When a phrase of two words becomes famous, it’s not only apt to be truthful but powerfully accurate.  “Creative destruction” was first articulated by Austrian economist Joseph Schumpter in 1942. He used the phrase to describe capitalism.  It meant any innovation in the manufacturing process which increased productivity. Schumpter intended the phrase to describe what he called, “the essential fact about capitalism.” To him it was the crucial reality of how capitalist economies evolve and grow. However, constant innovation creates opportunities for some while destroying what existed before.

The phenomenon had its beginnings when English textile workers, called Luddites, destroyed newly delivered machinery to woolen mills in 1811. The skilled weavers knew they would be marginalized by the machines. It was the start of what would become the age of industrialization. Today the creative destruction of the internet, has increasingly turned new business models into price destruction rather than innovation. Everyone’s price is known. Therefore “success” – meaning sales - goes to those with the cheapest price. New businesses have been turned into facades of perceived innovation.

This ill-conceived illusion has been largely financed by two of the greatest pools of money in history. Sovereign Wealth and Public Sector Union Funds channeled through venture capital firms.  When too much money chases too few new innovations, it creates excess. And that is exactly what has happened. Many, if not most, of the newly created entrepreneurially companies over the past 10-12 years of 0% interest rates have not been based on creative destruction but by price destruction.

An example is TV network CNBC’s yearly list of 50 new companies called “The Disruptors.” Among large names you might recognize are Peloton, Wework, Airbnb, Robinhood, Casper, Lyft, Uber, Oyo, Grubhub, Wayfair, Okta and Zoom. For lack of space, that’s just a few.  Not one of these companies makes money even though some have been in business ten or more years. Moreover, they have been funded with billions of dollars. Many are now starting to run into the Law of Big Numbers which states a large entity, which is growing rapidly, cannot maintain that growth forever.

That law significantly impacts the value of investing in such companies. The investor takes risk with his capital in the hope of earning a fair return over time. Some of these startups already have billions in revenue. After all, how hard is it to sell something for seventy cents that cost you a dollar to make? The investor makes lasting money only when a company does. If a company doesn’t make money, the financial reward of being public accrues to venture capitalists, company management, corporate employees, investment banking firms and accounting firms. The overwhelming theme here is: these companies compete not on innovation but price, which is why they do not make money.

This business model is the financial equivalent of looking through a telescope backwards. When one looks through the back end, with a focus on massive revenue generation, profit is seen as far away; but when one looks through a financial telescope correctly, profit is close, upfront and clearly seen.  Joseph Schumpter’s “Creative Destruction” observation was about growing capitalism. Creating large eleemosynary institutions to benefit just a few parties is a broken “business” model in any century.

-Francis Patrick Boland