Buy the Disruptor, Sell the Disrupted

Buy the disruptor. Sell the disrupted.

If you want to build a portfolio that consistently outperforms today’s highly tech-driven market, there’s your one golden rule to follow.

The idea of buying the disruptor should be straightforward enough. Companies that innovate are consistently among those offering the highest returns in the market. This is a fact that’s always been true but is ever more apparent today, when disruption can happen in the mere blink of an eye.

Consider, for instance, the biggest gainers (excluding OTC stocks) so far of 2015. Of the top 10, only one company falls outside the umbrella of technology and biotech. This is not coincidence, but rather a consistent pattern now experienced by the market.

In fact, if you look at the top 10 best-performing stocks over the past two decades, you’ll find that 90% of companies qualify as technology-driven disruptors. If you’re looking to beat the paltry gains of the broader market, disruption is exactly where you need to look to do it.

But buying disruptive companies isn’t the only way to profit off innovation. In fact, it’s often not even an option for public investors at all…

In 2014, for example, 40 upcoming start-ups were given valuations of $1 billion or more, doubling the number of such companies in 2013. The catch? According to Rule 501 of Regulation D of the Securities Act of 1933, you would have needed to qualify as an accredited investor to get a piece of the action.

In other words, you’d have to meet one of the following three qualifications to invest in today’s fastest-growing companies:

1. Have a liquid net worth of more than $1 million — excluding real estate.
2. Have earned in excess of $200,000 for the last two income tax years as an individual or $300,000 with a spouse.
3. Be general partner, executive officer, director, or a related combination thereof for the issuer of a security being offered.

Needless to say, the vast majority of investors don’t fit the bill…

Missed Opportunities

Today, Chinese smartphone maker Xiaomi Corp. is the most valuable of these private companies at $46 billion, with ride-sharing app Uber not far behind at a $41 billion valuation.

Just a few years ago, these companies were valued at virtually nothing…

The numbers are especially staggering once you consider that at the start of 2014, the highest-valued start-up was priced at just $11.7 billion. A 400% rise in just over a year? Sounds almost too good to be true.

With private start-ups earning such lofty valuations in the blink of an eye, it’s no secret public investors are missing out on an industry worth not just tens but hundreds of billions of dollars…

The list below highlights just a few of the opportunities investors are missing out on:

Now, I don’t know about you, but personally I find this to be a bit unfair. The intention of Rule 501 may have originally been to protect retail investors from risky endeavors, but in reality it has only served to promote nepotism and make the wealthy elite richer than they already are.

The reality is that while the state might think it knows what’s best for investors, it often does not.

One popular example of missed opportunity dates back to 1980, when Massachusetts labeled the IPO of Apple Computer stock “too risky” and did not allow its citizens to participate as result.

The good news, at least, is that last month, the SEC released the final Regulation A+ rules under Title IV of the JOBS Act. In short, these rules will allow growth companies to raise up to $50 million from unaccredited investors in “mini-IPO” style offerings as early as May of 2015.

In other words, we can all finally participate in the long-anticipated market of equity crowdfunding. After nearly decades of pushback, investors are getting (almost) exactly what they want.

Of course, as of today, we still have little to no idea how equity crowdfunding will actually play out.

For one, we need to keep in mind that the venture capitalists of Silicon Valley are incredibly powerful and well connected — don’t expect them to hand over the world’s fastest-growing companies to public investors anytime soon.

The reality is that once a private company opts to take this new investment route, it will be required by law to meet a number of conditions, namely a slew of financial reporting obligations. More often than not, these companies are burning cash, and though that’s generally a given for a young start-up, many would prefer to keep the exact figures close to their chest.

It should also go without saying — especially after looking at the list of start-ups above — that $50 million is chump-change to a lot of these companies. Even with these new rules, venture capitalism will remain the primary source of funding for the word’s largest start-ups.

Now, don’t get me wrong — Regulation A+ is certainly a win for investors, but it’s a relatively small win. My expectation moving forward is that the majority of start-ups that end up taking this funding route will be bottom of the barrel. Opportunities will be there, but they’ll be few and far between…

Sell the Disrupted

Fortunately, though, just because you can’t own a piece of a company doesn’t mean you can’t profit from its success. In fact, you often don’t have to own any companies at all.

I’m talking about the second part of my golden rule: selling the disrupted.

Take Comcast (NASDAQ: CMCSA) and Time Warner Cable (NYSE: TWX), for example. In the months surrounding the Netflix IPO (May 2002), the companies depreciated in value as much as -33.7% and -57.25%, respectively.

Granted, 2002 was a down year for the market overall, but the broader losses were just a fraction of what was seen by cable companies in the initial wake of Internet television.

Better yet, consider Blockbuster Video (I bet you haven’t heard that name in a while), which went from nearly $30 a share in early 2002 to the $0.01 liquidation company it is today.

Taking a short on Blockbuster in the 2000s would have provided an easy 100% return. Purchasing puts, however, would have leveraged those gains exponentially.

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This strategy of shorting the disrupted applies to just about any industry about to be antiquated by disruptive technology.

You can pair the rise of the first iPhone, for instance, with the downfall of Dell, Blackberry, and Nokia.

Or you can attribute triumph of broadband and the free email model with the dethroning of AOL.

You can even look at non-tech-based business models such as Chipotle (NYSE: CMG) and decide to take a short position on an outdated organization like McDonald’s (NYSE: MCD).

The list of examples goes on, but you get the idea — even if a company isn’t public, you can still turn a healthy profit with a bit of creative investing. The steps are actually quite simple:

1. Identify the disruptive technology
2. Identify the industry it disrupts
3. Locate publicly traded companies within said industry
4. Sell! Sell! Sell!

Until next time,

Jason Stutman

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