Why You Want To Invest In Trends — Not Asset Managers

Why You Want To Invest In Trends — Not Asset Managers

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The vast majority of individual investors have no idea how to pick stocks. So they often let someone else invest for them, and pay a hefty fee of anywhere from 1% to 5% of their assets annually. Or they buy some sort of fund or portfolio index, where they pay the fund manager usually more than 1% of assets for managing the fund. In the worst case, they pay the financial advisor their fee, and then the advisor buys a fund for the investor – which has that investor paying anywhere from 2% to 8% or even 10% of assets annually for investment advice.

Yet, we know that few asset managers can beat “the market,” whether measured by the DJIA (Dow Jones Industrial Average) or the S&P 500. A study in Europe showed no active manager beat their benchmark over 10 years, and in the U.S. 80% to 90% of fund managers failed to do as well as their benchmarks. And there are studies showing that even if a manager beats their index, after accounting for management fees and costs the investors almost never beat the market.

Any individual could buy the market index by simply opening an on-line account at any discount brokerage, for a very small cost, and buying the exchange traded fund (ETF) for the Dow (DIA – often called “Diamonds”) or the S&P (SPDR – often called “Spiders”). Thus, individual investors can do as well as the “market” at very, very low cost. Most academics will tell investors to not try and beat the market, because the market is wildly inefficient and investors are always without full knowledge of the company, and thus buy these indices.

But most investors are lured by the notion of “beating the market” so they pay the high fees in order to – hopefully – have someone do a better job of investing. And they end up disappointed.

Investors can “beat the market,” but it requires a different approach to investing than fund managers use. And it is far more suited to individuals, with long-term horizons – and it avoids paying those outrageous financial services fees. To be a long-term high-return investor individuals simply need to invest in trends.

247wallst.com published an article stating the editors had seen a report published by Jefferies, sent to them by Bloomberg, which claimed that 20% of all the gains in the total stock market since 1924 (some 93 years) were created by a mere 14 stocks. This sort of blows up all academic theories about investing in portfolios, as it drives home that most market returns are driven by a small collection of companies. Individuals would be better off if they invested in just a few stocks, rather than all stocks. But this means you have to know which stocks to own.

 You would think this might be hard, until you look at the list of 14. There is a striking pattern. All were simply the biggest, most powerful companies leading an important, large trend. So if you identified the trend, and invested in the largest company creating that trend, you would do really well. And because these are large companies, investors aren’t carrying the risk of small companies that could be competitively destroyed by larger players. Interestingly, identifying these trends and the large players really isn’t that hard. Nor is it hard to recognize when the trend is ending, and it is time to sell.

We can understand this by looking at the list of 14 not by how much market gain they created, but rather historically when the majority of those gains occurred.

People have enjoyed smoking tobacco since at least the 1500s. Long before anyone knew about the chemical affects and shortened lifespan people simply enjoyed the practice of smoking and the impact nicotine had on them. As tobacco spread from France to England, eventually it moved to the U.S. and was the first ever cash crop – grown in America for sale in Europe. For literally hundreds of years the trend toward tobacco consumption grew. So, it is easy to understand why investing in Phillip Morris, which was renamed Altria, was a good move. As long as people kept buying more cigarettes investing in the largest cigarette company was a good way to increase your returns.

For hundreds of years people used whale oil and similar animal products for candles and lanterns.  Wood and coal were used for cooking. But then in 1859 oil was successfully found, and it changed the world. Oil was far cheaper to produce than animal or vegetable oils and burned more consistently at a higher temperature than those products, wood or coal. And that unleashed a trend toward hydrocarbon production leading to the birth of countless new products. It would not have been hard to see that this trend was going to be very valuable.  Thus two other names on the list pop up, Exxon and Chevron. These companies are successors of the original Standard Oil founded by John Rockefeller – which created tremendous returns for investors for many years as oil consumption, and production, grew.

Hydrocarbons were a tremendous contributor to the industrial revolution, allowing manufacturers to use engines in new products, and to improve their manufacturing. One of the earliest, and soon biggest, manufacturers was General Electric, another big value producer on the list of 14. And one of the biggest industrial revolution gains was the automobile, where General Motors became by far the largest producer. Investors who put money into the industrial revolution and the trend toward making things – especially cars – came out very well by buying shares in these two companies.

