These phases suggest a consistent pattern of a sharp upswing in the number of companies in an industry when it is in the early stages followed by a sharp downswing as the pruning process takes hold. The process appears very wasteful when we see how many alternatives it dismisses. But ultimately the interplay between technical capabilities and market choices selects a product design that best suits the environment.
This pattern has played out over and over in the business world.6 Take two giants in the annals of American industry—the automobile and television (see exhibit 19.1). In both cases, investors allocated capital liberally in the early phases as each industry’s growth potential was significant but uncertain. But both industries saw steep declines in the number of competing firms over time, especially once the industry gravitated toward a dominant design.
The more recent history of the disk drive and personal computer industries shows the same pattern (see exhibit 19.2), although the pruning process occurs over a much shorter period. What took thirty years in the auto industry a century ago took fifteen years for the disk drive industry and more like a decade for the PC manufacturers.
The Internet, too, went through a similar process at the turn of the twenty-first century (see exhibit 19.3). Although the Internet is not an industry per se, there was a period of rampant experimentation through the late 1990s. The pruning process came forcefully in 2001; according to Webmergers.com, 544 Internet companies were shut down in 2001, up from 223 in 2000. Through the first half of 2002, shutdowns dropped almost 75 percent from the previous year’s total.7 While the excesses of the Internet and telecom booms in the late 1990s carried into the twenty-first century, this boom-and-bust pattern is by no means unique. I expect to see the same process unfold in the future.
EXHIBIT 19.1 The Decline of Firms
Source: Utterback, Mastering the Dynamics of Innovation, 35 and 38, and author estimates. Used by permission.
EXHIBIT 19.2 More Declines: Disk Drives and Computers
Source: DISK/TREND reports, Management Science, and author estimates.
EXHIBIT 19.3 Internet Failures
Source: WebMergers.com, CommScan, and author estimates.
As we transition from infants to adults, we trade vast mental flexibility for capabilities tailored to our environment. Skill and competence improve even as the number of synaptic connections declines. What occurs in the business world is comparable. An industry continues to grow even as the number of competitors shrinks as forces select a dominant design, process, or both (see exhibit 19.4).
Pundits often deride the boom-and-bust phenomenon as wasteful and speculative even though it provides the necessary platform for future growth. Further, over the 3 billion years of life on earth, nature has repeatedly settled on this process. In fact, paleontologist David Raup draws a direct analogy between the stock market and the fossil record.8
Investors: Use the Brain
Now that the picture has been filled out a little more, let’s return to investor benefits. The first is a basic appreciation for the existence of the boom-and-bust pattern and why it is so prevalent. In effect, when the environment is uncertain, it helps to start with lots of alternatives (e.g., synaptic connections) and then select (via pruning) the ones that are best given the environment. The process is undoubtedly costly because lots of energy and resources necessarily go to waste, but it’s the best one going.
EXHIBIT 19.4 The Personal Computer and Disk Drive Industries
Source: DISK/TREND reports, Management Science, and author estimates.
The second benefit is how this process plays into manias. Imagine a baby’s brain as a market, with each synapse representing a company or entrant. When the baby is born, the market is buzzing because the brain is creating a lot of synapses and some will be wildly successful. Enthusiasm reigns. Introduce prices, and you have a foundation for a mania.
Investors use price as an important cue, among others, toward a business’s potential success. As the price is bid up, humans naturally want to participate. A positive-feedback loop kicks in, which bootstraps a mania. But as we know, many synapses, or companies, don’t make it. The path to innovation is paved with failure and waste.
Market participants must recognize, however, that because the business environment is generally fluid in periods of innovation, it’s often hard to know which businesses will succeed or fail. The payoff for the survivors can be significant, though, which leads to my final point.
EXHIBIT 19.5 OEM Hard Disk Drive Survivors
Source: Bygrave, Lange, Roedel, and Wu, “Capital Market Excesses,” 13. Reproduced with permission.
Investors are wise to look around for survivors at the end of the pruning process because a portfolio of surviving companies often presents an opportunity for attractive shareholder returns. For example, an investment in the twelve hard-disk-drive companies that survived through the beginning of 1985, held through June 2000, would have generated an 11 percent annual compound return. Further, despite continued failures and brutal competition, investors who sold their winners at peak prices would have realized compound annual returns of 21 percent (see exhibit 19.5).9 I found similar results with the PC stocks from 1989 to 2000.
While markets and businesses are social constructions, they exhibit features that have strong parallels in nature. The similarity between brain development and industry innovation is but one example.
20
Staying Ahead of the Curve
Linking Creative Destruction and Expectations
You know that you’re over the hill when your mind makes a promise that your body can’t fill.
