Concentration, Diversification, and Dumb Trades

As a value investor I've always struggled with how diversified or concentrated my portfolio should be. I've followed both approaches -- imperfectly -- over the past 12 years. Much of the problem stems from the fact that I'm a big fan of both Warren Buffett (who favors concentration) and Benjamin Graham (who generally favored diversification).

Excellent books I've read over the past year have simultaneously clarified and exacerbated this confusion: Warren Buffett's Ground Rules by Jeremy Miller, Deep Value by Tobias Carlisle, and Concentrated Investing by Allen Benello, Michael Van Biema, and Tobias Carlisle. I also recently discovered a superb blog site, Base Hit Investing (BHI) by John Huber and Matt Brice, that has added greatly to my knowledge of return on invested capital, return on incremental capital, and the impact of portfolio turnover on overall returns. BHI has been pulling me toward the concentrated approach.

In an effort to capture the best of Graham's mechanical cigar butt approach and Buffett's more subjective concentrated approach, I've decided -- for the time being -- to go with a quantitative approach that tries to identify undervalued, unleveraged companies with high returns on incremental capital and/or invested capital. I'm using these return on capital metrics to try and avoid cigar butts (similar to Joel Greenblatt's approach). Below are the notes I made to justify this decision -- I often do this to steel myself from my own emotional and return-damaging whims:

  1. The problem with concentrating in select positions is that you get too emotional and you end up making dumb trades that hurt returns (motivated by fear, greed, etc.). Concentrated positions often lead to second guessing (due to the exposure that comes with a large bet) and overly aggressive, unnecessary buying and selling. It’s better just to equal-weight your positions and hold enough positions that you don’t mind taking a bath every once in a while. Good diversification and a clear sales trigger reduce dumb, unnecessary trading.
  2. Based on experience and the literature, you can reliably make good money with a diversified approach (occasionally great money). On an averaged, portfolio basis you'll always own a group of undervalued, unleveraged, well-run companies earning attractive returns on incremental capital and/or invested capital. Some picks won’t work out, but on average things should work out well. This is the big advantage of a diversified portfolio strategy: with a diversified strategy it’s not as important to be right about each pick (like you have to be with a concentrated approach) — you just have to be right on average. 
  3. A diversified, group approach allows you to buy smaller, more volatile companies and accept more stock-specific uncertainty, which can then drive higher returns. It also relieves the pressure to predict the future or know every single thing about a company/industry. By staying diversified you can use an easy, quantitative approach, make a few mistakes, and still get good results. And the companies you choose don’t have to be cigar butts with declining businesses — you can use return on incremental capital and return on invested capital to identify well-managed companies that are growing in a smart way. Smart companies don't just grow earnings — they grow earnings at a rate that’s attractive relative to the incremental capital required to support this growth.

So that's my investing approach, at least for now. I've also noticed a side benefit of diversification -- fewer stomach issues.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.

Simple Businesses

I've always been a value investor, picking both "cigar butt" Benjamin Graham stocks and selectively concentrating a la Warren Buffett. What I haven't always done -- that Buffett often talks about -- is invest in simple, understandable businesses. When I look over my time as a value investor, which started in 2005, it seems like most of my big mistakes/losses have involved companies where I didn't fully understand the product or how the company generated revenues. For this reason I'm now applying the following checklist to any concentrated investments:

  1. The business is simple and understandable;
  2. the business is quantitatively cheap, based primarily on financial ratios like price to earnings, price to free cash flow, enterprise value to operating earnings, price to tangible book, and/or price to net current asset value;
  3. The business is unleveraged and has plenty of working capital;
  4. The business is not heavily regulated or heavily supported by government funding/subsidies/programs;
  5. The business is not experiencing technological disruption; and
  6. The business is not experiencing business model disruption (a la Clayton Christensen).

I'm either avoiding or investing smaller amounts in companies that don't meet all these criteria. 