As the industrial revolution grew the middle class emerged, enjoying a vast improvement in quality of life. This led to the trend of consumerism, as it was possible to make things much cheaper and distribute them wider.  Three of the biggest companies that promoted this consumer trend were Johnson & Johnson, Proctor & Gamble and Coca-Cola. All were in different product markets, but all were very big leaders in the growth of consumer products for a 1900s world (especially post-WWII) where people had more money – and the desire to buy things.  And all three did very well for their investors.

Soon a new trend emerged with the capability of electronics. First came the advent of instant, modern communications as the telephone emerged. Regardless the cost, there was high value in being able to communicate with someone “now” even if they were in a distant location. Investors in Alexander Bell’s AT&T did quite well as phones made their way across America and around the world.

Soon thereafter mechanical adding machines were greatly improved by using electronics – initially relays – to make tabulations and computations. IBM was an early developer of these machines for commercial use, and very quickly came to dominate the market for computers. It was not long before every company needed a computer, or at least access to use one, in order to compete. Investors in IBM were well rewarded for spotting this trend.

As the market  for consumer goods exploded Sam Walton recognized the inefficiency of retail product distribution. He discovered that by owning more stores he could negotiate better with consumer goods manufacturers, purchase products more cheaply and sell them more cheaply. He created the trend toward mass retailing driven by efficiency, and he rapidly demonstrated the ability to drive competitors completely out of many retail markets. Investors who identified this trend toward low-cost retailing of a wide product array made considerable gains by purchasing Wal-Mart shares.

As computers became smaller the market expanded, leading to the development of ever smaller computers. Microsoft created software allowing multiple manufacturers to build machines with interoperability, allowing it to take a dominant position in the trend to computers so small every single person could have one – and indeed eventually felt they could not live without one. Microsoft investors made huge gains as the company practically monopolized this trend and created the personal compute marketplace.

It was Apple that first recognized the trend toward mobility being created by ever faster connection speeds. Mobility would allow for radical changes in how many product markets behaved, and investors who saw this mobility trend were amply rewarded for investing in Apple – the company that became synonymous with internet-enabled products.

And as computing mobility improved it created a trend toward buying at home rather than going to a store. Mail order had almost entirely disappeared, due to lack of timely product fulfillment. But with the internet as the interface, coupled with modern, highly efficient transportation services, Amazon was able to give a rebirth to shopping from home and the e-commerce trend exploded. Investors that recognized Amazon’s vastly lower cost retail model, coupled with the infinite prospects for product variety, have been rewarded for investing in the large on-line retailer.

These 14 companies created 20% of all stock market gains across nearly a century. And each was the dominant competitor in a major trend. Several are no longer on the trend, and even a couple have filed bankruptcy (like AT&T and GM), thus it is easy to recognize why some have done far less well the last decade. The world changed and their business model which once produced excellent returns no longer does. But savvy investors should recognize when a trend has run its course, and drop that company in favor of investing in the leader of a major, new trend.

All investors should be long-term investors. Trying to be a market timer, and a trader, is a fool’s errand.  To make high investment returns requires taking a long-term (multi-year) view – not monthly or quarterly. Therefore it is important that when investing in trends they be big trends. Trends that will have a large impact on every business – every person. Trends that can generate tremendous returns for many years.

Not everyone can be a stock picker. Therefore, most investors should probably have a goodly chunk of their money in an ETF. That can be done easily enough as described above. But, if you want to increase your returns to beat the market the key is to invest in companies that are large, and the leaders in a major trend.

What are the big  trends today? There is no doubt “social” is a huge trend. How every business and person interacts is changing as the use of social tools increases. This is a global phenomenon, and it is a trend with many years left to extend its impact. Investing in the market leader – Facebook – shows good likelihood of obtaining the kind of returns created by the 14 companies discussed above.

What other trends can you identify that have years yet to go? If you can spot them, and invest in a dominant, large leader then you just may outperform nearly every active fund manager trying to get you to pay their fees.

The 4 Reasons Verizon Should Buy Yahoo

The 4 Reasons Verizon Should Buy Yahoo

Verizon tipped its hand that it would be interested to buy Yahoo back in December.  In the last few days this possibility drew more attention as Verizon’s CFO confirmed interest on CNBC, and Bloomberg reported that AOL’s CEO Tim Armstrong is investigating a potential acquisition.  There are some very good reasons this deal makes sense:

AOLHooFirst, this acquisition has the opportunity to make Verizon distinctive.  Think about all those ads you see for mobile phone service.  Pretty much alike.  All of them  trying to say that their service is better than competitors, in a world where customers don’t see any real difference.  3G, 4G – pretty soon it feels like they’ll be talking about 10G – but users mostly don’t care.  The service is usually good enough, and all competitors seem the same.

