Last night, my friend Dr. Larry and I were discussing the day’s equity market activity. As he was bemoaning his lackluster Home Depot position, I opined that the company had once, long ago, been among my consistently superior portfolio selections, but that it hadn’t returned to being in that group in many years. He asked if very many large-caps ever could produce a successful “act two.” I’ve been musing about that this morning. Actually, the question has flitted in and out of my mind for a decade. Are there explainable successful second acts among large-cap companies and, if so, are there common characteristics among them?
After reviewing my portfolio strategy’s selections over the past fifteen years, a pattern does become clear. Companies that sell discrete items or services that are not considered “technology” may regain the characteristics of consistent superiority, i.e., consistently above-average revenue growth and total returns. Retailers, white goods manufacturers, apparel makers, pharmaceutical companies, financial services companies and other producers of discrete products and services are examples of this. Software makers are not.
If you think about “technology” companies, many of them, by their very nature, will only have at most one significant period of consistently superior performance. Various generations of computing platforms, such as mainframes, minicomputers, and, yes, even personal computers, seem destined to experience only one explosive period of superiority. After that, either growth rates fall with saturation, or the investment community learns to expect appropriate performance from the maturing firm, and returns no longer out-perform the market.
Software is even more prone to obsolescence. It creates the “installed base” or “legacy” problem, even as it provides a convenient price/performance target for the next generation of solutions to exceed. I first became acquainted with the installed base issue while at AT&T. While electro-mechanical telephones did not have software legacy issues, the time and expenses involved in servicing its vast installed base of older telephone equipment caused AT&T to carry a burden for years. Due to regulatory constraints, the firm was unable to recapture competitive profits on the expensive older base. Yet, early termination of the equipment would have thrown huge numbers of existing customers into the market at a time in which AT&T’s market share was slipping, causing its cashflow to shrink just as it had to fund new digital communications products.
For a firm like Microsoft, the legacy challenge is perhaps even more daunting. The firm must provide reasonable portability between generations of its products for its customers, even as it attempts to remain competitive with new entrants on performance and price/performance bases. This probably accounts for much of Microsoft’s slowing new product introduction rate, as well as the lack of significant new “killer applications”. Worse still, eventually moving to a web-based access model competitively priced to rival new entrants such as Google is likely to force it to devalue its own core products without additional new sources of revenue.
But let’s return to the initial focus of this piece. Actually, retailers like Home Depot, Wal-Mart, Kohls and Bed, Bath and Beyond have a greater probability to return as consistently superior portfolio selections in my strategy, after falling out of the group, than many other companies. This is because they satisfy frequently recurring customer needs, yet they don’t have to design or manufacture their products. As end-distributors, they simply need to continually offer the best choices of relevant products, and be well-managed. This is not to say it will happen all that often. Dysfunctional cultures and myopic management are still the rule among most US large-cap corporations. However, since consistently-superior revenue growth is the single hardest business phenomenon to create, these companies have the advantage of serving recurring needs of fairly large sized customer bases.
As I observe this week’s continuing business media fascination with Microsoft, it baffles me that they can’t grasp the fundamental nature of technology companies. The latter compete to solve specific customer needs with a (typically) proprietary or unique technical solution. The solution requires substantial resources dedicated to a particular methods, technologies and capabilities. When another company eclipses their solution, why would any intelligent person think that the once-successful vendor should be able to simply technologically leap-frog new competitors to reclaim its past pre-eminent position?
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2 comments:
But aren't retailers like Home Depot, Wal-Mart, Kohls and Bed, Bath and Beyond--and in its day, A&P, per your excellent post below--all creatures of technological innovatione within their own realms, and thus subject to the very "creative destruction" forces that are so painfully obvious in the "pure" software arena? I'm not as sure that they are as immune to these factors as you seem to imply.
That's a fair point. However, in this case, retailers in these product/market spaces, their "legacies" are much more easily remedied, because it does not involve necessarily servicing a prior installed base of procedures and methods.
For instance, if A&P had a "legacy," it might have been locations. But one can dispose of these and start a new brand, with new locations. Think the Limited, of which I've written here before.
Wal-Mart has its vaunted "back office" seamless distribution and inventory system. That remains an asset, but does not remedy its current challenge, which seems to be having missed a move upmarket by its core customer base.
The technological bases of retail competition are, and, I think, will remain primitive by the standards of "technology" companies. While retailers are not immune to creative destruction by any means, their downfalls tend to be more consumer-oriented rather than the provision of their own new products. For example, missing the boat on customer needs in terms of product mix or price points might, and did, weaken Kohls and Wal-Mart. It's not like they have to offer a backward-compatible sweater, pair of shoes, or shower curtains. They might guess wrong on the needs of their current or targeted customer base.
With Microsoft, though, they seem to have missed because their own internal product design limitations and legacy burdens hamstring their ability to act on needs they may, or may not, actually see among their customers.
I still think Gates would do better to spend his weeks among real users, rather than alone in a lakeside house, reading internal memos and drinking sodas.
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