More Than You Know

by Michael J Mauboussin

  EXHIBIT 17.3 Correlation Between CIO Survey Data and Stock Price Performance

  Source: http://www2.cio.com/techpoll/index.cfm and author analysis.

  Researchers have shown that people tend to overestimate the likelihood of two events occurring. This error is called the conjunction fallacy and occurs because we tend to lump thoughts into categories. Investors working off derivative calls must be very alert to avoid the conjunction fallacy.12

  Seeking new information is a worthy goal for an investor.13 My fear is that much of what passes as incremental information adds little or no value, because investors don’t properly weight information, rely on unsound samples, and fail to recognize what the market already knows. In contrast, I find that thoughtful discussions about a firm’s or an industry’s medium- to long-term competitive outlook are extremely rare.

  Part 3

  Innovation and Competitive Strategy

  INTRODUCTION

  Just to give you some sense of how much change we’ve seen in the past hundred years or so, take a gander at the first list of industrial stocks Charles Dow assembled in May 1896:

  American Cotton Oil Laclede Gas

  American Tobacco North American

  Chicago Gas Tennessee Coal & Iron

  Distilling and Cattle Feeding U.S. Leather

  General Electric U.S. Rubber

  The only company that’s still around is General Electric, and today it’s a lot more general than electric. These were the blue chip companies of their day and reflected the commodity-based economy in which they competed. It’s hard to imagine that Distilling and Cattle Feeding and American Cotton Oil were hot stuff, but future generations might get similar chuckles from Microsoft and Merck.

  Do the changes of the past century give us any inkling about the next century? Well, we know a couple of things for sure. First, any predictions about the distant future are likely to be wildly off the mark. And second, the only thing we can pretty much count on going forward is innovation. How to think about and cope with innovation is the theme of this section.

  Investors need to understand innovation because it’s the primary mechanism shaping which companies will win and lose. But here’s the problem: Even though most investors acknowledge that tomorrow’s successful companies will be very different from today’s leaders, the changes driving the overhaul are generally small and incremental. So unless you think carefully about innovation’s cumulative effects, the small changes will escape your detection and you’ll end up with yesterday’s favorites.

  One of this section’s main ideas is that innovation is inevitable. Innovation is the result of recombining existing idea building blocks. So the more ideas that exist and the quicker we can manipulate them, the more rapidly we can come up with useful solutions—innovations. Indeed, there’s a good case for an accelerating pace of innovation. Naturally, innovation implies winners and losers. Evidence shows that today’s winners are likely targets for competition and that once companies go from good to bad, they rarely recover.

  Another key principle is that humans are terrible at dealing with change. As investors, we tend to extrapolate. The expectations embedded in valuations frequently assume more of the same: good companies will continue to thrive and poor performers will remain in the doghouse. Corporate executives, too, settle into comfortable routines, sowing the seeds for future competitive failure.

  A final theme is how to deal with change. When new industries emerge, sorting good from bad strategies is nearly impossible. So the pattern we often see is that the industry tries many different strategies and lets the marketplace dictate which ones are good (there’s a fascinating parallel here with brain development). The result is a set of attractive strategies, but at the significant cost of many failures. Rather than view these failures as undesirable, we might consider them as a vital part of business-model search.

  A firm grasp of innovation’s underlying principles may not help you anticipate what stocks your grandchildren will hold, but it will aid immensely in your ability to anticipate expectations changes for your portfolio.

  18

  The Wright Stuff

  Why Innovation Is Inevitable

  All innovations represent some break from the past—the light-bulb replaced the gas lamp, the automobile replaced the horse and cart, the steamship replaced the sailing ship. By the same token, however, all innovations are built from pieces of the past—Edison’s system drew its organizing principles from the gas industry, the early automobiles were built by cart makers, and the first steamships added steam engines to existing sailing ships.

  —Andrew Hargadon, How Breakthroughs Happen

  We must see to it that our industry shall be able to produce annually up to 50,000,000 tons of pig iron, up to 60,000,000 tons of steel, up to 500,000,000 tons of coal, and up to 60,000,000 tons of oil. Only when we succeed in doing that can we be sure that our Motherland will be insured against all contingencies.

  —Josef Stalin, Speech, 1946

  The empires of the future are the empires of the mind.

  —Winston Churchill, Speech at Harvard University, 1943

  Take Off with Recombination

  On December 17, 1903, Orville Wright made history when he controlled his engine-powered plane for a sustained flight, covering 120 feet in twelve seconds (see exhibit 18.1). With that, the Wright brothers launched multiple industries and forever altered the nature of long-distance travel.

  How did the Wright brothers achieve their world-changing feat? They neither relied on divine inspiration nor started with a clean slate. You could best describe the first plane as a recombination of known ideas and technologies. 1 As management professor Andrew Hargadon says, all innovations represent some break from the past, built from pieces of the past. The Wrights’s genius was the insight that combining a light gasoline engine, some cables, a propeller, and Bernoulli’s principle would result in a flying contraption.

