The Power of Focus and A Sustainable Comparative Advantage

The concepts of focus and diversification are diametrically opposed, but both are crucial concepts in finance.  As investors, we are wise to diversify, to not put all of our eggs in one basket.  As one extreme, employees of Enron who also invested their personal assets in the fast rising company lost both their wealth and their income when the firm collapsed.

For companies (and for individuals considering career options), the opposite is true, and much research has found that those companies that focus on their core competencies are those that prosper.  Companies, like people, have distinct advantages at certain things - but not at everything.  Effective strategic leadership requires defining and honing a sustainable comparative (competitive) advantage.  Let's consider that phrase more fully:

• Comparative (competitive) Advantage means that you can deliver a service or product more effectively, or with higher quality or more inexpensively than your competition.  Now whether you focus on quality or cost is another major decision that we leave for later discussion, but the choice comes down to knowing your marketplace, to understanding customer wants and needs. But as my colleague Joe Rizzi points out, make sure your advantage is comparative: "Having smart people doesn’t mean anything if all your competitors have smart people as well."

• Sustainable - means you will continue to enjoy this advantage for at least the next several years.  This is why Warren Buffett and other great investors talk of finding companies with moats protecting them from competition.  The moat may be in the form of a superior product that cannot be duplicated -  perhaps due to technological knowledge, but more likely due to patents.  It could be from regulatory advantages or political alliances. It could also be from brand capital - the reputation of your firm in the marketplace.  A moat could also exist because of natural barriers to entry like regulation or other legal structures or because the business requires intense capital or other requirements, not easily copied.  There are many more ways to build a 'moat' but the concept is the same, find a way to stay ahead of the competition - a way that is not easily duplicated.

Note that managements can have moats built around themselves as well - a highly undesirable characteristic.  Moreover, management can be so enamored with the size of their empire that they forget the need to focus.  When this happens, external forces - takeovers or activists - step in to correct the situation.  Indeed, the need to focus, to find the sustainable competitive advantage is at the heart of much recent activist activity.  See Joe's recent post discussing Yahoo, Darden, Ebay, Hewlett Packard and DuPont (Royalists Vs. Governistas).  

You can think of sustainable comparative advantage as overlapping circles.  One circle contains the set of all things a company is good at - another partially overlapping circle contains the set of things the market will reward.  The intersection of these circles is the sweet spot where businesses (and people) can prosper.  For businesses and individuals with a sustainable competitive advantage, the sweet spot exists for a longer period of time, but even here the circles are continually moving as technology, consumer tastes, regulation, political climates and other catalysts shift the circles.  It is essential to stay ahead of the shifts.  

Note: for individuals considering career choice, I'd add a third circle consisting of things you enjoy doing.  If you find the intersection of those three circles in your life you are indeed fortunate, doing something you like, that you are good at, that the market values. 

All the best,

Ralph

Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J

Schumpeter’s Ghost and Hewlett-Packard (HPQ)

Joseph Schumpeter is known as the prophet of innovation who coined the term Creative_destruction. Firms and industries go thru life cycles. As they age, the value of their business portfolio and growth prospects change. This is especially true for tech firms with rapid product cycles subject to becoming commoditized. Competition, usually from smaller more innovative competitors, erodes their competitive advantage period (CAP), what Warren Buffett calls “the moat”. The result is a decline in the excess return over the firm’s cost of capital, and a decrease in value.

Some firms attempt to reinvent themselves by searching for new growth engines either organically or thru acquisitions. Unfortunately, their size and resulting bureaucracy complicate this effort. Their ability to innovate slows and they are unable to maintain their competitive position. This is true not only for tech firms, but for firms in general, albeit at a slower pace. For example, the average life for a firm on the S&P 500 has fallen to less than 20 years. At this pace, 75% of the S&P 500 firms will be replaced over the next 20 years.

Some firms are unwilling to accept these facts. They feel if they just try harder they can overcome the odds and recapture their growth. The problem, however, goes beyond management-it is structural. Firms failing to recognize this fact often embark upon misguided growth initiatives, especially acquisitions, and destroy shareholder value. I am afraid this is happening again at HPQ under Meg Whitman.

HPQ reported disappointing 3Q13 results last week with sales off 8 % Third Quarter. This raises questions concerning the sustainability of their turnaround efforts. The stock dropped over 12% on the announcement. Year to date stock performance, however, had been excellent, up over 70%. Disturbingly, Whitman stated a return to acquisitions was being considered to increase growth. Keep in mind HPQ’s disastrous acquisition track record resulting in $20B+ in recent write-offs alone Merger Prof. Unfortunately Steven Ballmer’s recent “resignation” at Microsoft for sluggish performance may reinforce HP’s misguided acquisition related growth initiatives.

Returns, not growth, should be the objective at HPQ at the current point in its life cycle. HP’s current CAP is close to zero and its return spread over its WACC on new investments is probably negative. The focus should be:

1)     Efficiency: achieve world class returns thru cost improvements. You cannot grow off a weak base.

2)     Refocus Product and SBU Portfolio: profitability is hampered by uneven performance from complex operations. Thus, exit businesses where HP is no longer the best owner. HPQ’s diverse businesses tie up capital and incur needless costs.

3)     Dividends: continue to return excess funds from operations and divestments to shareholders via dividends and share repurchases. There is nothing wrong at becoming a cash-cow dividend play.

4)     Reconsider Debt Reduction: do not retire too much debt as that reduces the interest tax shield. Additionally, it leaves management with too much financial flexibility, which can lead them to waste money on questionable activities like acquisitions.

5)     Explore Strategic Alternatives: this could include finding a partner for part or all or part of the firm to capitalize on the break-up value of the firm. Another is a breakup-up via spinoffs into 2 or more independent companies. This would release the units from the corporate bureaucracy, and allow them to become innovative again.

Growth alone does not necessarily lead to increased shareholder value. HP is a big bureaucratic firm, which complicates successful growth efforts. Trying to hide from Schumpeter’s ghost with ill advised growth, especially acquisition based growth given HPQ’s track record, is unlikely to succeed. Sometimes as Kenny Rodgers noted “you have to know when to hold them and know when to fold them”. That time may be approaching for HPQ. For the sake of HPQ’s long suffering shareholders let us hope that Meg Whitman has the wisdom to chose wisely this time.

J