—Little Feat, “Old Folks Boogie”
Losing Pride
It’s a familiar scene to anyone who’s watched a nature show on TV. A young and brash lion challenges the pride’s imposing but aging leader. The elder lion, using intimidation and measured force, succeeds in keeping the insurgent in check for a while. Eventually, though, the leader succumbs and the younger and stronger lion succeeds him.1
One obvious observation is that while not all challengers become the pride’s new leader, the new leader of the pride is always a challenger.2 In business, as in the savanna, there is a never-ending struggle for leadership. Success in nature means passing your genes to the next generation. Success in business means that a company generates high economic returns and total shareholder returns in excess of its peer-group average.
How does thinking about leader/challenger dynamics help investors? These dynamics are not only a mental model for innovation but are also useful because there appears to be a discernable pattern of investor reaction to innovation. Investors tend to understate and overstate growth prospects.
The stock market adds a wrinkle to the innovation process because stock prices are not about the here and now but rather reflect expectations for the future.3 Investors, using myriad means and methods, place a present value on a company’s future—more accurately, the present value of the company’s future cash flows. Stock prices reflect the collective expectations of investors.
So investors can’t just consider innovation; they must assess how the market will consider innovation. Therein lies the potential opportunity.
Goldilocks Expectations: Too Cold, Too Hot, Just Right
There is substantial evidence that industry sales and earnings trace an S-curve after a discontinuity or technological change.4 Growth starts slowly, then increases at an increasing pace, and finally flattens out (see exhibit 20.1). This diagram is useful for thinking about shifting expectations. Investors (indeed humans in general) often think linearly. So at point A, investors do not fully anticipate the growth and economic returns from an industry, and they extrapolate relatively low growth. Expectations for future financial performance are too low. Following a period of sustained growth (point B), investors naively extrapolate the recent growth into the indefinite future. Expectations are too high. Finally, at point C, investors reign in expectations and adjust stock prices to refle
ct a more realistic outlook.
EXHIBIT 20.1 S-Curve Growth Markets Often Generate Perception Gaps
Source: Author analysis.
So the obvious goal for an investor is to buy a stock at point A and sell it at point B—avoiding the unpleasant downward expectations revision at the top of the S-curve. The work of technology strategist Geoffrey Moore—including the best-selling Gorilla Game—provides a framework to anticipate such an upward revision. Moore discusses the key issues involved in getting beyond point A, or the elbow in the S-curve, and articulates strategies to identify the potential winners. The difficulty, of course, is that many companies try, but few succeed in becoming the leader in a new industry. It’s a jungle out there.
My goal is to document that the transition from point A to point B presents opportunities for excess returns and that the transition from point B to point C often spells poor stock-price performance. Recognizing these inflection points can be very useful for investors for a couple of reasons. First, accelerating innovation assures that industry and product life cycles are shortening.5 Because the waves of innovation are coming faster and faster, there will be more A-to-B opportunities, and investors must be more nimble to anticipate the expectations revisions.
Second, humans often fall into automatic action when an experience “imprints” on them. For instance, stocks that have performed well in the recent past leave an imprint on the minds of many investors. As a result, following difficult periods investors want to go back to the stocks that drove their portfolio performance in the past.6 These companies are often at point B and hence are generally the stocks that investors should avoid. In a fast-changing world, you’re almost always better off betting on the new guard than the old. You may not know which new company will generate the excess returns, but you can be almost assured that the older company will not.
Out with the Old, In with the New
In their very important book, Creative Destruction, Richard Foster and Sarah Kaplan show that new entrants generate higher total return to shareholders (TRS) than their older and more established competitors (see exhibit 20.2). This represents the transition from point A to point B in exhibit 20.1. These data cover a time span in excess of thirty years and literally thousands of companies. All that the researchers required for a company to get into the sample was that it had to be in the top 80 percent of all companies by market capitalization and have 50 percent or more of its sales in the defined industry.
Admittedly, this analysis is skewed toward innovative industries. However, one can argue that the sharper rate of change in the global economy is tilting the challenger/incumbent balance even more dramatically in favor of the challengers. Foster articulated the process of innovation in his path-breaking 1986 book, Innovation: The Attacker’s Advantage.
Specifically, the research shows that most of an entrant’s excess shareholder returns versus its industry come in the first five years. In the subsequent fifteen years, the entrant delivers total shareholder returns that are roughly in line with the industry. Twenty years after entry, a company’s stock tends to underperform its peers.
EXHIBIT 20.2 Eventually the Edge Wears Off…
Source: Foster and Kaplan, Creative Destruction, 47. Reproduced with permission.
