INVESTING ON THE FAULT LINE
Recently, Paul Philp suggested that we might understand something more about gorilla game investing by re-reading the chapter on shareholder value in Geoffrey Moore's (2000), Living on the Fault Line. Here is my synopsis focused on Moore's extension of the logic of investing in The Gorilla Game. Although Moore is writing for Fortune 500 companies where he hope to consult, my summary and commentary focus on the logic of investing in the gorilla game. My opinions, which are set in italics, usually follow Moore's writing. The bottom line for investors is that managing for shareholder value in the Age of the Internet raises shareholder value.
I. The Age of the Internet.
In the Age of the Internet, companies live on a fault line created by the potential for massive change introduced by the Internet itself. Whereas the advance in high technology has been driven by the continual and accelerating impact of Gordon Moore's law that produces a 10X change (requiring three replications in about five years), the Internet represents another order-of-magnitude shift, a 100X change, in driving power. Moore's law changed the game; the Age of the Internet changed the rules of the game.
If Moore's thesis is correct, then it narrows our focus of investing: above all else, we must catch the 100-times-change wave of high technology specifically driven by the Age of the Internet. That is, Moore indirectly stipulates an unprecedented investment opportunity, specifically where we should search for gorillas. Also, implicitly, Moore counsels that we avoid traditional companies with qualities that impede their awareness and adaptation to the fault line.
Given this shift in the economic bedrock, the Age of the Internet has created a fault line that must be appreciated by all companies who intend to "build to last." This tectonic shift in the plates beneath the bedrock of business requires a new flexibility to make the necessary transitions. Businesses must change because major transitions are underway in the nature of business. This 100X increase in power moves businesses from long-trusted sources of value creation to new, even surprising, sources of value creation. When earthquakes along the fault line topple rigid business structures, Darwin will select as the next generation the adaptive companies who embraced this new set of transitions, just as natural selection will fossilizes any dinosaurs not adaptively fitted to living on the fault line.
The next generation of successful investors will recognize that living on the fault line is an opportunity to align themselves with the complexities of a market in transition from traditional sources of value to new sources of value that require different priorities. These six remarkable transitions identify the salient vectors of transformation in sources of competitive advantage and, hence, in stock price.
Moore identified six remarkable transitions:
1. From Assets (atoms) to Information (bits). In the Age of the Internet, information about an asset has become more valuable than the asset itself. The dramatic progress in information technology has created an Internet that enables an efficient global market that, in turn, has elevated to new prominence the competitive strategy of placing the highest value on information.
2. From Products to Service. This transition reveals that products are becoming less valuable than services. People and what they know are becoming more valuable than the assets on the balance sheet. From a strategic perspective, the relationship between service and product is fungible, changing from a professional answering service to a product called an answering machine to a transaction service called voice mail. Products can be delivered in the form of equivalent services because the Internet reduces transaction costs to near zero. People want the benefit, not the product per se. Moreover, core strategy shifts from products to services whenever transaction services create significant recurring revenue streams.
3. From Vertical to Virtual Integration. Vertically integrated companies hoarded the value chain, creating a proprietary integrated system that locked-in a customer to their high prices. The arrival of open-systems architecture created a value chain of best-of-breed components organized around a de facto standard. The takeaway from this transition is that virtual value chains scale much faster and are more cost-competitive than a vertically integrated offering in the mass market (although niche markets may require vertical integration if quality that is better than just "good enough" is needed). The Internet becomes the virtually integrated backbone of open-architecture value chains. Moore (p. 9) perceived the massive impact of Christensen's innovator's dilemma, "disruptive technologies like the Internet force changes in strategy and behavior that are deeply counterintuitive to established companies and are normally not embraced."
4. From Command and Control to Self-Organizing Systems. As value shifts from assets to information, from products to services, and from vertical to virtual integration, the organizational system must match this new open-systems architecture. Organizational functioning determines organizational form. And, this virtual organizational form becomes self-organizing as the collaborative process grows and develops. Self-organizing systems are the cats that command-and-control try, but fail, to herd. A new technology paradigm begins as a market-to-market competition, where the new open-systems-architecture value chain collaborates to displace the old paradigm. Collaboration is the critical strategy because only it can produce a win-win for all members in the category of the new technology wave. Once the category is established, then competition determines who emerges as the market leader or as the controller of the open-architecture value chain. Companies that "get it" adapt their strategy to whatever works rather than following a business or financial plan that purports to command and control an inherently self-organizing process.
