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Innovation and Creating Markets - What to Look for

(Guest Commentary by Rick Konrad – March 3, 2011)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick again discusses innovation—only this time from an individual company perspective and how to look for it within a company.  Rick also discusses how to spot markets for new and emerging products and services.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Innovation as an Investment Theme” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


“If I'd asked people what they wanted, they would have asked for a better horse”- Henry Ford

I apologize for the delay in my post. It has been a very busy time for us between work and marketing. If you would indulge me, I have a few more thoughts on innovation and corporate management in particular.

Why is it that so few companies innovate? Why is it that so many investors, and I confess, particularly value or fundamentally driven investors miss out on innovative companies? Today being an important day for the iPad 2's intro made me think back to IBM and its brief glory in PCs.

Whenever a new market evolves, the sands around it shift to accommodate the change. IBM, so revered for its enormous competitive advantage in mainframes, simply had none of the ability to dance to the new rhythms of the evolving PC market. All those capabilities that IBM enjoyed in terms of scale, in terms of balance sheet, in terms of distribution meant squat. Once “Wintel” became the way of the personal computer world, the market rapidly shifted to recognizing PCs as a commodity rather than a unique product. The hardware side of the business became Dell's. Direct selling, mass customization, keeping costs low, and using suppliers' working capital rather than their own became enormous advantages that IBM could not dream of competing. Sadly for Dell, capabilities that were once distinctive and prized became humdrum, normal and expected. In the long run, successful innovative businesses extend their capabilities and learn new ones.

New creative ideas tend to be maverick ideas. As per the Henry Ford quote above, consumer surveys don't help most businesses come up with new radical improvements. Jeff Bezos, the founder of Amazon really nails the “vision thing”: “Human beings aren't good at understanding exponential growth—it's invisible today and ubiquitous tomorrow.”

For a company to maintain a sense of innovation, it needs to maintain clarity of its strategic vision as well as leadership that maintains that focus. Although most executives like to think they are in charge, it's really the customers that effectively control what the company can do or can't do. Clearly, customers wield tremendous power in directing a firm's investments, and hence, its capital allocation, and hence its returns. New product development projects frequently receive inadequate funding and are starved of the resources needed to get it done.

This weekend's Barrons magazine spent considerable time looking at the 3M model for innovation. As the article (http://tinyurl.com/45fkwau- subscription required) indicated:

“Last year, 3M spent about $1.43 billion -- 5% of sales -- on R&D, the highest percentage among its peers, except for Danaher. It has 35 international labs, and 7,500 of its 80,000 workers are in R&D. In 2010, it won 2,400 patents and launched 1,300 products. Today, about 31% of revenue comes from new products, up from 21% five years ago. The goal: 40% by 2015.”

The R&D is diverse, both geographically and across divisions. Here are some comments from a product manager who described his work at 3M to prospective candidates:

  • Diversity of businesses across different industries
  • Job security is pretty stable
  • Leader in innovation
  • Great place to spend a long career
  • Collaborative culture
  • Praise is given when deserved
  • Encourages personal development

I suspect that most innovative companies will have employee commentary that reads similarly. Executives can boost the chances for the probability of success if everyone involved recognizes the project as being essential to the firm's future growth and profitability. Under these conditions, when things go wrong as they inevitably will, the firm's people will find ways to muster whatever is required to find a solution to the problem.

Many new and emerging markets tend to be initially viewed as being small, likely too small for a larger company to justify. Small markets are unlikely to be considered essential to success in a large company; they barely contribute to solving the growth demands of a large company. Hence, many successful companies will embed the project in a spin-off. At least this way, the organization around the spin-off is small enough to be motivated by the opportunity offered by this technology, product or service.

What does it take to actually create a new market? In my opinion, the following:

  1. Value propositions that are so compelling that they can change customer behavior and switch loyalties.
  2. A strategic vision that is based on finding a radical way to meet an unsatisfied customer need.
  3. Genuine concern for the quality and consistency of the customer experience.
  4. Distinctive capabilities in technology and/or marketing.

Whenever a company develops a project that really strikes a major chord with its consumers, magic happens and demand far outstrips the wildest dreams of management. Where management can take credit is in spotting the need before anybody else and developing the capabilities that meet that need and finally, offering an appealing value proposition.

Historically for technology companies, switching costs were the strongest inducement to build customer loyalty. For IBM in particular,”Nobody gets fired for buying IBM” became a mantra. Locking in a customer by making it almost impossible to escape worked well for years. It seems now that network effects are more important than the economic costs of switching. Positive feedback loops produce a bandwagon effect, likely promoted by social networks like Twitter or Facebook. Success tends to breed success. For Apple, the customer is locked in largely by emotional investment rather than the economic investment. For some customers, no matter what price the Android smart-phone may be discounted, the iPhone will likely get the nod. Markets with lots of positive feedback will tend to tip to a particular supplier or technology. Successful firms also became very adept at scalability, relying on others to do most of the manufacturing.

Creating a brand new market is tough enough, but holding on to it requires incredible versatility. Distinctive capabilities have a rather short half-life before they are imitated and made irrelevant. The notion that a company has a sustainable competitive advantage is illusory…it is never permanent. But companies like 3M have managed to stay relevant and quite profitable for years.

As investors, we need to find businesses that have close, binding relationships with customers. Companies need to be adaptable, to recognize significant changes in the competitive environment and to plough ahead. Companies need to review and renew their organizational knowledge and to develop new capabilities. It's not all technology—a strong brand and a good reputation reinforces differentiation and loyalty.

Disclaimer: I, my family, or clients have positions in 3M, and IBM.

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