Friday, November 11, 2005

Successful Second Acts

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?

Wednesday, November 09, 2005

After the Peak: Microsoft Part 2

To see an example of how Bill Gates should be approaching his second act, consider his sometime-nemesis, Steve Jobs.

Jobs has demonstrated a talent for successfully implementing two, perhaps three, business visions. However, to do so, he started Pixar separately from Apple. He didn’t attempt to create it as a division of the latter. Rather, Pixar is about entertainment technology. Who knows how warped its development may have been, were it to have been birthed within a personal computer maker. It seems to be in the nature of human behavior, especially for leaders of previously successful enterprises, that these people seldom lead those organizations to long-term domination of a product/market across technological divides.

It’s interesting to consider that Job’s, and Apple’s, latest and greatest invention, the iPod line, occurred after Pixar. Perhaps Jobs appreciated the needs and solutions for personal entertainment better after having created and successfully run an entertainment-related company. The iPods are a far better concept and implementation than the Apple Newton was in its day.

However, contrast Jobs and Apple with Gates and Microsoft. The former created a radically new business by starting from scratch. The latter are attempting to recover from several product/market defeats with a biased, existing culture. Even Ray Ozzie, Microsoft’s new visionary team member, is on at least his third organization. To him, it’s a new culture and environment, so he isn’t limited by Lotus or Groove Networks.

However, Bill Gates is still at Microsoft. Despite Ozzie, whatever Microsoft does to compete with Google will look a lot like, well, how Microsoft would do online/internet services.

For an example of how wrong this can go, consider this. In my youth, when I joined AT&T, I met veterans from the company’s first large-scale digital PBX development team. They described how Bell Labs product developers had originally provided access to computer software on the product via four-digit numerical access codes. While everyone else in the world was using computers via full keyboards, these guys were going to give their users access via numeric touchpads on a telephone. It was simply the world they knew.

I think Gates will have much more success by simply putting Ray Ozzie in charge of a new company, funded by Gates/Microsoft, to pursue the latter’s latest visions. It will bear none of the cultural burden and ponderous size of Microsoft, both of which are sure to be handicaps in the race to compete with Google, Yahoo, You can’t really believe that Microsoft’s employees feel totally free to change direction with Gates’ personality still in resident. That’s not to say Microsoft can’t develop online service versions of their current product portfolio. But at this point, who cares? Nobody else is competing in those now-commoditized and basic niches anyway.

Mind you, I don't think this takes away any credit whatsoever for what Bill Gates did with Microsoft. He performed a very successful wealth-creation job. Nobody should discount that. It's just that now, Microsoft's time is over- like GM's, IBM's, AOL's, etc. These companies have already seen their most creative, consistently-superior wealth-creating days. They are now simply large, slower-growth, mediocre remnants from once-hot product/markets.

When I began these two latest posts, I was focusing on Bill Gates and his belated attempts to not just change the direction of his supertanker that is Microsoft, but actually rebuild it in the water en route. What I have concluded, surprisingly, is that the really great role model for radical corporate change is Steve Jobs. He had the courage to found an entirely new company (two, actually, if you count Next) in order to implement part of his digital vision. And probably used that to pollinate Apple with ideas that led to the iPod line and iTunes.

After the Peak: Microsoft

Today’s Wall Street Journal article concerning the “radical reshaping of how Microsoft develops software and services in the face of competition from a new generation of Internet services” is rather amusing to me. Reading of Microsoft’s very late, panicked reaction to the destruction of the environment which favored its rise to power reminded me viscerally of my time with AT&T in the late 1970s and early ‘80s. It also fits with the findings of my proprietary research concerning how long large-cap companies can sustain a path of consistently superior performance.

Bill Gates’ new manifesto won’t work as imagined. At best, Microsoft may develop several competitive offerings for web-based services. However, the days of the desktop operating system being a gatekeeper are now over.