5. From Money to Time. "The key to managing within emerging self-organizing systems is timing." Like a fetus, an emerging market develops during critical periods. All necessary and significant developments must happen within a critical period of opportunity. The solution set, the value chain, the initial customer, and the killer-app are either on time, or they never come on-line at all. In emerging markets, you must be in-line-on-time or fail. Thus, time trumps money because no short-term profits could ever match the lifetime value of proprietary control of an architectural standard. Moore (p. 11) noted that this transition explained stock market valuations over the last five years of the 20th century: "Enormous amounts of private and public capital are being thrown at a one-time opportunity, the emergence of Internet-based markets, in an effort to secure long-term leadership positions that can be exploited more or less permanently." This influx of capital was not about the extrinsic value of "money," it was very much about the intrinsic value of "time." Building shareholder value in emerging markets is a game of timing requiring great flexibility in dealing with the unpredictability of self-organizing systems. The takeaway is that this transition shifts the crucial concern from "earnings in established markets" to "building market-share in emerging markets."
6. From Profit and Loss to Market Cap. Total market capitalization has become the new scorecard for business competition because it unambiguously ranks all of businesses globally across industries. Accounting is trapped in a P&L view of the world, but investors "get it" (or, at least, they did until the prices collapsed). Darwinian selection of fitness occurs through time; capital necessarily flows to the highest risk-adjusted returns. In the Age of the Internet, in emerging markets, think of profits as residual capital that could not be applied successfully to create market expansion during the window of hypergrowth.
This set of six transitions in the economy defines two populations of stocks for the gorilla game investor. On the one hand, the stocks to be avoided are those of companies who cherish assets, products, vertical integration, command and control, money, and profit and loss; on the other, the stocks to be embraced value information, services, virtual integration, self-organizing systems, time, and market capitalization. It is the difference between IBM and BEAS. Managements who "get it" will talk this talk and walk this walk.
To "get it" is to understand that "IT" now stands for the centrality of information technology. All these transitions are shifts driven by the fundamental shift from Assets to Information, because IT is both the enabler of information exchange and the host of information itself. Information is valuable; it can become invaluable; and multiple degrees of freedom in its exchange make its value incalculable.
Information technology has been transformed from a line function to the heart of the business itself, the executive function, because it is central to business strategy. IT is the business, and all business strategy employs its enabling and informing power as the generator of competitive advantage.
IT also defines a new equation for managing resources. Three abundant resources---Money, Computing, and Service Providers, must balance three scarce resources---Time, Talent, and Management Attention. The obviousness of the scarcity of time, talent, and management attention requires no justification, with Management Attention being the scarcest resource of all.
Just as the transition is from money to time, the abundance is money and the scarcity, time. The emergence of venture capital as a significant source of funding for start-ups attests to the plentitude of capital seeking new investment opportunities in emerging markets. The losers erroneously believe that money in the form of earnings is the only valuable resource. Yet, they lose when their profits are not used to cannibalize their status quo to gain market share in the emerging opportunities of the Age of the Internet.
The second element in the new resource equation substitutes packaged software for talent. Moore contends that this shift must continue for the next decade by replacing all in-house custom software with standard application software for all non-mission-critical tasks. Whatever fails to differentiate by creating a competitive advantage is mere hygiene, perhaps necessary, but not a core concern that creates shareholder value.
The final element in the new resource equation is outsourcing, a substituting of the plentiful resource of service providers for the scarce resource of management attention. If a business function does not increase stock price, then it should be outsourced to someone whose stock price does depend on doing this job right.
Although the premium on time mandates "go ugly early and just ship" during the tornado, companies must move toward outsourcing context to focus on core. A laser-like focus (first, on catching the technology wave in time and, second, on achieving architectural control) is the key differentiating feature of the young gorilla from the has-been pretender, who is controlled by the P&L.