One of the reasons I like simple, understandable businesses is that you’re less likely to be blind-sided by technological or business model disruption, or by unanticipated regulatory changes or lost government funding. It's generally easier to see potential disruption risks with a simple business -- the risk is usually more obvious. Investing in simple, cheap businesses, and diversifying appropriately, may be the two best ways to guard against "falling knives" and surprise stock losses due to disruption or regulatory changes.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. This article should not be construed as investment advice.

Overstating Disruptive Threats

Some entrants present existential, disruptive threats to incumbents, but many do not. Entrants often fail to generate meaningful profits and move upmarket, allowing incumbents to wait them out -- albeit with a temporary sales loss. The incumbent eventually regains the sales -- it just takes time for entrants with unprofitable business models to start exiting the market. 

A strong balance sheet makes it easier for incumbents to wait out competition from unprofitable entrants. If the entrant has a disruptive model that's profitable, and is therefore a true long term threat, an incumbent with a strong balance sheet can either: (1) alter its business model to compete with the entrant (often difficult to do, for reasons explained by Christensen), or (2) shed assets and serve a smaller share of the total market. A leveraged incumbent may find downsizing difficult or impossible, since it must generate revenues/profits sufficient to service debt.

A lot of investors assume every entrant poses an existential, disruptive threat to incumbents without considering whether the entrant's model is profitable/sustainable or whether the incumbent can survive through business model changes or downsizing.

Some Thoughts on Investing

I've been picking stocks and managing my own portfolio since 2005, buying undervalued positions based on the strategies of Benjamin Graham and Warren Buffett. See Concepts page for discussion of Graham and Buffett. For about half this time I was highly concentrated in a handful of good companies a la Warren Buffett. I held these companies as long as they were undervalued or fairly valued based on a conservative analysis of discounted cash flow (with low, medium, and high estimates of value). This usually led to holding periods ranging from three to five years.  

For the remaining time from 2005 to 2016 I managed a portfolio of 12 to 30 "cigar butt" stocks. These companies were chosen based on Graham-style quantitative analysis. This second approach was focused on limiting downside risk. Stocks were selected and held only if they appeared undervalued based on ratios like price to earnings, price to "owner earnings" (similar to free cash flow), enterprise value to operating earnings, and price to tangible book. This often resulted in more turnover, especially if positions were rising. Tax avoidance did not enter the decision making process.

With both these approaches I tried to stay in companies that were fairly unleveraged and had reasonable levels of working capital, consistent with Graham's writings. A highly leveraged company with low liquidity can be forced into bankruptcy through a single period of poor profitability and tight credit conditions — even if historical profits have been good. As Buffett notes, "any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero." From a psychological standpoint it’s also harder to buy additional shares of a highly leveraged company getting beaten up in a broad economic downtown — it’s harder to be contrarian. That’s because the market may be correctly assessing the leveraged company’s ability to survive a more difficult economic environment.

Out of this experience the following seems worth noting (these are all personal observations/opinions and are not intended as investment advice -- anyone considering a stock market investment should consult a registered investment advisor):

