Capital Allocation

In his annual letters Warren Buffett talks about the importance of capital allocation. Paraphrasing Buffett, when a company can invest its earnings in incremental assets at high rates of return it should do so, or it should use this money to acquire — in whole or in part — fairly priced “wonderful” companies generating attractive returns. When these options are unavailable, the company should return earnings to shareholders through share buybacks if the company is meaningfully undervalued, or though cash dividends if the company is fairly valued or overvalued.

Buffett says one of Berkshire Hathaway’s key advantages is its ability, as a conglomerate, to dispassionately invest capital in closely held and publicly traded companies across a range of industries. This kind of choice makes it easier for Berkshire to find fairly priced companies — to purchase in whole or in part — that are growing sales and earnings at high capital return rates. Additionally, Buffett doesn’t insist on operating control when looking for investing prospects — he’d rather own part of a great company than all of an average company. This gives Berkshire a flexibility advantage over companies that want control. Buffett also notes how easy it is for Berkshire to internally shift capital from a “cash cow” subsidiary that can’t invest retained earnings at attractive returns to a growing subsidiary that can.

Berkshire’s flexibility in deploying capital allows it to continue growing despite large sales and a large market capitalization. Most companies can’t invest capital in such a varied way: they operate in one business and one industry, resulting in fewer acquisition choices and fewer ways to shift money around internally. Limited choice often causes a company’s management to invest capital poorly, either by (1) expanding an existing, low capital return business or (2) making a controlling acquisition at a premium price.

Berkshire benefits not just from the varied ways it deploys capital, but from the large capital amounts it has to deploy. The company invests equity capital in the form of earnings generated by its subsidiaries, in addition to debt capital in the form of insurance float generated by subsidiaries like GEICO. Insurance float is the up-front premium money insurers hold/invest until these monies are paid out in claims. Berkshire invests float in attractively priced equities generating high capital returns. Float is a debt liability on the balance sheet, but Buffett believes this is a mischaracterization: he views Berkshire’s float as a costless, revolving fund — which Berkshire can invest in attractive equities — whereby claim payouts are continually replenished by insurance premiums. Through the years Berkshire’s insurance float has steadily grown, giving the company more and more money to invest. Buffett notes that returns from invested float are then augmented or reduced by underwriting profits or losses. When insurance premiums exceed expenses and eventual losses there’s an underwriting profit. When expenses and eventual losses exceed premiums there’s an underwriting loss. In most years Berkshire’s insurance subsidiaries have generated an underwriting profit. 

Companies shifting from growth to maturity often have trouble adjusting their capital allocation: they retain earnings for low return projects or acquisitions instead of distributing this money to shareholders through dividends or share repurchases. It takes managerial discipline for a company to forgo low return investments, even when these investments generate additional sales, earnings, and earnings per share. Low return investments waste retained earnings because shareholders could invest this money elsewhere at higher returns.

Poor capital allocation, industry competition, technological disruption, and business model disruption all cause declining returns and regression to industry mean returns. A company can delay and sometimes prevent declining capital returns through (1) shareholder-friendly capital allocation and (2) unique activities/strategy a la Michael Porter (e.g., Apple and Southwest Airlines). 

Buffett notes that shareholders of companies that allocate capital poorly actually pay twice: once via the earnings retained and invested by management at low returns, and once via the lower market value assigned to companies that behave this way. Smart capital allocation, whether it’s repurchasing shares at appropriate times or retaining earnings at appropriate times, may be the best quantitative indication of good management.

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.

Business Models vs. Strategies

If you target customers who value cheap and good enough more than design and user experience, then it's really easy to end up competing on price and selling a commoditized product (think low end smartphones and tablets). This point is frequently ignored by new entrants trying to enter existing markets with a simple, low end product and a low cost business model (what Christensen calls low end disruption). See Concepts page and discussion of Clayton Christensen. To avoid commoditization, low end entrants must remember that a profitable low cost business model isn't the same as a unique strategy.

A business model focuses on the subject company's viability -- its revenues and costs and whether it can make money. An effective business strategy focuses on developing a unique set of activities that allows the subject company to stay viable and earn superior profits relative to competitors. See Concepts page and discussion of Michael Porter; Understanding Michael Porter, by Joan Magretta (Harvard Business Review Press, 2012).