  Investors need to appreciate the innovation process for a couple of reasons. First, our overall level of material well-being relies heavily on innovation. Second, innovation lies at the root of creative destruction—the process by which new technologies and businesses supersede others. More rapid innovation means more success and failure for companies.

  EXHIBIT 18.1 The Wright Brothers First Flight

  Source: Corbis Corporation.

  How Does Wealth Happen?

  Economist Paul Romer often starts with a very simple question, How is it that we are wealthier today than we were 100 or 1,000 years ago? After all, the underlying quantity of the world’s raw materials—in the extreme, the earth’s total physical mass—hasn’t changed, and we have to divide this mass among a much larger human population. Yet worldwide per capita GDP is roughly thirty times what it was a millennium ago, with much of the increase occurring in the past 150 years (see exhibit 18.2).2

  Romer’s rather straightforward explanation is that we have progressively learned how to rearrange raw materials to make them more and more valuable. Whereas control over physical resources was the primary source of wealth one hundred years ago (in 1896, ten of the twelve companies in the Dow were in commodity businesses), today the ideas and formulas to manipulate raw materials form the engine of wealth creation.

  EXHIBIT 18.2 The Explosion in Per Capita GDP

  Source: Angus Maddison and author estimates.

  As Churchill correctly noted sixty years ago, the empires of the future are empires of the mind.3

  To make his point more concrete, Romer distinguishes between two parts of the value-creation process: the discovery of new instructions, ideas, or formulas and the carrying out of those instructions. New instructions are of no value unless someone can effectively execute them.

  Romer suggests that a contrast between U.S. Steel in 1900 and Merck in 2000 represents the shift in our economy at large. Had you studied U.S. Steel a century ago, you would have seen many employees following instructions—transporting ore, feeding furnaces, shaping
steel—and only a handful working on identifying new instructions. The evolution of instructions was important, of course; it was just much less visible.

  Take a tour of a pharmaceutical company like Merck today, and the emphasis is flipped. Most employees are trying to find new instructions. No doubt there are workers carrying out instructions, but they are a small part of the picture. You can use these terms to recast the ongoing debate about job outsourcing: Is it all right to outsource the jobs that execute instructions provided you encourage opportunities for those who create instructions?

  That instructions to shape the world are central to wealth creation (an element that, ironically, classical economic growth models consider exogenous) comes with some important implications.

  The first is the difference between what economists call rival and nonrival goods. With a rival good, one individual’s consumption reduces the quantity available to others. A car, a pen, and a shirt are examples. In contrast, many people can use a nonrival good—a set of instructions—at once. Software is the prototype. A company can distribute software widely. And since the additional use of this knowledge does not rely on scarce resources, wider sharing may lead to more growth.4

  A second implication is that since innovation is about recombining the building blocks of ideas, the more building blocks that exist, the more opportunities there are to solve problems. A simple mathematical example illustrates this principle. Say you had four building blocks to create potential solutions. The number of possible combinations is 4 x 3 x 2 x 1, or 24. Now increase the number of building blocks to six. The potential combinations—6 x 5 x 4 x 3 x 2 x 1, or 720—is thirty times larger. As Romer likes to point out, you can sequence twenty steps in roughly 1019 ways, a number larger than the total number of seconds that have elapsed since the Big Bang created the universe.

  This leads to the final implication: more idea building blocks lead to more innovation, which ultimately leads to faster aggregate growth. For companies that largely rely on physical resources, the costs associated with scarcity lead to diseconomies of scale and hence limit size and growth. Companies that primarily create knowledge don’t face the same barriers (although they may face other challenges).

  We can see how this theme of size begetting growth plays out on a national level. The per capita GDP growth of the United States (which we measure in roughly forty-year increments) has actually been accelerating over the past two hundred years in spite of the economy’s increasing size (see exhibit 18.3). In a world of ideas, size per se may not be a governor of growth. In fact, the opposite may be true.

  EXHIBIT 18.3 Size Does Not Impede U.S. Growth

  Source: Angus Maddison and author estimates.

  Sic Itur ad Astra (This Is the Way to the Stars)

  We should expect three interrelated drivers—scientific advances, information storage capacity, and gains in computing power driven by Moore’s Law5—to continue to spur innovation at an accelerating rate. Here I focus on one aspect of innovation: changes in information transmission.

  In his provocative book As the Future Catches You, Juan Enriquez traces the evolution of human symbolic communication.6 Twenty or thirty thousand years ago, Paleolithic people painted on cave walls (see exhibit 18.4). Scientists believe these drawings communicated rituals related to hunting. These paintings are beautiful, but since they can’t be reproduced or moved, they have limited communication value.

  Communication technology improved when Mesopotamian and Egyptian civilizations introduced written alphabets using cuneiform letters and hieroglyphics about 5,000 years ago (see exhibit 18.5). This period also saw some of the first symbols for mathematical expression, based on physical tokens. These crude alphabets were a large step in the right direction but remained cumbersome. Typically, only the elite in these societies were literate.