  1. With Buffett's concentrated approach I was looking for good companies I could hold for a long time. To justify a long holding period -- and keeping money tied up in the investment -- I tried to predict future outcomes and understand everything about the company.
  2. I generated good returns with Buffett's approach, but I had difficulty keeping these returns because I sometimes held fairly valued positions too long. I invested so much time learning about each company that I "fell in love" with certain picks, making me less objective about buy/sell decisions. With big gains I was also reluctant to take the tax hit. These problems led to money sitting "fallow" and not generating a return.
  3. With Graham's cigar butt approach I did not fall in love with positions. I was always in undervalued stocks and had a firm selling rule, so emotions didn't really come into play. Because this approach was mostly quantitative, and because I had a diversified portfolio (rather than a highly concentrated portfolio), I felt less pressure to know everything possible about each company. I felt less need to predict future outcomes.
  4. Comparing Graham and Buffett, I think it's easier to take advantage of cigar butt volatility -- through a quantitative approach -- than it is to pick a handful of good companies that will grow over a long time period. That's because: (1) Buffett's approach presents emotional challenges, as already noted; and (2) stock volatility is a more common/reliable phenomenon than a single company's growth/survival. All stocks experience volatility and temporary mispricing, while few companies grow/survive over long periods. As Ben Graham observed, you cannot reliably depend on past trends to continue, growth or otherwise. You have to recognize what you don't know or can't reliably predict.
  5. I seem to do better -- and sleep better --  by trying to avoid losers rather than pick winners. In my experience, when you focus on downside risk you improve long term returns more than you do by trying to predict the future or find growth. Losses are hard to recoup -- if you lose 25% you have to make 33% on that money to get back to even. Graham's cigar butt approach seems better if your first priority is avoiding loss.
  6. I did worse when I became too concerned about avoiding taxes or holding on for maximum gains. I now focus on avoiding loss by making sure I stay in the cheapest low debt stocks I can find.
  7. One way to beat the tax issue is to "out-run" the tax hit through great returns, even if it means higher turnover from a quantitative, cigar butt approach.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. This article should not be construed as investment advice.

Retail Disruption

Brick-and-mortar retailers that only distribute and don't manufacture are being disrupted by convenient, low price online retailers with low cost structures. This is impacting a big swath of the retail industry.

Traditional retailers are protected -- to some extent -- when the distributed product is something consumers want to try on or touch before buying. Even then, however, sales of "try on" products are impacted by e-commerce: after a buyer makes the first purchase of a try on product at a physical store, he can make repeat purchases online.

Brick-and-mortar retailers trying to bolster sales through an online presence must compete with Amazon. And the difficulty here is that Amazon has the competitive advantages afforded by massive scale, a low cost structure, and a huge selection of products. By selling almost everything, Amazon provides one-stop convenience that other online retailers can't match. This convenience edge has been strengthened by Amazon Prime. So traditional retailers face daunting challenges when trying to compete online.

Retailers manufacturing unique products that they also sell -- like Apple -- are largely protected from Amazon. That's because these retailer-manufacturers can control distribution and/or distribute their products exclusively.

Looking beyond retail, other industries are experiencing widespread dislocation, often due to new technologies rather than Christensen-style low end or new market disruption. The oil industry is becoming less profitable due to EV's, abundant natural gas, and cheaper and cheaper solar/wind alternatives.

If a disruptive force doesn't swallow the entire industry market, then a disrupted company can try and adjust to reduced market share by downsizing. An unleveraged balance sheet makes downsizing easier and survival more likely. In the case of retail, many brick-and-mortar companies will survive -- particularly the companies that manufacture what they sell or sell products that people want to try on first -- but their sales may be lower. 

The Investor's Best Disruption Defense

It's hard to tell which companies are going to be disrupted. Newspapers once looked infallible but have since suffered low end disruption from free online news. Many traditional brick-and-mortar retailers have lost sales to online retailers who charge less and have lower cost structures. The traditional car industry, which has been fashioned around car ownership and performance attributes like gas mileage, handling, acceleration, and looks is probably going to be disrupted by (1) cheap, ultra-convenient transportation as a service (e.g., self-driving Uber cars) and by (2) electric, self-driving vehicles -- with tightly integrated hardware/software -- that function as mobile offices and living spaces.

Cheap transportation as a service is a form of low end disruption that appeals to people who don't derive additional benefits from car ownership. Electric, self-driving mobile offices/spaces are a new market disruption appealing to consumers who need transportation and a place to work/live -- a mobile work/living space gives these consumers an economical way to "kill two birds with one stone."

The flip side is that many traditional businesses survive disruptive threats. Some brick-and-mortar retailers are doing well, sales of printed books have stopped declining, and newspapers like the New York Times, the Washington Post, and the Wall Street Journal have made successful transitions to online content. It's hard to predict the future.