Core Versus Context. Companies spend too much time, talent, and management attention on tasks that are context when they should be focused on tasks that are core, on tasks that directly affect competitive advantage and, hence, stock price. Time, Talent, and Attention create and sustain competitive differentiation. The objective for contextual tasks is to execute them effectively and efficiently, while using as little time, talent, and attention as possible. Contextual tasks should be routinely standardized, not differentiated. The market may expect you to do hygiene well, but it does not raise your stock price for doing it. Thus, outsourcing is an efficient solution that balances these scarcities. Moreover, it lets you focus on gaining strong and sustainable competitive advantage.
The Internet demonstrates that there is no context that is not someone else's core. The good news is that capital is available; computing and standardized software are increasingly plentiful; and service providers want your hygiene business, which, because it is their core, they can do more cheaply than you and still boost their stock price.
And so, capital continues to flow to its best risk-adjusted return. In the Age of the Internet, confusing core with context is extremely risky, a stigmata of the damned.
II. The Mechanics of Shareholder Value and Stock Price.
If you invest on the fault line, you need to develop earthquake awareness. To do this, investors must overhaul the traditional understanding of stock price and how to build shareholder value. According to Moore (p. 41, his italics), "Much of what we always thought was true about valuation is, in fact, only situationally true and, indeed, is untrue in the age of the Internet." Too meet this new challenge, we need to recast out thinking. First, we will look at the mechanics of shareholder value, with a focus on stock price. Only then can we look at the dynamics of shareholder value, with a focus on competitive advantage.
To perform effectively, a management must focus on increasing shareholder value. In the aggregate, investors represent an emergent force, the hidden hand: moving capital to the sources of the greatest risk-adjusted returns. If confused in the short-run, over the long run the true lay of the land become clear, and investors can be trusted to act unflaggingly on their economic self-interest. Collectively, over time, the judgment of investors will prove to be correct. Over time, capital ends up in the hands of the Darwin's adaptively fit because poor investors lose capital and good investors gain it.
All follow a simple and single end, seeking excess returns. According to Moore (p. 43, his italics), "Capital, in other words, flows to competitive advantage and abandons competitive disadvantage." Thus, when capital follows its natural course it raises stock price and unerringly points to competitive advantage. This means that stock price functions as an information system about competitive advantage.
Because Moore was focused on influencing traditional management here, he is, in fact, arguing that stock price informs them about whether they have competitive advantage in comparison to the dot.coms whose stock price had soared. Moore hoped to convince them that there were informed reasons for their price surge, namely that the hidden hand of the market recognized the set of transitions discussed above, particularly the emphases on the importance of time over money in emerging markets, on outsourcing context so that management could focus on core to create competitive advantage, and the Internet's threat as a disruptive technology to their traditional approach. Stock-price-as-an-information-system is used in this context as a motivational strategy for overcoming the inertia of political alliances holding the old system in place. For the consultant Moore, stock price is a lever to move the rigidity of the traditional corporation into the Internet Age. The fulcrum is the stock option that aligns managers' interest with stock price. Thus, Moore can argue, "your low stock price means the old ways are out step with Internet Time, embrace the new and raise your stock price by a renewed focus on creating competitive advantage."
Here is Moore's (p. 45, his bold) definition of shareholder value:
The total value of a company, its market capitalization, is equal to the present value of its forecastable future earnings from current and planned operations, discounted for risk.
To explain his definition (and expand his argument), Moore parses the ingredients of shareholder value in bold typeface: (a) it is present value because all investment is a competition for cash from an investor who must determine how much of this cash in hand is this company really worth in the future; (b) it is market capitalization because the stock market continually reports on its perceptions of a cash-equivalent present value through the stream of stock prices and, specifically, the most recently cleared stock price, thus, everyone can estimate market capitalization, which is the best estimate of the company's present total value at any time by multiplying the current stock price by the number of shares outstanding; (c) it is forecastable future earnings that are significant in several respects: first, although the price of the last trade is a benchmark for the next trade, it is alwaysfuture considerations that set the value of the next trade; second, it is earnings (cash flow), not revenues, that are tracked because what the investor is entitled to is her share of future earnings; third, it is future earnings, not past earnings, because that investor is only entitled to a share in a possible future that may or may not become an actuality; and fourth, it is earnings that are forecastable because the investor needs some current foundation for incorporating the future into her present calculation; (d) it is forecasts focused on the current and planned operations, not on one-time bonanza earnings derived, say, from investing in the stock of a strategic partner, and (e) it is discounted for risk because the investor demands extra compensation beyond the discount rate for putting her cash at risk.