Without an underlying business strategy, a low cost business model can be copied, leading to product commoditization. Per Michael Porter, an enduring business strategy is founded on a unique set of trade-off based activities that fit well together. New entrants following a low end disruptive approach should have a unique, trade-off based strategy that other competitors are unwilling or unable to match (a la Southwest or IKEA). See posts titled "Acquisitions, Rivalry, and Strategic Trade-Offs" and "Surviving Competitive Attrition."

Apple's Strategy

Apple uses an integrated approach to products and services to pursue the following strategy:

(1) Target customers who value good design and the best user experience (a subset of the consumer market) more than they value getting something cheap and good enough (the typical corporate customer). Develop a unique set of activities with great fit to deliver the best design and best user experience, and to generate the most customer loyalty. See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs." Products should be designed around specific jobs-to-be-done.

(2) Follow good design principles to keep products simple, useful, and affordable. A well-designed product is valued because it's kept simple and useful, without  features that detract from usefulness, which also helps keep the product affordable. See posts titled "Showcasing Design and Improving Affordability Through Design" and "Apple's Design Strength Prevents Overserving."

(3) Don't target customers who value cheap and good enough more than they value good design and the best user experience. If these customers end up buying the product (often when it fully matures), then that's fine, but don't make product choices based on these customers.

This post is based in part on recent articles by Ben Thompson and John Kirk. See Ben Thompson's "How Apple Creates Leverage, and the Future of Apple Pay" and John Kirk's "Apple's Design: The Gift That Keeps Giving (1 of 2)."

The author owns stock shares of Apple.

The Problem with Copying

Horace Dediu at asymco.com recently posted a great interview/article titled "What next, Samsung?" In the article Horace notes that "[t]he fast follower strategy belies its own limitations: it implies a transience or impermanence in strategy," and that "[i]n a fast following strategy it's only a matter of time before late followers eat into the business [of the fast follower], similar to the way that the fast follower ate into the innovator." When I read these kinds of brilliant insights, usually coming from Horace at asymco.com or Ben Thompson at stratechery.com or Benedict Evans at ben-evans.com, I honestly feel a rush. Anyway, it made me think of a couple more points, so here goes.

Horace's insight made me wonder whether the original product innovator sometimes has an advantage over the fast following copier. I think the answer is yes, as long as the original product innovator creates something through a unique set of activities with great fit and/or trade-offs (a la Apple, Southwest, and IKEA). See post titled "Acquisitions, Rivalry, and Strategic Trade-Offs." The original innovator may lose market share to the fast following copier, but an innovator with a unique strategy can survive competition from a fast follower much better than a fast follower without a unique strategy can survive competition from late followers.

A unique strategy also buys the original innovator time -- it allows the innovator to milk mature products for all they're worth, until technology advances permit the innovator to again push the technological envelope and create a new product that satisfies or solves an unmet job-to-be-done (often unmet because it was previously technologically impossible to solve). In this way a unique set of activities and a unique strategy allow original innovators to be in control of their own destiny.

Fast followers are focusing their internal resources, processes, and priorities on quickly matching another company's innovations, which buys them temporary but not long term success. Wouldn't it be better for companies to focus on unique activities and unique strategies, and on the development of internal resources, processes, and priorities that permit them to create, on a repeat basis, unique, trade-off based solutions to unmet jobs-to-be-done? See Concepts page and discussion of Clayton Christensen.

The author owns stock shares of Apple.

Acquisitions, Rivalry, and Strategic Trade-Offs

There have been a lot of acquisitions lately. Facebook is acquiring WhatsApp for $19 billion, and WhatsApp apparently received a multibillion dollar competitive offer from Google. Google is acquiring Nest for $3.2 billion.  In 2012 Facebook acquired Instagram for $1 billion and Google acquired Motorola for $12.5 billion; Google is now selling Motorola to Lenovo for $2.9 billion.  In 2010 Amazon acquired Diapers.com for $540 million, and in 2009 Amazon acquired Zappos for over $900 million.