  EXHIBIT 18.4 Cave Painting

  Source: Corbis Corporation.

  The Chinese developed characters that allowed for greater standardization (see exhibit 18.6). A simpler form of symbolic communication, this alphabet allowed the Chinese to print books using wood blocks roughly 500 years before Gutenberg invented the printing press in Europe.

  The Greeks simplified many sounds into just a few letters, which serve as the basis for the twenty-six-letter Roman alphabet used in many western languages today. We can combine these letters to represent almost any concept. This alphabet helped contribute to a sharp rise in literacy and improved the world’s standard of living.

  But shortly before World War II, another language came to prominence—the language of 1s and 0s. Binary or digital language allows us to encode almost any information possible—from words, to music, to the map of the human genome (see exhibit 18.7).

  Because digital language is simple, we can code, transmit, and decode it very quickly.7 It also maintains remarkable fidelity and is easy to store.

  EXHIBIT 18.5 Hieroglyphics—Syllabic Signs

  Source: Corbis Corporation.

  EXHIBIT 18.6 “Consilient Observer” Written in Chinese

  Source: Jean Yu.

  EXHIBIT 18.7 “Consilient Observer” Written in Binary Code

  Source: http://nickciske.com/tools/binary.php.

  EXHIBIT 18.8 Worldwide Storage of Original Information

  Source: Lyman and Varian, “How Much Information? 2003.” Reproduced with permission.

  Exhibit 18.8 shows the change in information production from 1999 to 2002. Note the large increases in magnetic and optical storage mediums.

  What does all of this mean for innovation? Because of the flexibility of digital language, we can now identify and manipulate building blocks like never before. Combine this with the growing inventory of building blocks, and the conclusion is that the rate of innovation is likely to accelerate. Changes in healthcare, for example, will likely be sweeping as scientists combine digitization, biological knowledge (the map of the genome), and increased computing power.

  Creative Destruction—Here to Stay

  Twenty-first-century Wright Brothers have unprecedented access to and ability to find combinatorial solutions. And wealth in the future is likely to follow those who create the useful ideas instead of those who execute those ideas.

  19

  Pruned for Performance

  What Brain Development Teaches Us About Innovation

  I think that’s exactly what you see going on here. Every experiment [on the Internet] is getting tried. Many of them are going to succeed, and many of them are going to fail.

  —Jeff Bezos, Internet summit, 1999

  Too Clever by Half

  Whenever I start to feel smart, I take a good look at a three-year-old child. That child is learning at a staggering pace. Research shows that preliterate children learn a new word every two hours they are awake on their way to knowing approximately 45,000 words by high school graduation.1 Young children have a remarkable ability to learn what is useful given their environment.

  Adults, on the other hand, have a more difficult time absorbing so much new information. Learning a second language, for instance, is much more challenging for a middle-aged adult than for a young child. Why? The answer is not only interesting from the standpoint of child development but also provides a useful way to think about the process of innovation in the business world.

  From a child’s birth to the age of three, there is a huge increase in the number of synapses—connections between neurons—in the brain. In fact, a toddler has roughly 1 quadrillion synaptic connections, twice as many as an adult. Children have brains that are more active, more connected, and more flexible than those of grownups.2

  But following this synaptic proliferation is a significant pruning process. Through experience, useful synaptic connections are strengthened, and those that aren’t used get pruned (known as a Hebbian process after psychologist Donald Hebbs).3 Estimates suggest that young children lose approximately 20 billion synaptic connections each day.4 This process fine-tunes the brain to survive in its particular environme
nt. By the time we are adults, synaptic selection has shaped our brains to succeed.

  This process of synaptic overproduction and pruning may not seem remarkable, except when you consider that it’s an incredibly expensive tactic in terms of neural components and energy cost. Why has evolution allowed this wasteful process to persist? Nature is pretty smart. Models of neural networks show that the overproduction/pruning approach is very flexible and more reliable at preserving information than a feed-forward network. Starting with lots of alternatives and winnowing down to the most useful ones proves to be a robust process, even though it appears quite inefficient.5

  Why should investors and businesspeople care about neural development? Neural overproduction and subsequent pruning appears to parallel closely what happens when a new industry emerges. An understanding of this process provides investors with three benefits. First, it is a model of innovation that is both theoretically sound and that researchers have tested empirically. Second, the process provides investors with a basis for understanding manias or bubbles. Finally, it shows that the innovation process often leads to investment opportunity.

  The Dynamics of Innovation

  In his thoughtful book Mastering the Dynamics of Innovation, James Utterback suggests three phases in industry innovation. The first is what he calls the fluid phase, a period in which there is a great deal of experimentation. This mirrors the upswing in synaptic connections. The transitional phase comes next, where evolutionary forces select the dominant product design. This phase is similar to the pruning process. The final phase is the specific phase, where changes in product or process are modest. That’s what most of us adults face.