Gates and Microsoft are fortunate to have picked up Ray Ozzie, but I doubt it will really make a difference in Microsoft’s ability to dominate a significant software product/market niche again. Ozzie’s success with LotusNotes demonstrates that he just sees the world differently than his employers at Microsoft have, do and will. So it’s unlikely that the full value and intent of his thinking will be executed at his new corporate home. It’s too late in the game now. MSN Messenger, the web browser, multi-platform operating systems, a search engine, all were nascent at Microsoft while someone else succeeded with them as a business model. This was no accident.

This is why, to me, Microsoft now looks a lot like AT&T did when I first joined it in 1979. It was a large company by virtue of its position in a soon-to-be obliterated competitive landscape. The guys who ran AT&T thought they could control how they would allow competition to affect their very large organization. We had tons of meetings and projects, always infused with the top-down attitude that when we were ready, when AT&T really hit back, then the market and competitors would be stunned with our offerings and success. Well, it never happened, because those senior executives simply could not comprehend the magnitude of the environmental change coming over them. AT&T was first with the transistor, multi-media telephony communication, data switching and processors in the network. At one time, its subsidiary, Teletype, completely controlled the terminal market. To what end?

It looks like the same thing has happened to Bill Gates. Rather than spend weeks alone in some lakeside cottage, sipping sodas and reading a lot of navel-gazing papers from his own employees, he should be out among consumers, watching what they do, listening to what they want.

These personal observations are reinforced by my extensive research on corporate performance. It is astonishingly hard for one company to accomplish what Microsoft did in the 1980s and ‘90s. The firm hasn’t been in my list of consistently superior return generators in this decade. For a technology company to return to the list is virtually impossible. What made it great, its focus on its then-crucial competitive advantages, virtually guarantees that it will find those advantages blunted by later competitors. So long as the firm remains even remotely attached to its earlier product/market strategies, it will not return to its prior success in the equity markets.

Frankly, so long as Gates remains the leader of Microsoft, whether chief technical officer or not, it has virtually no chance of returning to its former status as a consistently superior total return creator.

To be continued…………

Tuesday, November 08, 2005

Video To Go

There’s a lot of activity suddenly in the area of very small, portable video viewing devices, and nearly current content to play on them.

I’m referring in particular to the video iPod and the recent deals to allow network TV programs to be downloaded onto them via iTunes for 99 cents, as well as this week’s announcement that Comcast will allow on-demand viewing of network programs for the same cost.

The final major transformation of consumer content control is underway. What the big three networks will do with all that now-redundant delivery bandwidth is beyond me. Sure, you can still tape what you want and watch it when you want. And you can still get the default airwave schedule for free. But you can see the new model very clearly now. All content will become available on demand for under a buck.

The real question is what you’ll use to view it. Except for some teens and 20-somethings, I don’t think it will be your cell phone or iPod. They can technically support some programming, with special modifications, but I don’t think most people want to have to hold and view a device that small to see, say, an hour program, much less a movie. And let’s not discuss how long it takes to download even short video clips.

Many years ago, a friend bought me a Sony Watchman portable TV as a gift. Very small screen with a sharp picture. However, it was so tiny that it became tiresome to hold and view it for much more than a few minutes. I don’t see the video iPods or today’s cell phones being used for serious viewing, either, other than perhaps short music videos. Of course, you miss a lot of the action and atmosphere on those small screens.

That leaves a very attractive market for publicly-accessible viewing devices which are cabled up to the internet. Since nobody probably wants to carry a 21" viewing screen with them for idle moments of entertainment, it's logical to assume that various locations where people now wait (airports, coffee shops, etc) may have swipe-card operated viewing devices.

I have suspected for a few months, like the staff on CNBC’s SquawkBox concluded this morning in their discussion of this topic, that the end result of this will be personal content accounts accessible anywhere, anytime. But not through small personally-owned devices. Rather, think web-accessed accounts- networks, private producers, old movie library websites, etc. Or viewing a just-released movie, courtesy of Bob Iger’s new Disney plans, in your hotel room, for only a few dollars, by accessing your personal account on a website using the hotel’s high-speed connection.