An investor trying to read the tea leaves can only really protect himself through adequate diversification. If you're a Benjamin Graham disciple, this means holding 10 to 30 stocks. If you're Seth Klarman, it means holding 10 to 15 stocks. If you're Warren Buffett, it means holding five or more stocks and knowing as much as possible about each one. Adequate diversification -- however you define it -- is probably the most reliable way for an investor to protect himself from the catastrophic effects that disruption can have on a single company/stock.

It's also worth noting that incumbent companies trying to address disruption through the creation of a low end or new market product often make their returns and balance sheets worse. Incumbents trying to self-disrupt often leverage up and/or pour money into projects with a poor return on capital employed (capital employed meaning working capital plus net fixed assets). Low end and new market disruptions that initially appear promising frequently fail because margins and/or sales volumes are too small to generate a meaningful return (that's why entrants generally pursue new and low end markets before incumbents do).

It's ironic: from an investor perspective capital expenditures to develop disruptive/promising new products should often be distributed as dividends instead, since new products usually fail and investors are well-positioned to invest dividend income in companies with higher/better returns on capital, while from a management perspective self-disruption through low end and new market offerings is critical to long term corporate survival, even if it means lower overall returns on capital employed.

Discounted Cash Flow Analysis

Every so often I read an article about how discounted cash flow ("DCF") analysis produces an unreliable stock value due to all the assumptions involved -- in terms of baseline/normalized earnings, discount rate, growth rates, termination values, etc. -- and how small changes in these assumptions can dramatically impact the present value of future cash flows. 

I think there's great danger in an investor trying to determine one stock value based on DCF analysis, and then making a purchase decision based on this one figure. An investor who computes one DCF value never discovers the impact of changes to his assumptions; these changes may make the investor's one estimate of stock value less helpful/realistic than it first appears.

DCF analysis becomes more valuable and realistic when it's used to compute a range of possible values based on worst, normal, and best case scenarios. When a stock is priced below a conservative worst case scenario, then DCF analysis is helpful in determining whether the stock is undervalued, especially when combined with an examination of financial ratios like price to earnings, price to free cash flow, and/or price to book.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.

Recurring Revenues and New Products

A saturated market, increased competition, or longer replacement cycles (due to a "good enough" product) eventually cause product sales and profits to flatten or decline. 

To compensate for flat sales and profits a company may be able to create other successful products. Unfortunately it's impossible to determine: (1) whether and what future products will be created; and (2) whether any future products will generate meaningful sales and profits. Some things are too difficult to predict.

Because the success of hypothetical future products is too difficult to predict, an investor should believe a company is undervalued -- or at least fairly valued -- based on recurring sales of existing products, factoring in flattening sales and profits. An investor should be confident these recurring sales/profits will occur, hopefully because the company's offering is produced through a defensible, unique, trade-off based set of activities that's difficult for competitors to match. Recurring, defensible sales and profits provide the investor with a "floor" of downside protection.

In choosing between two companies that appear undervalued based on defensible recurring revenues, it makes sense to invest in the company with the best track record of creating successful new products. While it may be too speculative to determine whether a company is undervalued based on unknown future products, it makes sense to prefer companies that: (1) are undervalued based on defensible recurring revenues from existing products; and (2) have the demonstrated ability to create profitable new products. Some companies are better at creating and marketing new products than others, often due to internal capabilities -- what Christensen calls resources, processes, and values -- acquired over time.

Marginal Improvements

As a product gets better, the additional, functional benefit of each product improvement tends to get smaller. Certain product functions become good enough. Continued improvement of these good enough functions: (1) isn't valued as highly by consumers, and may not be enough to convince consumers to upgrade to the latest product version; and (2) leads to over-complex, overserving, overpriced products that only appeal to the most demanding users, ultimately hurting a company's sales and profits.