So, that leads to the second element they advertise – price.  How many different price programs can anyone invent?  And how many phone or tablet give-aways.  What is clear is that the competition is about price.  And that means the product has become generic.  And when products are generic, and price is the #1 discussion, it leads to low margins and lousy investor returns.

But a Yahoo acquisition would make Verizon differentiated.  Verizon could offer its own unique programming, at a meaningful level, and make it available only on their network.  And this could offer price advantages.  Like with Go90 streaming, Verizon customers could have free downloads of Verizon content, while having to pay data fees for downloads from other sites like YouTube, Facebook, Vine, Instagram, Amazon Prime, etc.  The Verizon customer could have a unique experience, and this could allow Verizon to move away from generic selling and potentially capture higher margins as a differentiated competitor.

Second, Yahoo will never be a lead competitor and has more value as a supporting player.  Yahoo has lost its lead in every major competitive market, and it will never catch up.  Google is #1 in search, and always will be.  Google is #1 in video, with Facebook #2, and Yahoo will never catch either.  Ad sales are now dominated by adwords and social media ads – and Yahoo is increasingly an afterthought.  Yahoo’s relevance in digital advertising is at risk, and as a weak competitor it could easily disappear.

But, Verizon doesn’t need the #1 player to put together a bundled solution where the #2 is a big improvement from nothing.  By integrating Yahoo services and capabilities into its  unique platform Verizon could take something that will never be #1 and make it important as part of a new bundle to users and advertisers.  As supporting technology and products Yahoo is worth quite a bit more to Verizon than it will ever be as an independent competitor to investors – who likely cannot keep up the investment rates necessary to keep Yahoo alive.

Third, Yahoo is incredibly cheap.  For about a year Yahoo investors have put no value on the independent Yahoo.  The company’s value has been only its stake in Alibaba.  So investors inherently have said they would take nothing for the traditional “core” Yahoo assets.

Additionally, Yahoo investors are stuck trying to capture the Alibaba value currently locked-up in Yahoo.  If they try to spin out or sell the stake then a $10-12Billion tax bill likely kicks in.  By getting rid of Yahoo’s outdated business what’s left is “YaBaba” as a tracking stock on the NASDAQ for the Chinese Alibaba shares.  Or, possibly Alibaba buys the remaining “YaBaba” shares, putting cash into the shareholder pockets — or giving them Alibaba shares which they may  prefer.  Etiher way, the tax bill is avoided and the Alibaba value is unlocked.  And that is worth considerably more than Yahoo’s “core” business.

So it is highly unlikely a deal is made for free.  But lacking another likely buyer Verizon is in a good position to buy these assets for a pretty low value.  And that gives them the opportunity to turn those assets into something worth quite a lot more without the overhang of huge goodwill charges left over from buying an overpriced asset – as usually happens in tech.

Fourth, Yahoo finally gets rid of an ineffectual Board and leadership team.  The company’s Board has been trying to find a successful leader since the day it hired Carol Bartz.  A string of CEOs have been unable to define a competitive positioning that works for Yahoo, leading to the current lack of investor enthusiasm.

The current CEO Mayer and her team, after months of accomplishing nothing to improve Yahoo’s competitiveness and growth prospects, is now out of ideas.  Management consulting firm McKinsey & Company has been brought in to engineer yet another turnaround effort.  Last week we learned there will be more layoffs and business closings as Yahoo again cannot find any growth prospects.  This was the turnaround that didn’t, and now additional value destruction is brought on by weak leadership.

Most of the time when leaders fail the company fails.  Yahoo is interesting because there is a way to capture value from what is currently a failing situation.  Due to dramatic value declines over the last few years, most long-term investors have thrown in the towel.  Now the remaining owners are very short-term, oriented on capturing the most they can from the Alibaba holdings.  They are happy to be rid of what the company once was.  Additionally, there is a possible buyer who is uniquely positioned to actually take those second-tier assets and create value out of them, and has the resources to acquire the assets and make something of them.  A real “win/win” is now possible.

