Were you ever told “pretty is as pretty does?”  This homily means “don’t just look at the surface, it’s the underlying qualities that matter.”  When I read analyst reviews of companies I’m often struck by how fascinated they are with the surface, and how weakly they seem to understand the underlying markets. Financials are a RESULT of management’s ability to provide competitive solutions, and no study of financials will give investors a true picture of management or the company’s future prospects.

The good:

Everyone should own Apple.  The list of its market successes are clear, and well detailed at SeekingAlpha.com “Apple: The Most Undervalued Equity in Techdom.” The reason you should own Apple isn’t its past performance, but rather that the company has built a management team completely focused on the future. Apple is using scenario planning to create solutions that fit the way people want to work and live – not how they did things in the past. 

And Apple managers are obsessive about staying ahead of competitors with better solutions that introduce new technologies, and higher levels of user productivity.  By constantly being willing to disrupt the old ways of doing things, Apple keeps bringing better solutions to market via its ongoing investment in teams dedicated to developing new solutions and figuring out how they will adapt to fit unmet needs.  And this isn’t just a “Steve Jobs thing” as the company’s entire success formula is built on the ability to plan for the future, and outperform competitors.  We are seeing this now with the impending launch of iCloud (Marketwatch.com “Could Apple Still Surprise at Its Conference?“)

For nearly inexplicable reasons, many investors (and analysts) have not been optimistic about Apple’s future price.  The company’s earnings have grown so fast that a mere fear of a slow-down has caused investors to retrench, expecting some sort of inexplicable collapse.  Analysts look for creative negatives, like a recent financial analyst told me “Apple is second in value only to ExxonMobile, and I’m just not sure how to get my mind around that.  Is it possible growth could be worth that much? I thought value was tied to assets.” 

Uh, yes, growth is worth that much!  Apple’s been growing at 100%.  Perhaps it won’t continue to grow at that breakneck pace (or perhaps it will, there’s no competitor right now blocking its path), but even if it slows by 75% we’re still talking 25% growth – and that creates enormous value (compounded, 25% growth doubles your investment in 3 years.)  When you find profitable growth from a company designed to repeat itself with new market introductions, you have a beautiful thing!  And that’s a good investment.

Similarly, investors should really like Netflix.  Netflix did what almost nobody does. It overcame fears of cannibalizing its base business (renting DVDs via mail-order) and introduced a streaming download service.  Analysts decried this move, fearing that “digital sales would be far lower than physical sales.”  But Netflix, with its focus firmly on the future and not the past, recognized that emerging competitors (like Hulu) were quickly changing the game.  Their objective had to be to go where the market was heading, rather than trying to preserve an historical market destined to shrink.  That sort of management thinking is a beautiful thing, and it has paid off enormously for Netflix.

Of course, those who look only at the surface worry about the pricing model at Netflix.  They mostly worry that competitors will gore the Netflix digital ox.  But what we can see is that the big competitors these analysts trot out for fear mongering – Wal-Mart, Amazon.com and Comcast – are locked-in to historical approaches, and not aggressively taking on Netflix.  When you look at who has the #1 market position, the eyes and ears of customers, the subscriber/customer base and the delivery solution customers love you have to be excited about Netflix.  After all, they are the leaders in a market that we know is going to shift their way – downloads.  Sort of reminds you of Apple when they brought out the iPod and iTunes, doesn’t it?

The bad:

Google has been a great company.  The internet wouldn’t be the internet if we didn’t have Google, the search engine that made the web easy and fast to use, plus gave us the ads making all of that search (and lots of content) free.  But, the company has failed to deliver on its own innovations.  Android is a huge market success, but unfortunately lock-in to its old mindset led Google to give the product away – just a tad underpriced.  Other products, like Wave were great, but there hasn’t been enough White Space available for the products to develop into commercial successes.  And we’ve all recently read how it happened that Google missed the emergence of social media, now positioning Facebook as a threaten to their long-term viability (AllThingsD.com “Schmidt Says Google’s Social Networking Problem is His Fault.“)

Chrome, Chromebooks and Google Wallet could be big winners.  And there’s a new CEO in place who promises to move Google beyond its past glory.  But these are highly competitive markets, Google isn’t first, it’s technology advantages aren’t as clear cut as in the old search days (PCWorld.com “Google Wallet Isn’t the Only Mobile POS Tool.”)  Whether Google will regain its past glory depends on whether the company can overcome its dedication to its old success formula and actually disrupt its internal processes enough to take the lead with disruptive marketplace products.