Foster and Kaplan offer three reasons for this pattern. First, competitors imitate or improve on yesterday’s innovations, leaving the original innovators with little opportunity to generate either returns above the cost of capital or meaningful growth. Second, the market reflects expectations more accurately for businesses that are more stable and that have longer operating histories than the challengers typically do. Finally, almost all companies eventually lose the innovative edge as the result of size, success, or established institutional routines (the authors call it “cultural lock-in”).
Here’s the crucial message: the companies that outperform the market are “temporary members of a permanent class.” The aggregate returns of the stock market indexes belie an accelerating rate of change in the composition of those indexes as young innovators unseat their established competitors in the market-capitalization game. Corporate longevity is on the wane, and company-specific volatility is rising.7 Both companies and investors face great opportunity and risk.
The Mind Makes a Promise That the Body Can’t Fill
In 1998, the Corporate Strategy Board published a detailed study on what they called “stall points”—the inflection point at the top of the S-curve.8 Stall points are the transitions from point B to point C in exhibit 20.1. The board found that 83 percent of the companies that reach the stall point grow sales at a rate in the mid-single digits or less in the subsequent ten years. Even more relevant for investors, they show that roughly 70 percent of these companies lose at least one-half of their equity market capitalization. This is evidence that investors extrapolate trends of the recent past into the foreseeable future, only to have those expectations revised down when growth slows.
The researchers also found that it is extremely rare for companies to generate double-digit (real) top-line growth when revenues reach roughly $20 billion (although the ceiling is slowly rising over time). The stock prices of some large technology companies still reflect expectations for strong double-digit growth today.9
A noteworthy parallel between the research in Creative Destruction and in Stall Points is that an inability to innovate and grow is the result of largely controllable organizational and strategic factors. Foster and Kaplan discuss in detail how corporate routines allow companies to slip into senescence, and the authors provide some useful guidelines for constant renewal. The Corporate Strategy Board report provides a detailed analysis of the cause of stall points and suggests that companies can attribute less than 20 percent of the explanation to factors outside of their control.
Expectations and Innovation
The research indicates that where there is innovation, there are winners and losers. The data show that challengers have the advantage and that incumbents often don’t innovate enough to sustain leadership positions. Since stock prices reflect expectations, investors must not only consider the dynamics of innovation but also what the market anticipates. The evidence suggests that expectations for challengers are at first too low and then too high.
21
Is There a Fly in Your Portfolio?
What an Accelerating Rate of Industry Change Means for Investors
The results . . . provide strong evidence that periods of sustained competitive advantage, as evidenced by its consequence, superior economic performance, are growing shorter over time. These results hold across a wide range of sectors of the economy.
—Robert R. Wiggins and Timothy W. Ruefli, “Hypercompetitive Performance: Are the Best of Times Getting Shorter?”
I think the multiples of technology stocks should be quite a bit lower than stocks like Coke and Gillette, because we are subject to complete changes in the rules. I know very well that in the next ten years, if Microsoft is still a leader, we will have had to weather at least three crises.
—Bill Gates, Fortune, 1998
Fruit Flies and Futility
Geneticists and biologists love to work with Drosophila melanogaster, a common fruit fly, and have made it a staple of biological study. Indeed, insights from Drosophila research helped a trio of scientists win the 1995 Nobel prize in medicine. Thousands of researchers continue to study the Drosophila to better understand various genetic and developmental issues.
Drosophila is attractive to scientists because they understand its features and it is easy to handle. But the fly has another essential feature that scientists covet: its life cycle. Drosophila go from embryo to death in about two weeks. This rapid rate of reproduction allows scientists to study hundreds of generations of the fly’s development and mutations in a relatively short time. Drosophila’s fast evolution provides scientists with important clues about evolution in other species, which generally evolve at a relatively glacial pace.1
Why should b
usinesspeople care about Drosophila? A sound body of evidence now suggests that the average speed of evolution is accelerating in the business world. Just as scientists have learned a great deal about evolutionary change from fruit flies, investors can benefit from understanding the sources and implications of accelerated business evolution.
The most direct consequence of more rapid business evolution is that the time an average company can sustain a competitive advantage—that is, generate an economic return in excess of its cost of capital—is shorter than it was in the past. This trend has potentially important implications for investors in areas such as valuation, portfolio turnover, and diversification.
Speed Trap?
In his book Clockspeed: Winning Industry Control in the Age of Temporary Advantage, Charles Fine defines clockspeed, a measure of cycle time, on multiple levels.2 The first is product clockspeed. Consistent with intuition, product clockspeed considers how quickly an industry launches new products and how long products live. Evidence of accelerating new product activity is everywhere. For example, Technology Review reports that General Motors has reduced the time it takes to develop and build a new vehicle from forty-eight to twenty-one months. In fact, GM is launching a new vehicle every twenty-three days, on average.3
More Than You Know Page 13