Here, I need to inform the reader that in a footnote on p. 45, Moore acknowledges his indebtedness to Michael Mauboussin for guidance in writing much of this section. Also, he noted that, technically, it is not earnings, which can be defined differently using accepted accounting methods, but cash flow that the stock markets tracks because cash in and cash out leaves an unmistakable trace of value created.
Next, Moore recognized that "risk is the true wild card" in all investment decisions. Here, I need to quote Moore (p. 46) at paragraph length, with my bolding, so I can make a subsequent argument:
Risk is the true wild card in all investment decisions. It can never be known, only probabilistically assigned. Moreover, perceived risk changes dynamically with new information about any of the myriad of variables incorporated in its view. So, rather than try to calculate it, free markets use the mechanism of many investors buying and selling to let the price seek its own level. That is why the stock market is so jittery. It is continually rebalancing its equations to account for streams of information that may have bearing on the risk factor. The market does this not through some grand mathematics but rather through the simple expedient of free exchanges, some right, some wrong, but all having the effect of automatically rebuilding the new equation. We may never be able to write this equation down, but with the ticker tape we have the output before us at all times.
Let's begin, as Mauboussin and Moore advise, by considering the stock market to be a complex adaptive system. Adam Smith's "hidden hand" is frequently invoked to illustrate a self-organizing system's ability to display emergent properties, like superior decision-making in comparison to any single individual at any one moment in time. The stock market fluctuates in the short run, but gets it right over the long run because it Darwinian process selects superior companies that demonstrate their adaptive fitness as competitive advantage. Capital flows downhill toward competitive advantage.
Individuals buy or sell based on either their immediate or long-term perception of risk, either responding to the news of the day or sticking with their system of forecasting future cash flow. Always, the human being urgently cares about what she knows. On the one hand, at her best, the human being is capable of considered, informed, and reasoned judgment that is amplified by affective interest-excitement so that she cares positively and deeply about what she knows. On the other hand, at her worst, the urgency of affect overwhelms reasoning, producing the market's exciting manias and fearsome panics. Because affect is contagious and escalates the emotions of all who are in the market, it has a strong impact on perceived risk as "good" or "bad" news cumulates, creating cycles, not only of increasing returns in which the winners win more and the losers lose more, but also market cycles where positive feedback creates runaways, both when good news becomes overly invested with interest-excitement, creating a mania and the when bad news becomes overly invested with fear-terror. As a psychologist, I posit that over- and under-evaluations of the market are driven by investor's emotions that become difficult to control.
When an event like the 9/11 WTC tragedy occurs, the level of investors' uncertainty and fear drives the markets down. (This is not to say that some individual's cannot profit by employing specific strategies that anticipate this probable subsequent downturn). If risk is a wild card, then a "rational market" cannot efficiently assess a wild and unprecedented event that creates a possible turn in world history.
The hidden hand restores order in time, but it does not ever announce that the time of "order" is now, that this moment's fair valueequals the present value of the company's intrinsic value. Instead, as individual investors buy and sell, price simply seeks its own level. So the current price as each trade clears reveals a momentary opinion of market value; it happens to be the best opinion available at this time. Yet, the patient investor in the gorilla game believes she know something that the market does not yet recognize but will eventually about strong and sustainable competitive advantage.
In the bolded passage above, I believe that Moore opened a window for us to see the crucial distinction between the behavior of individual investors and the behavior of the stock market. In the long run, individual investors prove to be adaptively fit if they survive the risk of investing. Over the long run, the market is right, but it is never at risk. Still, for the individual investor, the wild card remains risk, challenging our abilities to understand its nature, to hedge it though stock selection, and to manage the emotions it evokes in the process.
Each trade is cleared by the actions of individuals reaching an agreement in the midst of an ongoing auction of many stocks. The market continually rebalances its equations; over time the market uses the input of millions of trades to approximate a specific fair-value-for-the-moment that is presumed to take more considered information into account than that available to any individual. That judgment of fair market value is not absolute, but remains ongoing, and it is always relative to other fair values in the market. That is, it is an auction of many stocks whose prices are assessed against other stocks as well as against a stock's forecastable future cash flows. Although individual investors must seek to evaluate risk, the market as a whole "uses the mechanism of many investors buying and selling to let the price seek its own level." Free exchanges by individuals, some right, some wrong, from the perspective of the future, set the present stock price. Individual investors come and go, but the stock market just keeps rebalancing along.
