Once again, in chapter 20, Michael Mauboussin has chosen to provide a natural phenomenon to help explain something in business and investing.
Writing in "More Than You Know: Finding Financial Wisdom in Unconventional Places," the author began with young lions challenging the aging leader of a pride. At first, the young lions fail to dislodge their leader but eventually, a younger and stronger lion will succeed the existing leader.
He observed, “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.”
For reasons he will later explain, Mauboussin noted that investors both understate and overstate the growth prospects of innovative companies. Stock prices reflect investors’ expectations for the future, and in various ways establish a present value for a company, or more specifically, the present value of a company’s future cash flows.
As a result, investors cannot take innovation on its own, they must also try to anticipate how the market will assess innovation. And that, he wrote, creates a potential opportunity.
Meet the “S-curve.” Whenever some form of technological or disruptive change occurs, we can expect an innovating company’s fortunes to follow a familiar pattern. At first, it is slow, but over time it grows increasingly faster, and then it finally flattens out. Mauboussin created this chart to illustrate his ideas about the S-curve:
The S-curve pattern is familiar to innovation watchers, as are investors’ expectations:
- At Point A, the leftmost position, investors don’t expect much growth or economic return and forecast low growth in the future.
- Point B (middle) occurs after a sustained period of rapid growth, which prompts investors to expect bullish growth will continue indefinitely.
- At Point C, investors realize their expectations had been too high and resign themselves to a more realistic outlook.
For savvy investors, Mauboussin had this advice: “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.”
He added that recognizing these inflection points could be very useful to investors. Accelerating innovation means the waves are coming faster, and investors must be nimble. Despite that, companies that have served us well in the past are like comfort foods and we tend to go back to them, even if they have passed Point B.
Why the emphasis on new entrants rather than old standards? According to the book, “Creative Destruction” by Richard Foster and Sarah Kaplan, newcomers generate higher total returns to shareholders than more established companies. More specifically, their research established that excess shareholder returns from newcomers, versus their industries, occurs in the first five years. Over the following 15 years, total return to shareholders is about the same as that for their industries and after 20 years, the previously new entrants underperform their peers.
This happens for three reasons, according to Foster and Kaplan:
- Competitors improve on previous innovations, while the original innovators tend to become stuck.
- Market expectations are more accurate for established companies with longer operating histories.
- Most companies eventually lose their competitive edges because of their size, their success or institutionalized routines.
Mauboussin wrote:
“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. Both companies and investors face great opportunity and risk.”
Digging more deeply, Mauboussin turned to a 1998 study by the Corporate Strategy Board on what it called “stall points,” at the top of the S-curve. That study found that 83% of companies that reached the stall point had growth rates in the mid-single digits in the following 10 years. And 70% of companies lost at least half of their equity market capitalization.
The study also found it was rare for companies to generate double-digit top-line growth after they reached about $20 billion (presumably $20 billion in sales).
Both “Creative Destruction” and “Stall Points” concluded that failure to keep growing is a management failure. The “Stall Points” report, for example, found that less than 20% of growth failure could be blamed on factors beyond management’s control.
To sum up:
“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.”
Conclusion
Innovation brings change to an industry, and it also affects the way investors assess that innovation. Broadly speaking, investors' expectations are low at first and, not surprisingly, because there has been little hot growth so far.
Once that hot growth becomes apparent, investors jump in and for a time can enjoy the ride. Unfortunately, many think the growth will continue indefinitely when wiser investors know it will eventually flatten and growth rates will be mediocre at best. Success for investors will come from knowing they should get in soon after Point A and get out near Point B.
As we have seen, creative destruction and investor expectations go hand in hand, as innovation changes businesses, industries and markets.
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