The Facebook/WhatsApp acquisition seems motivated by Facebook's desire to: (1) grow its user base and market share; (2) eliminate WhatsApp as a potential rival and as a buying opportunity for competitors like Google; and (3) possibly experiment with WhatsApp's paid subscription business model. In one of his recent Critical Path podcasts (Critical Path #112), Horace Dediu at asymco.com noted that Facebook and Google may both be experimenting with different business models, trying to move away from reliance on ad revenues. This motivation may be behind Google's recent acquisition of Nest. Similar to the WhatsApp acquisition, many of Amazon's acquisitions appear motivated by the desire to grow market share and eliminate potential rivals.

So the question is, do these acquisitions make good business sense, at least based on the strategic writings of Clayton Christensen and Michael Porter? See Concepts page for discussion of Clayton Christensen and Michael Porter and list of sources.

What is Strategy?

Porter defines a strategy as a unique set of activities that fit well together, making it hard for competitors to duplicate. Duplication becomes more difficult as the number of activities increase -- matching one activity is obviously easier than matching several. See Concepts page for discussion of Michael Porter and list of Michael Porter sources.

Southwest Airlines, for example, tailors its activities around delivering low cost, quick turnaround, on-time flights to budget-conscious consumers, so it doesn't serve meals on planes, doesn't take advance seat reservations (thereby permitting quicker boarding), and tries to fly in and out of more cost-competitive secondary airports (such as Midway in Chicago). Southwest's activities are carefully chosen based on the target audience (the budget-conscious traveler), and these activities are all designed to fit well together and complement each other. As a result competitors have not been able to effectively match Southwest's strategy.

Southwest competitors that try to offer low cost flights while also offering premium, full service flights typically fail because they haven't crafted a unique set of activities aimed at one target audience. When a competing airline targets the high end traveler and the budget traveler, it ends up splitting the difference in terms of activities and fit. Porter calls these companies "straddlers." A straddler tries to address more than one target market at a time, often through inconsistent activities that don't fit well together. Companies like this are unwilling to make the trade-offs needed to create a tailored set of activities that squarely address the needs of a specific target market; straddlers often try to address the entire market, leading to a haphazard, unintegrated set of activities, poor fit, and no real strategy. For these reasons it's easier for new entrants to compete with a straddler than with a company that has a unique, hard to duplicate strategy comprised of many well-integrated activities.

So an airline straddler targeting budget travelers and high end business travelers might give up reserved seating, going for quicker boarding and faster turnarounds, but be unwilling to give up service to primary airports like Chicago O'Hare. The problem is that this kind of middling product/service often appeals to neither the budget traveler nor the high end traveler. And straddlers generally lack the focused execution of a company that's made meaningful trade-offs based on its target market and the activities it's crafted around that target market.

Porter's point is that a company needs to try and move toward a unique strategy, with carefully chosen, integrated activities that fit well together. And a unique strategy generally targets a specific market segment rather than trying to be all things to all people -- untargeted strategies usually result in poorly chosen activities and poor fit. This point dovetails with the following quote from Steve Jobs, from October, 2008:

"There are some customers we choose not to serve. We don’t know how to make a $500 computer that’s not a piece of junk, and our DNA will not let us ship that. But we can continue to deliver greater and greater value to those customers that we choose to serve. And there’s a lot of them. We’ve seen great success by focusing on certain segments of the market and not trying to be everything to everybody. So I think you can expect us to stick with that winning strategy and continue to try to add more and more value to those products in those customer bases we choose to serve."

Porter believes companies should compete to be unique rather than competing to be the best.  Competing to be the best generally leads to product one-upsmanship and head-to-head comparisons (often based on technical specifications), which ultimately leads to homogenous products and price-based competition (all of which hurts industry profitability). If companies in an industry instead compete to be unique, then more than one company can prosper and destructive rivalry can be avoided. And a unique, hard to duplicate strategy is the best protection against price-based competition.

Lastly, Porter believes organic growth is best achieved by deepening and strengthening a unique strategy over time. Acquisitions that strengthen a successful, unique strategy make sense. Acquisitions for the sake of market share growth do not, and often lead to unfocused straddling.