It also seems like products hit a point at which they can't be meaningfully improved in their current form. When this happens a product's form/shape has to change to stimulate sales. PC's are good enough and hard to improve further, leading to stagnating PC sales, yet computing products have continued to grow through different forms like tablets and smartphones. 

Product functions that aren't good enough are the ones a company needs to focus on, because improvement in these areas motivates consumers to buy the improved product.

When functionality is generally good enough, it's time for a company to: (1) start improving product access and affordability, making it easier for consumers to acquire and use the product; and (2) start exploring new product forms where improvement will be valued.

Dead Simple

Mass market consumers generally want a product to be as simple as possible. That's why defaults are so important, and why "the best" isn't necessarily the most widely adopted. Simplicity is also an important performance attribute for companies to improve on -- improving a product by making it simpler and simpler to use, often by removing unnecessary, unused features. This is an area where companies with established products often seem to go wrong: they add unused features or functionality and never strip this cruft away despite poor user adoption. Overserving, over-complex features or functionality leave the door open for entrants to introduce a simpler, better-designed, less expensive product that's more useful.

Certain questions seem especially relevant in assessing an incumbent's ability to avoid low end disruption while also creating dead simple products that create new markets:

  • Are the incumbent's formerly simple products becoming more complex and weighed down with unused features?
  • Is the incumbent trying to improve the simplicity of its products by removing unused features, even as it tries to add valued functionality?
  • Is an entrant having success with a simpler, less expensive product that only focuses on the essential? Is the incumbent ignoring this success or trying to compete with its own simplified offering?
  • Does the incumbent appear committed to creating simple, well-designed products that either compete in the low end or create entirely new markets, even if it cannabilizes existing products that are more complex?

New (Sometimes Great) Products and Bad Businesses

You often see companies release a great, innovative product that's not profitable -- so the product eventually gets discontinued or the company goes out of business. Sometimes this is because the great new product incorporates technologies that are too expensive to sell in quantities sufficient to generate a bottom line profit. Or the product is sold in quantities sufficient to generate a profit but never goes beyond a niche market because of its high price -- incumbents aren't really threatened in this scenario.

Entrants with an approach that could be a low end disruption often face a similar problem: the company has a new, low cost way of addressing a job-to-be-done but never improves its product enough to accrue the pricing power needed to generate a profit. So the company hovers around breakeven profits and often goes out of business. 

Conversely, you see lots of low growth, "cigar butt" companies that persist with a mediocre but profitable product. These companies often survive -- and stay profitable -- despite pricier, technically superior new products or new, low cost approaches to the problem. In fact, the company with the superior, pricey product or the innovative low cost approach is often the one that goes out of business, while the cigar butt company continues operating. So a superior new product or low end approach doesn't necessarily translate into a "good business," sometimes because the new offering/approach is too expensive or overserving or can't generate the profits needed for product improvement.

You could define a good business as one where the product/service targets the job-to-be-done well enough -- in terms of product quality, convenience, price, etc. -- for the company to sell the product at an attractive profit. An attractive profit is one where the return on capital employed (capital employed meaning working capital plus net fixed assets) is high enough to justify continued capital expenditures/investment. Otherwise continued investment is a waste of time, money, and talent that could be productively invested elsewhere. Innovative products or approaches that can't generate an attractive profit -- an attractive return on capital employed -- within a reasonable period of time may not be as promising as they first appear.

Getting Hamstrung by Legacy Services and Products

Ben Thompson at stratechery.com just wrote a thought-provoking article titled "Apple's Organizational Crossroads." In the article Ben says Apple should consider organizing its services into divisions with separate P&L's, creating a direct profit incentive to help it create better services and then rapidly iterate/improve these services. This would be a break with Apple's current functional structure, under which the company is organized around functions like design, engineering, marketing, and so on rather than by product division. 

I wrote a pretty lengthy response/rebuttal to Ben's article. Rather than rewrite the response I'm going to quote it in full:

I think Apple does iterate its services independent of hardware releases -- I get regular updates to iTunes and OS and iOS regardless of whether I purchase new hardware.