 

Netflix Valuation is Not a “House of Cards”

Netflix Valuation is Not a “House of Cards”

The Netflix hit series “House of Cards” was released last night.  Most media reviewers and analysts are expecting huge numbers of fans will watch the show, given its tremendous popularity the last 2 years.  Simultaneously, there are already skeptics who think that releasing all episodes at once “is so last year” when it was a newsworthy event, and no longer will interest viewers, or generate subscribers, as it once did.  Coupled with possible subscriber churn, some think that “House of Cardsmay have played out its hand.

So, the success of this series may have a measurable impact on the valuation of Netflix.  If the “House of Cards” download numbers, which are up to Netflix to report, aren’t what analysts forecast many may scream for the stock to tumble; especially since it is on the verge of reaching new all-time highs.  The Netflix price to earnings (P/E) multiple is a lofty 107, and with a valuation of almost $29B it sells for just under 4x sales.

Netflix House of CardsBut investors should ignore any, and in fact all, hype about “House of Cards” and whatever analysts say about Netflix.  So far, they’ve been wildly wrong when making forecasts about the company.  Especially when projecting its demise.

Since Netflix started trading in 2002, it has risen from (all numbers adjusted) $8.5 to $485.  That is a whopping 57x increase.  That is approximately a 40% compounded rate of return, year after year, for 13 years!

But it has not been a smooth ride. After starting (all numbers rounded for easier reading) at $8.50 in May, 2002 the stock dropped to $3.25 in October – a loss of over 60% in just 5 months.  But then it rallied, growing to $38.75, a whopping 12x jump, in just 14 months (1/04!) Only to fall back to $9.80, a 75% loss, by October, 2004 – a mere 9 months later.  From there Netflix grew in value by about 5.5x – to $55/share – over the next 5 years (1/10.)  When it proceeded to explode in value again, jumping to $295, an almost 6-fold increase, within 18 months (7/11).  Only to get creamed, losing almost 80% of its value, back down to $63.85, in the next 4 months (11/11.)  The next year it regained some loss, improving in value by 50% to $91.35 (12/12,) only to again explode upward to $445 by February, 2014 a nearly 5-fold increase, in 14 months.  Two months later, a drop of 25% to $322 (4/14).  But then in 4 months back up to $440 (8/14), and back down 4 months later to $341 (12/14) only to approach new highs reaching $480 last week – just 2 months later.

That is the definition of volatility.

Netflix is a disruptive innovator.  And, simply put, stock analysts don’t know how to value disruptive innovators. Because their focus is all on historical numbers, and then projecting those historicals forward.  As a result, analysts are heavily biased toward expecting incumbents to do well, and simultaneously being highly skeptical of any disruptive company.  Disruptors challenge the old order, and invalidate the giant excel models which analysts create.  Thus analysts are very prone to saying that incumbents will remain in charge, and that incumbents will overwhelm any smaller company trying to change the industry model.  It is their bias, and they use all kinds of historical numbers to explain why the bigger, older company will project forward well, while the smaller, newer company will stumble and be overwhelmed by the entrenched competitor.

And that leads to volatility.  As each quarter and year comes along, analysts make radically different assumptions about the business model they don’t understand, which is the disruptor.  Constantly changing their assumptions about the newer kid on the block, they make mistake after mistake with their projections and generally caution people not to buy the disruptor’s stock.  And, should the disruptor at any time not meet the expectations that these analysts invented, then they scream for shareholders to dump their holdings.

Netflix first competed in distribution of VHS tapes and DVDs.  Netflix sent them to people’s homes, with no time limit on how long folks could keep them.  This model was radically different from market leader Blockbuster Video, so analysts said Blockbuster would crush Netflix, which would never grow.  Wrong.  Not only did Blockbuster grow, but it eventually drove Blockbuster into bankruptcy because it was attuned to trends for convenience and shopping from home.

As it entered streaming video, analysts did not understand the model and predicted Netflix would cannibalize its historical, core DVD business thus undermining its own economics.  And, further, much larger Amazon would kill Netflix in streaming.  Analysts screamed to dump the stock, and folks did.  Wrong.  Netflix discovered it was a good outlet for syndication, created a huge library of not only movies but television programs, and grew much faster and more profitably than Amazon in streaming.