Cisco is in a similar situation.  A great innovator who’s products put us all on the web, and made us wi-fi addicted.  But markets are shifting as people change their needs for costly internal networks, moving to the cloud, and other competitors (like NetApp) are the game changers in the new market.  Cisco’s efforts to enter new markets have been fragmented, poorly managed, and largely ineffective as it spent too much energy focused on historical markets.  Emblematic was the abandoned effort to enter consumer markets with the Flip camera, where its inability to connect with fast shifting market needs led to the product line shutdown and a loss of the entire investment (BusinessInsider.com “Cisco Kills the Flip Camera.”)

Cisco’s value is tied not to its historical market, but its ability to develop new ones.  Even when they likely cannibalize old products.  HIstorically Cisco did this well.  But as customers move to the cloud it’s still not clear what Cisco will do to remain an industry leader. Whether Google and Cisco will ever be good investments again doesn’t look too good, today.  Maybe.  But only if they realign their investments and put in place teams dedicated to new, growth markets.

The ugly:

Another homily goes “beauty may be on the surface, but ugly goes clear to the bone.”  Meaning? For something to be ugly, it has to be deeply flawed inside.  And that’s the situation at Research in Motion and Microsoft.  Optimistic investors describe both of these companies as potential “value stocks” that will find a way to “protect the installed base as an economic recovery develops” and “sell their products cheaply in developing countries that can’t afford new solutions” eventually leading to high dividend payouts as they milk old businesses.  Right.  That won’t happen, because these companies are on a self-destructive course to preserve lost markets which will eat up resources and leave them shells of their former selves. 

Both companies were wildly successful.  Both once had near-monopolies in their markets.  But in both cases, the organizations became obsessed with defending and extending sales to their “core” or “base” customers using “core” technologies and products.  This internal focus, and desire to follow best practices, led them to overspending on what worked in the past, while the market shifted away from them.

At RIMM the market has moved from enterprise servers and secure enterprise applications to local apps that access data via the cloud.  People have moved from PCs to smartphones (and tablets) that allow them to do even more than they could do on old devices, and RIM’s devotion to its historical business base caused the company to miss the shift.  Blackberry and Playbook have 1/10th the apps of leaders Apple and Android (at best) and are rapidly being competitively outrun.

Likewise, Microsoft has offered the market nothing new when it comes to emerging markets and unmet user needs as it has invested billions of dollars trying to preserve its traditional PC marketplace.  Vista, Windows 7 and Office 2010 all missed the fact that users were going off the PC, and toward new solutions for personal productivity.  Now the company is trying to play catch-up with its Skype acquisition, Nokia partnership (where sales are in a record, multi-year slide; SeekingAlpha.com “Nokia Deluged with Downgrades“) and a planned launch of Windows 8. Only they are against ferocious competition that has developed an enormous market lead, using lower cost technologies, and keep offering innovations that are driving additional market shift.

Companies that plan for the future, keep their eyes firmly focused on unmet needs and alternative competitors, and that accept and implement disruptions via internal teams with permission to be game-changers are the winners.  They are good investments. 

Big winners that keep seeking new opportunities, but fall into over-reliance (and focus) on historical markets and customers can move from being good investments to bad ones.  They have to change their planning and competitive analysis, and start attacking old notions about their business to free up resources for doing new things.  They can return to greatness, but only if they recognize market shifts and move aggressively to develop solutions for emerging needs in new markets.

It gets ugly when companies lose their ability to see external market shifts because they are inwardly focused (inside their organizations, and inside their historical customer base or supply chain.)  Their market sensing disappears, and their investments become committed on trying to defend old businesses in the face of changes far beyond their control. Their internal biases cause reduction of shareholder value as they spend money on acquisitions and new products that have negative rates of return in their overly-optimistic effort to regain past glory.  Those situations almost never return to former beauty, as ugly internal processes lock them into repeating past behaviors even when its clear they need an entirely new approach to succeed.