A Value Investor’s Guide to Navigating Technology Disruption

This curve, shaped like the letter “s,” is a visual representation of the growth path that technology companies tend to follow. It begins with slow initial growth (the bottom of the “s”) then moves with rapid upward growth as adoption takes off, finally arriving at the plateau stage, at which businesses become increasingly commoditized, growth becomes saturated, and returns trend lower. Companies in the plateau stage of the S-curve often find it difficult to recapture their momentum, particularly in the tech sector, where megatrends tend to be irreversible. Consider the evolution of computer technology from mainframes to PCs and servers, to mobile and the cloud—each development a paradigm shift that didn’t reverse course and that rendered the previously used technology less favored and eventually obsolete. With artificial intelligence, a similar seismic shift is now under way.

As value investors, we naturally gravitate to the uppermost section of the S-curve. Quality companies often become undervalued by the market at this stage, providing the opportunity to buy at a significant discount relative to their long-term intrinsic value. But we need to be highly selective, identifying businesses that have the competitive moats and defensive characteristics that will extend the upward slope of the S-curve into the new technology frontier instead of entering the plateau stage.

By contrast, mature tech companies risk succumbing to the “innovator’s dilemma,” a term coined by the late academic and business consultant Clayton Christensen to describe how companies cling to their established markets and protect profit margins instead of focusing on innovations that might disrupt their core businesses but also open up new opportunities for growth. As new entrants exploit this complacency and carve out a niche in the market, legacy businesses eventually fall victim to a shrinking profit pool, as capital flows to new entrants that offer products with more power, efficiency, scalability, and affordability.

Without innovations to alter their weakening fundamental outlook, the old guard may see profits dwindle and their valuations deflate. It is a slow bleed, a value trap that lulls investors with seemingly cheap metrics but masks a bleak future. We feel it is important to avoid these long-term secular losers that might seem statistically cheap based on today’s valuation. A company trading at a depressed price-to-earnings multiple, for example, could be “cheap” for a reason, reflecting a declining business where valuation could remain low indefinitely or worse, continue to compress.

There are several important traits we look for when evaluating maturing technology businesses. They need to be innovative with an eye toward the future, developing new products and services that can position them for the next paradigm shift. Management needs to be willing to disrupt themselves, even if doing so risks revenue and earnings losses in the near term. We witnessed several companies created in the early days of the internet, for instance, that successfully navigated their way into mobile computing in the 2010s and are now attempting to repeat the same playbook as they make strides in the AI era of the 2020s.

Platform companies are probably the best examples of businesses that are most adept at steering through disruptions. Such companies have an extensive ecosystem of first-party software and hardware products and third-party partners that rely on their platforms. Cloud computing exemplifies this dynamic today, where several players control the majority of the market and are essentially the gatekeepers for all things artificial intelligence and cloud computing. In technology subsectors such as semiconductors and enterprise software, we seek those firms with durable business models and robust product road maps that can serve as the foundational layers of the next megatrend.

Technology companies primed for long-term success understand that disruption is a marathon, not a sprint. Conversely, those that struggle to adapt and innovate are the ones most likely to stumble. Value investors who recognize this could be primed to take advantage of outperformance in the tech sector. 

Mark Iong co-manages Homestead Advisers’ equity strategies. Before joining Homestead Advisers in 2019, he was a senior equity analyst and portfolio manager at Columbia Partners (acquired by Chartwell Investment Partners in 2018).  

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