Investment analysts wrote much about the attraction of ‘disruption’ during 2015. How new technology is enabling smaller, smarter and nimbler start-ups to build disruptive business models by achieving the “magical trifecta” of better service to more customers at a lower cost.

Buzzwords associated with this concept include:

Collaborative software. This allows many users to share information by collaborating on a common platform e.g. Uber and Aconex.

The network effect, which increases the number of users with a common denominator, usually location, creates an exponential increase in efficiency e.g. Airbnb and Domino’s online (DMP).

First-mover advantage, suggests that the first company to establish critical mass and meaningful scale gains an extremely strong position e.g. Google Search and Carsales (CRZ).

Global operational leverage. This concept refers to those businesses that can spread their cost base over a global customer base, providing a cost advantage over localised competitors e.g. Netflix, Amazon and Aristocrat’s (ALL) online games.

Investing in a ‘ten bagger’ by picking the next Google or Facebook is harder than it seems. Survivorship bias means we remain focused on the few companies that ‘make it’, rather than the multitude of ones that don’t. Furthermore, rapidly growing disruptors carry additional investment risk. This risk may include a lack of any cash earnings to underpin a valuation as the business grows its way to scale; as well as a lofty multiple of future earnings, EBITDA, revenue or even addressable market share, depending on how hot investor sentiment is at the time.

The preference at Pengana has been to find existing companies with proven robust business models and competent management at the right price that are using technology to either grow their addressable target market; lower costs through efficiencies or strengthen their customer service proposition.

Two pertinent examples come to mind.

ResMed (RMD), a home-grown global medical device company that designs, manufactures and distributes flow generators and masks to treat sleep apnea. By connecting each flow generator through a network similar to Amazon’s ‘Whispernet’ for the Kindle, the company has successfully connected patients, sleep doctors and equipment suppliers to a common database that enhances efficient and effective service at substantially lower cost. First-mover advantage has provided sales momentum in excess of 50% per quarter while simultaneously establishing a closer brand connection with its customers and end-users.

ResMed (RMD)

Source: Yahoo!7 Finance

Tatts Group (TTS). The domestic lottery provider has successfully increased its distribution of products by offering them online. Previously, lottery tickets were sold exclusively through newsagencies. For every $109 spent by the consumer on tickets, $9 stayed with the newsagent as a distribution fee, $60 went to [their] players as prizes, $30 went to the government and $10 remained with the operator to cover costs and profit. The online offering has broadened the company’s target market without requiring an intermediary or increasing its associated distribution costs; while simultaneously creating a direct interaction with its customers.

Tatts Group (TTS)

Source: Yahoo!7 Finance

In our view, just finding a company that has developed a better mousetrap is not (nearly) enough. The essential components of a good investment require not just a strong value proposition (good product) but also a coherent path to sustainable profitability (healthy earnings) underpinned by robust cash flows (high after tax cash earnings yields). Nanosonics is in this category.

Nanosonics (NAN)

Source: Yahoo!7 Finance

Nanosonics (NAN) has developed a world leading sterilisation solution for reusable medical devices. More importantly, however, is the company’s experienced management team with a track record for commercialising disruptive medical solutions. Our investment process includes having an investment thesis for every investment that lays out the key profit drivers – For NAN this would include:

a) the Installed base of solutions verifying acceptance of product and success of direct sales model into the US hospital market;
b) Volume of consumables validating use of product in customers’ operations and
c) EBIT margins confirming profitability.

More importantly, as investors, we require investment milestones against which we can test our investment thesis. By tracking the successful achievement of these milestones, we are able to increase our confidence in the product, management competence and the business model. This process allows us to add or trim our holdings on an informed basis rather than speculation.

The Darwinism of modern capitalism continues to allow the strong players to survive (and even flourish) while whittling away the inefficient. Our challenge as investors is to be able to identify and back the winners, while reducing the risk of being led down an evolutionary dead end. Be careful, it really is a jungle out there!

Rhett Kessler is the senior fund manager of the Pengana Australian Equities Fund.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.