Porter's concepts of activity and fit are very similar to Christensen's idea of avoiding disruption (i.e., building a strong competitive barrier) by integrating to do a job perfectly. See post titled "Avoiding Disruption by Integrating Around a Job-to-be-Done." Apple has integrated around the job of technology that's always available and that anyone can use, and is always striving to do this job more perfectly. Southwest has integrated around the job of providing cheap, reliable air travel to budget-conscious consumers. IKEA has integrated around the idea of providing cheap, easy to assemble furniture to budget-conscious consumers. All these jobs are accomplished through carefully chosen, integrated activities that fit well together.

So when you see an acquisition, or you see a company trying to grow rapidly, a relevant question is whether the company is trying to integrate activities to more perfectly accomplish a job that needs done.

Integrating Around a Job that Needs Done and Shifts in the Basis of Competition

Christensen says that over time the basis of competition for a product or service tends to shift from making functionality and reliability "good enough," to making convenience, accessibility, ease of use, customization, and affordability good enough. See Concepts page and discussion of Clayton Christensen. This shift may occur quite rapidly for companies without a unique, integrated strategy designed around a job that needs done. Companies without a unique strategy can quickly find themselves forced to: (1) compete on price; and (2) make expensive acquisitions to eliminate rivals, expand market share, and hopefully achieve sustainable network effects.

Incumbent companies with a unique, integrated strategy that squarely addresses a job that needs done may be able to avoid the final shift to low end, price-based competition. That's because it's very hard for new entrants to duplicate (let alone surpass) the tightly integrated activities of a well-entrenched incumbent with a unique strategy. New entrants may also be unwilling to make the trade-offs needed to pursue a unique strategy that targets a specific market segment (e.g., Apple giving up the low end market, Southwest giving up first class business flyers, and IKEA giving up consumers who don't want to assemble their own furniture). A new entrant's unwillingness to make strategic trade-offs gives focused, integrated incumbents a competitive advantage/barrier.

When you don't have a unique, trade-off based strategy, you're effectively forced to compete based on market share, network effects, operational effectiveness, and price. And when a company competes for the entire market, and doesn't have an integrated set of activities that's hard to duplicate, every industry competitor looks like a threat. Price and operational effectiveness can be competitively matched over time (Porter notes that cost efficiency and economy of scale benefits go to zero past a certain point), so your only competitive defense ends up being a dominant market share and network effects. The pursuit of market share and network effects leads to expensive acquisitions, new and often unrelated product/service lines, and new business models, all designed to grow revenues and eliminate competitive threats. In this scenario, a company's revenues may grow dramatically while its profits stay small. That's because a company with rapidly growing revenues or a "dominant" market share, but no unique strategy, lacks pricing power and can still lose sales to: (1) other large, price-based competitors with roughly equivalent scale and operational effectiveness; and (2) more focused, specialized competitors that are tightly integrated around the perfect solution to a job that needs done.

Large companies with dominant market share -- but no unique set of activities integrated around a job that needs done -- can be "unbundled" by one or more focused competitors with a unique set of well-integrated activities that squarely address a job that needs done (usually for a specific market segment, such as the budget-conscious Southwest traveler). Consumers in the target market segment will prefer the unbundled product that perfectly addresses the job they need done (often in a more affordable way). And as Christensen notes, focused companies that are integrated around the perfect solution to a job that needs done can avoid low end or new market disruption. See post titled "Avoiding Disruption by Integrating Around a Job-to-be-Done." 

Acquisition Fever

Google's unique strategy is effectively the algorithm for Google search, which has led to a successful advertising-based profit model. Google may now be moving away from this unique strategy, trying to match Apple's hardware-based profit model. To the extent Google tried to do this with Motorola, it clearly failed, selling Motorola to Lenovo at a substantial loss. Google appears to be making a second effort with Nest. The difficulty here is that Google has to duplicate (and probably surpass) the activities and fit of well-entrenched incumbents in order to succeed. If Google pursues a business model based on profitable computing hardware, it will have to match thousands of well-integrated activities already in place at hardware companies like Apple and Samsung. And as the number of activities increases, the likelihood of successful duplication decreases. The hardware business is also capital intensive, meaning that mistakes in this area are costly.

