Wednesday, March 26, 2008

Warren Buffett and Disruptive innovation

From time to time I turn to Warren Buffett and always come out refreshed. I find his letters to shareholders piercing and at the same time a sheer joy to read. In every letter, Warren delves deeper into one or more his favorite topics such as inflation & tax (1980), acquisition behaviour (1981) etc. In his 2007 letter, Warren goes into length to explain what he believes is “truly great business”

According to Warren, A truly great business must have an enduring “moat” that protects excellent returns on invested capital.

What is a “moat”? Warren explains later in this report, moat is a metaphor for the superiorities businesses possess that make life difficult for their competitors.

And what does “enduring” involve? Warren likes cost-leaders like Walmart and world-wide brand leaders like Coca-cola whose “moat” may last several decades.

Warren elaborates on what “enduring moat” precludes: Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s creative destruction is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Classic example of this is Motorola. During 2004-2005, Motorola’s RAZR was synonymous with “innovation”. Ed Zander was the “innovation” hero. If you look at market share numbers, a drop by 2% or 3% may seem harmless for a giant like Motorola. But looks like it is enough for it to go into tailspin. Even after pumping in several billion dollars, it could not bring out another “disruptive innovation”.

It is interesting to see that something like “disruptive innovation” is cool from a technologist’s and strategist's perspective and the same thing is totally “uncool” from wise investor like Buffett’s perspective. Buffett is right, society needs all kinds of people.

1 comment:

  1. Vinay,

    Good observations. It all depends on which end of table you are seating at.

    For a long term investor in a business, clearly, the lesser the disruptive innovation in the industry the better. The valuation of a business depends upon cash flows into distant future. In an industry beset with disruptive innovation, you cannot calculate those cash flows with any certainty.

    From the perspective on incumbent market leader too, the disruptive innovation is bad. Because disruptive innovation is extremely unlikely to come from the incumbent leader.

    However, if you want to enter a new field, disruptive innovation is your friend. You can steal the existing customers at low end and/or new price/feature curve.

    Finally, for a society as a whole, disruptive innovation matters a great deal. This is the Schumpeter's Creative Destruction.