There are bull and bear markets. Markets that grow and markets that decline. Some are more stable than others and are based on different measures of success. Resource markets such as oil and precious metals depend on supply and demand, but with technology there is another factor and that is innovation. New technologies destroy old ones and a good investor knows when and where to switch their investments.
Creative destruction is a branch of Marxist economic theory. As far as Karl Marx was concerned each economic system would have a fault, an Achilles Heel, which would lead to its inevitable downfall. Communism falls because different parcels of land are more or less productive than others. Austrian-American economist Joseph Schumpeter popularized the idea that one technology will be destroyed by an innovation and then will itself be gobbled up by the next, in his 1942 book�Capitalism, Socialism and Democracy.
The basis of creative destruction is that capitalism is a system whereby business owners and creators try to be as efficient as possible. This means they are not beholden to a single technology or means of producing something. A great modern example of this is the smartphone. When the smartphone was invented it did the work of a watch, a point and click camera, an mp3 player, a laptop for internet access, calculator, alarm clock, and many more devices.
Now the makers of each of those devices is faced with a single foe as competition. The watches, alarm clocks, laptops, mp3 players and so on, have to make their devices essential or at least desirable to a diverse range of customers. If they fail to do this the smartphone takes over. The market is on the side of the smartphone because it is multifunctional without costing more than the sum of its parts. In essence, if a customer bought all the devices separately, the smartphone would be cheaper and more efficient. This is creative destruction.magine how this works out for investors. In the 19th century investors put their money into horses. Horses pulled carriages, were ridden by all manner of people and the shire horses worked the fields pulling ploughs. At the time of the industrial revolution and the creation of steam engines, canny investors moved their investment to these industries. The same has been going on for over a century.
Investors need to look at both their current market and those developing around them. Investments only work when companies are gaining in value or are making vast profits for dividends. To benefit from creative destruction the investor needs to identify the next development on from their investment and make the job while their current investment is at the top of its value, but before the new one begins to eat away at it. If done well, the maximized profit from the first investment is moved to cheaper shares in the second and so on.
How does this affect small-cap markets? Well, research by Joachim Gramming and Stephen Jank has applied creative destruction in the technology sector to small and large cap valued firms in America and around the world. They applied Schumpeter�s ideas on the evolution and destruction of technology into asset pricing theory. As mentioned above, new technologies that take off, gain in value from a low base while chipping away at the companies that spawned/inspired them.
Creative destruction normally affects small and large cap firms in different ways. Let�s look at large cap firms first. They are usually companies with a value over $2 billion and often come with diverse portfolios and a diverse range of products and services. These are the kinds of big firms who need�fleet insurance�for a hundred company cars.
The diverse range of investments is like owning the shire horses and the steam powered tractors. If one fails, the company can take the loss, build profit off the successful arm of its operations and move on. The flip side is that any gains from a successful technology are small. This is why investors see large cap firms as a safe bet.
On the other hand, creative destruction is a major force in small cap markets. These firms are traditionally valued at under $2 billion and tend to focus on one product or service. This means that if the company�s core product is overtaken by a new technology the company can be gobbled up and its share value tumbles. They lack the cushions of larger firms. On the other hand, such firms tend to start off with lower share values and if they pick the correct technology or service to work on gains can be a lot higher.
As a result, small cap firms are less likely to survive a technological revolution. Small cap firms have an expected excess return per year of an additional 6.2 percent, but also have a t-statistic -2.3 percent negative exposure based on patent activity. This compares to an excess return of -2.4 percent and a patent exposure rate of 2.8 percent for large cap companies. Basically, investors need to avoid a technological shock to save their stock values.
The simple advice to investors for dealing with creative destruction in a small cap market is to remain fleet footed. The investor needs to be aware of the performance of their stocks and those of companies with similar products or services. They also need to pay attention to technology websites such as Techcrunch, which provide up to date information on technological developments. It is also good to look at which projects are looking for investment funding and to extrapolate which technologies and therefore firms will be affected by said innovation.
Last, it is worth remembering that not all small-cap firms will lose out to a technological revolution. Some are agile enough to adapt and exploit. An example of this is the personal computer. Xerox and other companies attempted to produce such a computer, but ultimately failed. This allowed fleet footed companies such as Apple and Microsoft to get ahead of the competition and go from small cap firms to large cap ones. In short, creative destruction, when exploited in the small cap market, can be a gold mine for investors.
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