Then Netflix turned to original programming.  Again, analysts said this would be a huge investment that would kill the company’s financials. And besides that people already had original programming from historical market leaders HBO and Showtime.  Wrong.  By using analysis of what people liked from its archive, Netflix leadership hedged its bets and its original shows, especially “House of Cards” have been big hits that brought in more subscribers.  HBO and Showtime, which have depended on cable companies to distribute their programming, are now increasingly becoming additional programming on the Netflix distribution channel.

Investors should own Netflix because the company’s leadership, including CEO Reed Hastings, are great at disruptive innovation.  They identify unmet customer needs and then fulfill those needs.  Netflix time and again has demonstrated it can figure out a better way to give certain user segments what they want, and then expand their offering to eat away at the traditional market.  Once it was retail movie distribution, increasingly it is becoming cable distribution via companies like ComCast, AT&T and Time Warner.

And investors must be long-term.  Netflix is an example of why trading is a bad idea – unless you do it for a living.  Most of us who have full time day jobs cannot try timing the ups and downs of stock movements.  For us, it is better to buy and hold.  When you’re ready to buy, buy. Don’t wait, because in the short term there is no way to predict if a stock will go up or down.  You have to buy because you are ready to invest, and you expect that over the next 3, 5, 7 years this company will continue to drive growth in revenues and profits, thus expanding its valuation.

Netflix, like Apple, is a company that has mastered the skills of disruptive innovation.  While the competition is trying to figure out how to sustain its historical position by doing the same thing better, faster and cheaper Netflix is figuring out “the next big thing” and then delivering it.  As the market shifts, Netflix is there delivering on trends with new products – and new business models – which push revenues and profits higher.

That’s why it would have been smart to buy Netflix any time the last 13 years and simply held it.  And odds are it will continue to drive higher valuations for investors for many years to come.  Not only are HBO, Showtime and Comcast in its sites, but the broadcast networks (ABC, CBS, NBC) are not far behind.  It’s a very big media market, which is shifting dramatically, and Netflix is clearly the leader.  Not unlike Apple has been in personal technology.

How Cable TV is Deaf to the Market Roar of Change

How Cable TV is Deaf to the Market Roar of Change

Do you really think in 2020 you’ll watch television the way people did in the 1960s?  I would doubt it.

In today’s world if you want entertainment you have a plethora of ways to download or live stream exactly what you want, when you want, from companies like Netflix, Hulu, Pandora, Spotify, Streamhunter, Viewster and TVWeb.  Why would you even want someone else to program you entertainment if you can get it yourself?

Additionally, we increasingly live in a world unaccepting of one-way communication.  We want to not only receive what entertains us, but share it with others, comment on it and give real-time feedback.  The days when we willingly accepted having information thrust at us are quickly dissipating as we demand interactivity with what comes across our screen – regardless of size.

These 2 big trends (what I want, when I want; and 2-way over 1-way) have already changed the way we accept entertaining.  We use USB drives and smartphones to provide static information.  DVDs are nearly obsolete.  And we demand 24×7 mobile for everything dynamic.

Yet, the CEO of Charter Cable company wass surprised to learn that the growth in cable-only customers is greater than the growth of video customers.  Really?

It was about 3 years ago when my college son said he needed broadband access to his apartment, but he didn’t want any TV.  He commented that he and his 3 roommates didn’t have any televisions any more. They watched entertainment and gamed on screens around his apartment connected to various devices.  He never watched live TV.  Instead they downloaded their favorite programs to watch between (or along with) gaming sessions, picked up the news from live web sites (more current and accurate he said) and for sports they either bought live streams or went to a local bar.

To save money he contacted Comcast and said he wanted the premier internet broadband service.  Even business-level service.  But he didn’t want TV.  Comcast told him it was impossible. If he wanted internet he had to buy TV.  “That’s really, really stupid” was the way he explained it to me. “Why do I have to buy something I don’t want at all to get what I really, really want?”

Then, last year, I helped a friend move.  As a favor I volunteered to return her cable box to Comcast, since there was a facility near my home.  I dreaded my volunteerism when I arrived at Comcast, because there were about 30 people in line.  But, I was committed, so I waited.

The next half-hour was amazingly instructive.  One after another people walked up to the window and said they were having problems paying their bills, or that they had trouble with their devices, or wanted a change in service.  And one after the other they said “I don’t really want TV, just internet, so how cheaply can I get it?”