To use another well-know analogy of Ben Graham's, the stream of clearing trades is like votes entering a voting machine, whereas the "considered" opinion of the market, which is always correct over time, acts as a weighing machine, calculating an emergent and closer-to-intrinsic value on the stock as it is informed through time by quarterly reports of cash flow. When you vote, say, for President, the votes are counted and that tally is final (unless you live in Florida gg). The intrinsic value of a stock is never finally judged, but its weight (stock price) is assumed to approach its intrinsic value over time in a free market. The stock price is assumed to reach equilibrium with its intrinsic value over time as information about it is widely disseminated. Leaving this assumption of equilibrium aside, what we know is that stock price tracks free cash flow, which, in turn, follows from competitive advantage.
Depending on the precinct reporting at the moment, votes on perceived risk come in haphazardly, influenced by investing style, economic climate, the business cycle, and events like the 9/11 tragedy. The voting swings with the moods of the market. In fact, Graham's analogy of a weighing machine is weak because the stock market never definitively weighs any stock for all time for all to see; instead it approximates a better judgment over time as the quarters pass into years. At the moment, as we read the tape, each of us sees only what is consistent with our own perceptions of risk, in the context of our considered opinions about value.
As a psychologist, I posit that the perception of risk is more strongly amplified by affect in the human being than is the considered and reasoned opinion about intrinsic value. We can be scared out of good stocks as they fall and overly enthusiastic about a stock that is placed at greater risk by its rising valuation. Thus, in a climate of intense affect that is contagiously spread and accelerating, it becomes difficult for us to buy low and sell high. Put another way, the market is responsive to sentiment in the moment and to information about competitive advantage only in the long run.
Only human beings are agents who act as risk-takers; whereas the stock market is only a metaphorical agent who takes no risks, who "perceives, "thinks, "feels," and "knows" only when we personify it, regarding the market "as if" it were an agent. For example, when we say, "the market looks through a downturn and anticipates the recovery," we are describing an empirical observation (that the stock market has frequently risen ahead of the economy) using anthropomorphic language. When we say, the market is "efficient," we literally mean that it clears trades efficiently. This is not the same as claiming that the market incorporates all known information into each stock price as it clears. When this metaphor of market-as-a-knower is literalized, it claims anthropomorphic, even god-like, qualities for the market-as-omniscient.
I believe that it is more useful to regard the market as a complex adaptive system, whose "wisdom" is an emergent property of the individual decisions of many investors, with various sentiments, composed of motives, strategies, rationales, affects and information, dictating their individual decisions. Just as the collective judgment of the thread or any other group containing disparate individuals with disparate information may become better informed by averaging all of it, so the market collates investors' sentiments to amass its wisdom. Whether we vote for Oscar winners or stock winners, the measure of central tendency from a group usually scores better, on average, than the individual's responses.
If risk is the wild card for the investor, Mr. Market is not playing the same game; its game is that of an auction-clearing house.
For the investor, however, the weighing of risk requires a careful examination of strong and sustainable competitive advantage, which underlies shareholder value, which is benchmarked as quarterly free cash flow, which is projected into a risky future as forecastable future cash flow after adjusting for risk. In contrast, the tape is steadfastly focused on the present moment; only the human being is conscious of the future and focused on its risk. Only the individual can decipher the intentions of other human beings who are trying to influence his perceptions of risk.
What's more, the nature of complex adaptive systems, like the stock market, means the future is inherently difficult to predict. For a gorilla to emerge, every step in the process must unfold on time during a critical period that may or may not be malleable. Not only that, nothing external, whether competitive threat or economic cycle downturn or world events, must interfere with the nascent gorilla's developmental progress. If the stock market is a complex adaptive system, then it should come as no surprise that the averages are so difficult to beat over time. The stock market game is biased in the investor's favor, but it remains genuinely difficult to beat the risk-adjusted return.
Nonetheless, if you believe that companies can be strategically managed, then you must believe that if you can recognize which companies are being managed to create shareholder value, then you can choose to take that risk of uncertain possible futures in hope of gaining substantial rewards. [To be continued, if this part helps.] |
