Last October, citing savings of up to 90%, GE’s technology team announced plans to eliminate 29 of its 34 private data centers, by shifting their workloads to the public cloud via Amazon Web Services. Because of this “tipping point” at GE and elsewhere, Amazon.comAMZN +0.18% reported that AWS’s revenue growth accelerated to 70% on average in 2015, setting it up to crack the $10 billion mark in 2016. Jeff Bezos, CEO of Amazon, has stated for some time that he believes AWS revenues could surpass those of its retail business, a tall order given the $100 billion that the latter delivered last year. What he had not been telegraphing, until Amazon broke Infrastructure-as-a-Service out in its income statement during the second quarter, is that AWS, with a 24% operating margin, is already nine-times more profitable than its retail business.
During unfriendly markets, the shift toward disruptive innovation typically accelerates, taking share from old-line products, services, and processes. Yet, during such market corrections, many investors gravitate back toward the established benchmarks against which most investment portfolios are measured: they sell the disruptive stocks held by ARK’s portfolios, and “lower their risk” by buying into stocks more heavily weighted in recognized benchmarks.
At the same time, they are less willing to extend their investment time horizons, focusing instead on short-term variables like quarterly earnings, current income (dividend yields) and current year valuations (price-earnings ratios). They migrate away from the game changers, which are “expensive” stocks based on PE ratios, toward more mature stocks that pay dividends and sell at a market multiple or lower.
I believe investors who are unfamiliar with evaluating companies at the forefront of disruptive innovation often misunderstand that these companies are using their growth in revenue to reinvest heavily in the near-term, seeking to capitalize on massive long-term opportunities. When the network effect is at work and the “winner will take most,” investing ahead of the competition is imperative. These stocks are “expensive” by design, often reporting little or no earnings in the short-term as a trade-off for potentially enormous revenues and exceptional profitability in the long-term.
If focusing on disruptive innovation, I believe investors can survive and ultimately thrive with high-powered original research that inspires the “courage of conviction.” Such research sizes the magnitude of the opportunities, battle-tests supposed barriers to entry, identifying the leaders, enablers and beneficiaries of innovation. It focuses on the next three to six years, not three to six months, and is not limited to or stifled by sectors, industries, geographies or market capitalization. It clarifies the potential value of innovative companies that can capture majority market share, and provides the opportunity to invest in stocks that are poised to return at least 15% per year over a full market cycle. When fears associated with the Fed, oil price deflation or China cause a stampede out of stocks or toward benchmarks, disruptive innovation ends up in bargain basement territory, giving ARK Invest, and other investors like us, opportunities to support our highest conviction names.
Why does disruptive innovation accelerate during tough or uncertain times?
The reason is exemplified by the response of U.S. based multinationals to a sudden 25% increase in the trade-weighted dollar from June 2014 to March 2015. In the span of nine months, U.S. based manufacturers lost a significant amount of competitive advantage and had to respond by increasing productivity, lowering costs or introducing new goods and services to salvage their profitability. As CEOs and COOs communicated this message internally, executives overseeing technology, research and development, marketing, sales, finance, legal, administration and other services had to scramble to meet new budget targets without impairing their departments. Many of them had to step out of the comfort zone that comes with traditional processes and procedures, and were forced to consider radical innovations to address their business challenges.
In response to the dollar’s strength last year, for example, companies restructured their sales, marketing and service departments, spurring a shift to Software-as-a-Service (SaaS) and driving Salesforce.com'sCRM +0.59% and ServiceNow’s revenue up by 24% and 47%, respectively, on average in 2015. According to research by Gartner, Inc., SaaS applications are now mission critical, valued by CIOs not just for their more attractive cost-structure but also for their operational agility. In contrast, old-line companies are struggling to adapt to this new world. Last year, MicrosoftMSFT +0.70%’s revenue dropped by 5%, OracleORCL -0.61%’s by roughly 4%, and IBMIBM +1.44%’s by 12%.