These were not busy college students, or sophisticated managers.  These were every day people, most of whom were having some sort of trouble coming up with the monthly money for their Comcast bill.  They didn’t mind handing back the cable box with TV service, but they were loath to give up broadband internet access.

Again and again I listened as the patient Comcast people explained that internet-only service was not available in Chicagoland.  People had to buy a TV package to obtain broad-band internet. It was force-feeding a product people really didn’t want.  Sort of like making them buy an entree in order to buy desert.

As I retold this story my friends told me several stories about people who banned together in apartments to buy one Comcast service.  They would buy a high-powered router, maybe with sub-routers, and spread that signal across several apartments.  Sometimes this was done in dense housing divisions and condos.  These folks cut the cost for internet to a fraction of what Comcast charged, and were happy to live without “TV.”

But that is just the beginning of the market shift which will likely gut cable companies.  These customers will eventually hunt down internet service from an alternative supplier, like the old phone company  or AT&T.  Some will give up on old screens, and just use their mobile device, abandoning large monitors.  Some will power entertainment to their larger screens (or speakers) by mobile bluetooth, or by turning their mobile device into a “hotspot.”

And, eventually, we will all have wireless for free – or nearly so.  Google has started running fiber cable in cities including Austin, TX, Kansas City, MO and Provo, Utah.  Anyone who doesn’t see this becoming city-wide wireless has their eyes very tightly closed.  From Albuquerque, NM to Ponca City, OK to Mountain View, CA (courtesy of Google) cities already have free city-wide wireless broadband. And bigger cities like Los Angeles and Chicago are trying to set up free wireless infrastructure.

And if the USA ever invests in another big “public works infrastructure” program will it be to rebuild the old bridges and roads?  Or is it inevitable that someone will push through a national bill to connect everyone wirelessly – like we did to build highways and the first broadcast TV.

So, what will Charter and Comcast sell customers then?

It is very, very easy today to end up with a $300/month bill from a major cable provider.  Install 3 HD (high definition) sets in your home, buy into the premium movie packages, perhaps one sports network and high speed internet and before you know it you’ve agreed to spend more on cable service than you do on home insurance.  Or your car payment.  Once customers have the ability to bypass that “cable cost” the incentive is already intensive to “cut the cord” and set that supplier free.

Yet, the cable companies really don’t seem to see it.  They remain unimpressed at how much customers dislike their service. And respond very slowly despite how much customers complain about slow internet speeds.  And even worse, customer incredulous outcries when the cable company slows down access (or cuts it) to streaming entertainment or video downloads are left unheeded.

Cable companies say the problem is “content.”  So they want better “programming.”  And Comcast has gone so far as to buy NBC/Universal so they can spend a LOT more money on programming.  Even as advertising dollars are dropping faster than the market share of old-fashioned broadcast channels.

Blaming content flies in the face of the major trends.  There is no shortage of content today.  We can find all the content we want globally, from millions of web sites.  For entertainment we have thousands of options, from shows and movies we can buy to what is for free (don’t forget the hours of fun on YouTube!)

It’s not “quality programming” which cable needs.  That just reflects industry deafness to the roar of a market shift.  In short order, cable companies will lack a reason to exist.  Like land-line phones, Philco radios and those old TV antennas outside, there simply won’t be a need for cable boxes in your home.

Too often business leaders become deaf to big trends.  They are so busy executing on an old success formula, looking for reasons to defend & extend it, that they fail to evaluate its relevancy.  Rather than listen to market shifts, and embrace the need for change, they turn a deaf ear and keep doing what they’ve always done – a little better, with a little more of the same product (do you really want 650 cable channels?,) perhaps a little faster and always seeking a way to do it cheaper – even if the monthly bill somehow keeps going up.

But execution makes no difference when you’re basic value proposition becomes obsolete.  And that’s how companies end up like Kodak, Smith-Corona, Blackberry, Hostess, Continental Bus Lines and pretty soon Charter and Comcast.

 

Avoid Gladiator Wars – Invest in David, Make Money Like Apple


When you go after competitors, does it more resemble a gladiator war – or a David vs. Goliath battle?  The answer will likely determine your profitability.  As a company, and as an investor.