I like the simplicity of Apple's approach to services: when I buy the hardware I know it's going to come with certain core services I need -- mail, messaging, contacts, calendar, Pages, Numbers, etc. -- and I don't have to worry about getting nickel and dimed for service updates (which is what Apple would presumably have to start doing if each service had a P&L).

Conversely, as an end user I really dislike the way Microsoft is following a nickel and dime approach by trying to funnel me into a yearly subscription for Word, Excel, etc. -- and I'm finding I can get along without state of the art services from Microsoft. Apple's core services are good enough for me. If any core Apple service isn't good enough then I just buy the service/app from a third party -- no big deal.

I think Apple is actually doing a fair job monetizing most of its services through its hardware, iCloud backup, and iCloud storage. And while hardware monetization doesn't provide a direct incentive for Apple to improve its services, it does provide an indirect incentive: Apple wants to make sure its core services are generally liked and used, since that use keeps the buyer purchasing future Apple products.

It's strange but you don't seem to hear as much about Google Docs anymore, despite powerful direct incentives for Google to improve this service (such as collecting user data, generating ad revenue, etc.). I continue to see complaints on Twitter about the limitations of Google Docs. I'm not convinced incentives have to be direct to be effective.

Apple Music may not be as good as Spotify but it's good enough for me, as is the ability to purchase videos through the iTunes Store. Apple Maps is also good enough for me and continues to get better (despite Apple's lack of direct incentives to improve Apple Maps).

I really think Apple's focus on the integrated user experience is appropriate, because this approach puts the focus on the job-to-be-done. Focusing on the job-to-be-done helps keep prevent unused features and non-meaningful improvements to services that are already good enough (again, I'm thinking of Microsoft services here).

And referencing Steve Jobs, Jobs always said you have to start with the user experience and work backward to the technology. You could arguably take this line, change a few words, and say something like: you have to start with the user experience -- which by its very nature is broad and encompasses both a hardware and a services component -- and work backward to a holistic, well-designed solution which isn't tied to whether particular components of this solution are profitable.

This holistic, integrated approach is enabled by a functional organizational structure. I don't think I'd ever want Apple to abandon this approach and go to product divisions/silos and a bunch of separate P&L's where great, integrated solutions/products become almost impossible.

Going forward I believe Apple will try to make a profit on services that don't have to be tightly integrated with Apple hardware. Such services might include: App Store revenues, iTunes music/video revenues, and Apple Music. This list might also include iCloud backup/storage tiers, since this is a backend service that's arguably more standalone. The more standalone nature of certain Apple services may explain why Apple made iTunes and Apple Music available horizontally to users of Microsoft and Android hardware.

Much of this response suffers from anecdotal, first person bias -- my own experiences and opinions regarding the "good enough" nature of many Apple services may not hold true for others. Despite this, I suspect at least some Apple users feel this way.

The Problem with Legacy Products/Services

After mulling around Ben's article and my response, it occurred to me that the Apple services struggling the most -- in terms of quality, complexity, and general cumbersomeness -- are the legacy ones. iTunes and Apple Music are confusing and complex because they still provide users like me with the legacy stuff I bought a few years ago (downloaded music, for example) while also giving me access to newer technologies/approaches like music streaming. iCloud can be confusing and cumbersome because I used to back things up to my computer and iTunes rather than backing up with iCloud. iPhoto can be confusing and cumbersome because Apple is trying to accommodate users who sync with their computers while also encouraging users to start using iCloud to save all their photos and videos.

I don't think the main thing holding up improvement/iteration of these Apple services is the absence of separate service divisions, each with a separate P&L. I think the main problem is the pre-existence of legacy solutions -- e.g., downloading and syncing music in iTunes or syncing photos with iPhoto on your computer -- that were developed before cheap cloud storage and high speed broadband became widely available. These legacy problems would exist regardless of whether Apple used a separate P&L for each service.