It’s ironic that the same digital format that is going to take out the telephone companies is also going to remove a huge chunk of value-adding services from licensed broadcasting as well. Which do you think will implode first, Verizon and AT&T, or NBC and CBS?

Monday, November 07, 2005

Thoughts On Executive Compensation

How likely is it that a CEO who has already been paid more than, say, $10MM by a company in total compensation, is truly motivated thereafter to take appropriate risks in order to earn shareholders a consistently superior return to that which they may receive from an index fund?

It strikes me as more hypothetical than practical that an already-wealthy CEO will still behave like a hungry decision maker who is straining to earn every last nickel of total return in the equity markets for his shareholders. How many of us would still feel the need to take chances when we already had more money than we reasonably required to live comfortably thereafter?

In my opinion, once a CEO has earned in the neighborhood of $10-15MM in compensation from a company’s shareholders, s/he should be given a new performance target: exceed the S&P500’s total return in each calendar year, or over an average of a few years, or face immediate dismissal.

My equity performance research confirms that it is a very rare company that can consistently outperform the S&P500 for more than a few years at a time. So many things can befall a firm that it takes quite a bit of effort and competence to accomplish this feat for even five years. As a shareholder, I would be suspect that a wealthy CEO with more than five years in the job is going to take appropriate risks, should hard times arrive on his watch.

Therefore, putting a wealthy CEO on notice that perfect performance, relative to the market, is now required, would be likely to return his behavior, and that of the firm, to that of a hungry, focused enterprise actively striving to be the best purveyor of customer solutions in its chosen markets.

If a CEO could not do this, what have shareholders lost by replacing him? He hadn’t achieved a superior return for them, relative to what they could earn in a market index fund. Any other viable candidate would be preferable. Should the incumbent CEO revive the firm’s fortunes, then he is, again, worth his compensation for having created even more shareholder wealth at superior rates of return.

Either way, it begs the question of why shareholders should tolerate the employ of CEOs whom they have made wealthy, but who cannot return the favor at an above-market rate of return.

Sunday, November 06, 2005

Mediocrity Isn’t What It Used To Be- Part 2

I wrote a few weeks ago on the subject of efficient market theory and mediocre participants. My contention is that the theory may have had more validity in the real world, but for the missing assumption that all players must have equal abilities to correctly process the supposedly equally-available information about securities.

The last 6-8 weeks of US equity market activity bear this out. No efficient market could have so many violent updrafts and downdrafts on the basis of so few pieces of genuinely “new” information.

We have, basically, five pieces of information which have been disseminated to the market: energy supplies, energy demand, inflation, consumer spending and economic growth.

Yet, going back to the second week of September, after hurricane Katrina tore through Louisiana, we have had 10 days in which the S&P500 Index rose or fell by 1% or more. There have been at least twice that many days in the same period in which it rose or fell by more than half that amount.

How can an “efficient” market display this many jarring price adjustments to essentially only five data inputs? My contention is that the vast army of mediocre, herd-following analysts and institutional investors are the source of this inefficient market behavior.

Failure of most participants to carefully piece together the puzzle pieces and see that energy demand had not been “destroyed,” and that consumer spending was not permanently crippled, as energy price increases abated as supplies returned to the market, was the cause of some of this market volatility. The practice of business news organizations to ceaselessly flail at all potential outcomes of any breaking economic story is probably another cause.

The truth is, two months after the hurricanes hit, economic growth in the US has been measured at being incredibly robust, while consumer spending continues with the help of increased total wages. It would seem that there was much short-term asset price movement on the basis of incorrect assumptions and expectations.

Yet another reason why my own portfolio strategy patiently holds its positions during periods of confusion and volatile asset pricing such as we are currently witnessing.