A hardware-based profit model also presents Google with a straddling problem. On one hand Google probably wants to use its hardware to collect user data, permitting better ad targeting on behalf of Google's advertising customers. On the other hand Google probably wants to preserve user privacy and minimize ads to enhance the hardware purchaser's experience, thereby boosting profitable hardware sales. If Google tries to sell ads at the same time it sells profitable hardware, it will be forced to serve two target markets at once (advertisers and hardware purchasers), resulting in compromised activity choices and poor fit across activities.

Facebook also depends on an ad-based revenue model, but it lacks Google's unique search algorithm. Facebook's acquisitions of WhatsApp and Instagram seem motivated by the quest for market share, network effects, and the elimination of potential rivals (including rival purchases by competitors like Google and Yahoo). These acquisitions don't seem to enhance or deepen a unique set of hard to match activities. Customers already have multiple messaging alternatives to WhatsApp, including Line, WeChat, iMessage, and traditional SMS services. And it's easy to switch among free messaging services -- users just give the service their contact information and then tap the correct app icon. Photo app alternatives to Instagram are also abundant.

To the extent Facebook is trying to move away from an ad-based model toward a subscription model (like the one used by WhatsApp), it has the same straddling problem as Google. On one hand Facebook wants to collect data and target ads for its advertising customers, which degrades user privacy and the user experience. On the other hand it wants to experiment with and possibly use subscriptions. Subscriptions enhance user privacy and the user experience but may antagonize Facebook's advertising customers.

And lastly, Amazon's acquisitions and rapid revenue growth seem driven by a quest for market domination and the elimination of potential rivals, hence the deals with Zappos and Diapers.com. Amazon is extremely cost efficient, and operates at tremendous scale, but as Porter notes the benefits of scale and operational effectiveness go to zero past a certain point. Operational effectiveness, massive scale, and the apparent pursuit of monopoly power don't constitute a unique strategy, and it's hard to discern what Amazon's unique set of well-integrated activities is. There don't seem to be any trade-offs based on a target market and the integrated activities needed to do a perfect job for this market. That's probably because Amazon is pursuing the entire retail market. The problem is that e-commerce has few barriers to entry, and Amazon still has a number of very large competitors, including: Wal-Mart, Sam's Club, Costco, Target, eBay, and Alibaba. All these companies offer a high quality e-commerce experience. Amazon's online experience may be a little better in certain cases, but this just comes down to operational effectiveness, and competitors typically catch up in this area. Amazon must also deal with more focused, integrated retail competitors who are trying to perfectly address a job that needs done for a specific target market.

Amazon's large competitors, as well as more focused, integrated competitors, limit Amazon's pricing power. Amazon can continue growing top-line revenues through acquisitions and new product/service lines, but bottom-line profit growth may be another matter.

Organic Growth and the Right Kind of Acquisition

So what kind of growth, and what kind of acquisition, makes sense? Blending the views of Porter and Christensen, a company should strive for organic growth by deepening integration and fit across carefully chosen activities, resulting in a more perfect solution to a job that needs done. Apple, for example, is focused on integrated activities to perfectly accomplish the job of always available technology that anyone can use. So good acquisitions enhance an integrated, perfect solution to this job. Apple's acquisitions of FingerWorks (multitouch control), AuthenTec (fingerprint security), and Embark (public transit mapping), all enhance product integration and make the technology easier to use. Good talent "acquisitions" for Apple might be people who can help it create and fashion new, integrated devices that are always available and easy to use. Every time Apple creates a new device that integrates into its existing device ecosystem, it strengthens the benefits of its unique, integrated strategy.

And when a market saturates, what should a company with a unique, robust strategy do? Porter says it should try and implement its strategy on a global basis. See Concepts page for discussion of Michael Porter and list of Michael Porter sources. Looking again at Apple, that's exactly what it's doing: (1) expanding into China, Brazil, and other large population areas with the necessary broadband infrastructure; (2) avoiding the low end and price-based competition; and (3) continuing to make technology that's always available and that anyone can use.

The author owns stock shares of Apple.