The Apple services without significant legacy issues seem to iterate/improve pretty rapidly. Apple Maps has no legacy issues and has rapidly improved. Apple services like contacts, calendar, notes, Pages, and Numbers have few legacy issues and have rapidly improved. iCloud has a few legacy issues related to traditional computer backup and iPhoto, as noted above, but because iCloud operates largely out of sight, it has also improved rapidly. Again speaking anecdotally, I now use iCloud Drive for all my folders/documents on both my Mac and iOS devices. 

The thing I like about Apple is that it's always trying to move users away from legacy approaches toward newer, more efficient ways of doing things. So Apple has abandoned built-in computer disk drives, is encouraging people to backup with iCloud instead of their computers, and is encouraging people to use Apple Music instead of continuing to download music through iTunes. Apple is trying to take care of legacy users who don't want to change while also "getting its foot in the door" by adopting new technologies that improve legacy services like iTunes and iPhoto (with services like Apple Music streaming and iCloud).

Companies that let legacy products and services rule their portfolio -- and don't get their foot in the door by adopting technologies that can improve products and services -- can pay a heavy price. Intel's adherence to legacy x86 chips, and its reluctance to shift to ARM chip designs, is a good example of this.

The author owns stock shares of Apple.

Functional Needs and Irrational Wants

The iPhone is like a pocket Porsche -- it comes in iconic, arguably artistic designs like a Porsche. The difference is that it's affordable to a lot more people. Artistic, iconic design leads to strong brand value and purchase decisions driven not just driven by rational, functional needs but also by irrational wants (desire, lust, envy, communicating status, etc.). Some consumer products have an inherent artistic element that goes beyond purely functional needs: cars, smartphones, fashion, furniture, and so on. Conversely, some consumer products are almost entirely functional in nature -- people buy or use them because of functional needs, not because of irrational wants. Some examples of purely functional products/services might be: hard drives (Christensen's famous example from The Innovator's Dilemma), backhoes, commodities like steel or glass, Internet search engines, and artificial intelligence. 

If you're selling a purely functional product, Christensen's "good enough" concept is particularly important. That's because irrational wants don't come into play, and the buyer can easily determine what's good enough by comparing the product's functional, measurable performance attributes with the particular job the buyer needs to get done. So a buyer can look at a hard drive, for example, examine its data retrieval rate and storage capacity, and compare that to his functional needs -- how he'll be using the computer and how many photos, videos, and documents he needs to store -- to determine whether the hard drive is good enough or whether it overserves.

As noted in other posts, the best way to keep functional product elements from overserving is to make sure improvements are meaningful and actually used by buyers.

Another great way to prevent functional overserving is through technological leaps that change consumer expectations of what's good enough. This happens when a company comes up with a breakthrough product that makes consumers think that existing alternatives -- that consumers previously felt were good enough -- aren't good enough anymore. The consumer's perception of what's good enough isn't static: it's relative and changing depending on the latest breakthroughs and what's available in the marketplace.

If a sustaining technological leap or breakthrough creates a large enough performance gap between the breakthrough product and existing incumbent alternatives, it may allow the entrant to establish the beachhead needed to effectively enter an existing market. An entrant with a sustaining improvement/innovation normally doesn't do well because incumbents respond vigorously. The exception may be an entrant with a surprise breakthrough product that catches incumbents off-guard -- you could argue the original iPhone succeeded this way.

Two challenges for an entrant with a breakthrough product may be: (1) the lack of a recognized, trusted brand; and (2) ramping up manufacturing, distribution, and marketing fast enough to take full advantage of the sales opportunity. Incumbents are highly motivated to "fast follow" the entrant's breakthrough product with similar products. The key question here is whether incumbents can quickly acquire the capabilities needed to compete with the breakthrough. In the original iPhone's case, Blackberry and Nokia were unable to fast follow the iPhone with similar products because they lacked Apple's integrated hardware and software capabilities. As a result Apple had the time needed to ramp up iPhone production and distribution. Apple's strong brand also helped.