After they achieve some success, most companies fall into a success formula – constantly tyring to improve execution. And if the market is growing quickly, this can work out OK.  But eventually, competitors figure out how to copy your formula, and as growth slows many will catch you.  Just think about how easily long distance companies caught the monopolist AT&T after deregulation.  Or how quickly many competitors have been able to match Dell’s supply chain costs in PCs.  Or how quickly dollar retailers – and even chains like Target – have been able to match the low prices at Wal-Mart. 

These competitors end up in a gladiator war.  They swing their price cuts, extended terms and other promotional weapons, leaving each other very bloody as they battle for sales and market share.  Often, one or more competitors end up dead – like the old AT&T.  Or Compaq. Or Circuit City.  These gladiator wars are not a good thing for investors, because resources are chewed up in all the fighting, leaving no gains for higher dividends – nor any stock price appreciation.  Like we’ve seen at Wal-Mart and Dell.

The old story of David and Goliath gives us a different approach.  Instead of going “toe-to-toe” in battle, David came at the fight from a different direction – adopting his sling to throw stones while he remained safely out of Goliath’s reach.  After enough peppering, he wore down the giant and eventually popped him in the head. 

And that’s how much smarter people compete. 

  • When everyone was keen on retail stores to rent DVDs, Netflix avoided the gladiator war with Blockbuster by using mail delivery. 
  • While United, American, Continental, Delta, etc. fought each other toe-to-toe for customers in the hub-and-spoke airline wars (none making any money by the way) Southwest ferried people cheaply between smaller airports on direct flights.  Southwest has made more money than all the “major” airlines combined.
  • While Hertz, Avis, National, Thrifty, etc. spent billions competing for rental car customers at airports Enterprise went into the local communities with small offices, and now has twice their revenues and much higher profitability.
  • When internet popularity started growing in the 1990s Netscape traded axe hits wtih Microsoft and was destroyed.  Another browser pioneer, Spyglass, transitioned from PCs to avoid Microsoft, and started making browsers for mobile phones, TVs and other devices creating billions for investors.
  • While GM, Ford and Chrysler were in a grinding battle for auto customers, spending billions on new models and sales programs, Honda brought to market small motorcycles and very practical, reliable small cars. Honda is now very profitable in several major markets, while the old gladiators struggle to survive.

As an investor, we should avoid buying stocks of companies, and management teams that allow themselves to be drug into gladiator wars.  No matter what promises they make to succeed, their success is uncertain, and will be costly to obtain.  What’s worse, they could win the gladiator war only to find themselves facing David – after they are exhausted and resources are spent!

  • Research in Motion became embroiled in battles with traditional cell phone manufacturers like Nokia and Ericdson, and now is late to the smartphone app market – and with dwindling resources.
  • Motorola fought the gladiator war trying to keep Razr phones competitive, only to completely miss its early lead in smartphones.  Now it has limited resources to develop its Android smart phone line.
  • Is it smart for Google to take on a gladiator war in social media against Facebook, when it doesn’t seem to have any special tool for the battle?  What will this cost, while it simultaneously fights Apple in Android wars and Microsoft for Chrome sales?

On the other hand, it’s smart to invest in companies that enter growth markets, but have a new approach to drive customer conversion.  For example, Zip Car rents autos by the hour for urban users.  Most cars are very high mileage, which appeals to customers, but they also are pretty inexpensive to buy.  Their approach doesn’t take-on the traditional car rental company, but is growing quite handily.

This same logic applies to internal company investments as well.  Far too often the corporate reource allocation process is designed to fight a gladiator war.  Constantly spending to do more of the same.  Projects become over-funded to fight battles considered “necessity,” while new projects are unfunded despite having the opportunity for much higher rates of return.

In 2000, Apple could have chosen to keep pouring money into the Mac.  Instead it radically cut spending, reduced Mac platforms, and started looking for new markets where it could bring in new solutions.  IPods, iTunes, IPhones, iPads and iCloud are now driving growth for the company – all new approaches that avoided gladiator battles with old market competitors.  Very profitable growth.    Apple has enough cash on hand to buy every phone maker, except Samsung –  or Apple could buy  Dell – if it wanted to.  Apple’s market cap is worth more than Microsoft and Intel combined.

If you want to make more money, it’s best to avoid gladiator wars.  They are great spectator events – but terrible places to be a participant.  Instead, set your organization to find new ways of competing, and invest where you are doing what competitors are not.  That will earn the greatest rate of return.