Returning to this post's original subject, a person buying a Porsche or an iPhone -- or any other product with an inherent artistic element -- considers (1) functional needs but is also influenced by (2) irrational wants like the desire/lust for something beautiful. The good enough standard is highly relevant to the functional needs part, but may not be very relevant to the irrational wants part. And irrational wants become even more of a factor when the product is distinguished by iconic, artistic design. So a product with an artistic element may overserve a buyer's functional needs but still be something the buyer wants to purchase because of irrational wants -- a Porsche or a Ferrari is a good example of this.  

You could almost look at a product on a sliding scale: as a product's artistic/iconic elements go up, the relevance of what's good enough -- and the danger of overserving -- go down. The ideal situation may be a product with improving artistic elements and improving functional elements: the key here is that functional elements must improve in a meaningful way that's valued by consumers (to prevent unused, overserving features that actually end up degrading functional performance and ease of use).

Applying another Christensen concept, when the buyer's "job-to-be-done" encompasses purely functional needs, overserving is a greater risk. When the buyer's job-to-be-done is broad, encompassing both functional needs and irrational wants, there's less danger of overserving. 

Art vs. Algorithms

Industrial design sometimes rises to the level of art, and art doesn't commoditize. Artistic design creates tremendous brand value and is very hard to copy, and close copies are never valued as highly as the original. Examples of companies producing iconic products and industrial art include Braun, Ferrari, Porsche, Apple, and Tesla. Industrial art has driven the brand value of each of these companies. 

Conversely, algorithms and machine learning methods can be copied, and the copy is valued just as highly as the original because the product's appeal is based purely on functional needs. Much of the theory behind algorithms comes from educational institutions and is in the public domain. As noted above, Christensen's good enough concept -- and the danger of overserving -- is much more relevant with purely functional products.

So if you're an investor, it seems to make sense to invest in companies that make products that aren't purely functional. The ideal situation may be a company that makes a product with artistic elements, and that is committed to iconic design. This kind of business model is (1) hard for competitors to copy and (2) reduces the danger of creating an overserving product (since buyers in this kind of market are driven by both functional needs and irrational wants).

This post has been amended since it was first written. 

The author owns stock shares of Apple.

Moving Downmarket Without Damaging Your Brand

With the iPhone SE Apple is differentiating its products through size while still offering a best-in-class product at every price level. By differentiating through size, Apple can move downmarket with a less expensive iPhone without damaging its brand, and without detracting from an important motivator for people purchasing an iPhone: the status that comes from owning a best-in-class product (best four inch phone, best large phone, etc.). This was one problem with the iPhone 5c -- it was a downmarket move but it wasn't a best-in-class product. As a result the iPhone 5c degraded Apple's brand and failed to accomplish the job-to-be-done of communicating status.

The author owns stock shares of Apple. 

Country by Country

All Apple can do is make the best product possible within the legal constraints of each country it sells in. If it wants to sell iPhones in the United States, it has to comply with United States law. It it wants to sell in China or India or France, it has to comply with the laws in those countries. 

The courts or legislators in a particular country may make bad decisions about what the laws should be. At that point Apple will have to: (1) modify products sold in that country or (2) stop selling in that country. The first choice is an option as long as country-specific product changes don't jeopardize the quality and security of products sold in other countries. Apple may be forced to stop selling products in countries with laws that jeopardize the security of Apple products sold in other markets.

Apple's competitors will have to deal with these same issues. Some will mount vigorous defenses to bad laws, some will not, but the competitive playing field should be the same on a country by country basis. I think the main thing is for Apple to take firm, ethical stands against legal and governmental overreaching, protecting the user's security and privacy as much as possible. Companies that don't do everything they can to protect user security/privacy will suffer big hits to their reputation and their ability to attract and retain customers.

The author owns stock shares of Apple.