Focusing on the Long View and Jobs-to-be-Done

I just watched two excellent YouTube videos of lectures given by Clayton Christensen in June, 2013 at Oxford University. One of the lectures addresses key management issues/problems and one addresses the need for companies to continue investing in disruptive innovations instead of just efficiency innovations. Below are the key points from these two lectures:

  1. Disruptive innovations are the real long term drivers of growth and employment, but often look unattractive in the short term due to uncertain returns and the CapEx and new fixed assets they require, which can hurt short term profitability measures like gross margin %, return on net assets, return on capital employed, and IRR. The problem is that disruptive innovations may take five to ten years to start providing attractive returns, while management is being judged on the next quarter or the next year. For this reason management tends to favor investments in efficiency innovations, which can quickly improve short term profitability measures but which do little for the prosperity of a company going five to ten years out. Continued, repeated investment in efficiency innovations, without sufficient investment in disruptive innovations, leads to declining growth and employment, sometimes at both a company level and a country-wide level (a la Japan).
  2. The cause of the Innovator's Dilemma, whereby incumbents flee upmarket and eventually get driven out of business by new entrants, is the pursuit of profit (often reflected by the short term pursuit of a higher/target gross margin %). Christensen suggests companies give additional weight to net profit margin %, since high volumes of lower end products can be attractive on a net margin basis if they help absorb fixed overhead costs. 
  3. Management tends to game profitability measures like financial ratios. For this reason "the key is to measure profitability in ways that cause people to do good things." Businesses need to search for profitability measures that cause them to do good things
  4. Market segmentation is often done through an arbitrary classification like product category or customer demographic or geographic region. These classifications then have an outsized, damaging impact on every decision the company makes, whether it's determining who to compete against, what products and market opportunities to pursue, or how the company measures success. Arbitrary market segmentation can have a large, negative impact on what the company chooses to focus on. 
  5. The alternative way for a company to segment the market and focus its efforts is to analyze the job-to-be-done. To understand what causes a purchase decision, you have to understand what job the customer is trying to get done. Don't focus on the customer or the product category in segmenting or analyzing the market -- focus on the job-to-be-done.
  6. Once you understand the job-to-be-done performed by a product, then it becomes very clear how to improve the product (which helps prevent meaningless improvements that overserve). 
  7. A company first has to understand the job-to-be-done (including the job's functional, emotional, and social elements). It then has to determine what experiences must be delivered to satisfy this job, and what services, processes, and systems should be integrated to make these experiences happen.
  8. Companies that focus, organize, and integrate around a job-to-be-done historically have no competitors -- other companies may sell the same products or services, but they typically can't compete with an integrated, end-to-end user experience that solves a job perfectly
  9. Companies must make a conscious decision about what to focus on, ideally based around the job-to-be-done. 
  10. The job itself typically doesn't change much over time, while the means of accomplishing the job may change dramatically. Over the centuries, one such job has been fast and certain delivery of a package from point A to point B. At first the hired solution for this job was delivery by horseback, followed by train delivery, followed by airplane delivery, followed by FedEx. The job stayed the same but the hired solution changed dramatically.   
  11. Because the job-to-be-done tends to stay stable over time, companies that focus on the job are in a good position to see what's coming next and be ready for the next better solution. Companies that focus on an irrelevant, arbitrary unit of market analysis -- like the product category or the customer -- have difficulty seeing what new, better job solutions are coming and are more likely to be surprised/disrupted.
  12. Business models and businesses converge when people need different products/services at the same point in time and space. People need gasoline at the same time they need a snack or junk food, so convenience marts have merged with gas stations. 
  13. Conversely, one business model or business will diverge into two when people need the offered products/services at different points in time and space. Wal-Mart electronics merchandise is also sold by a specialized retailer like Best Buy, while Wal-Mart hardware merchandise is also sold by a specialized retailer like Home Depot. Best Buy does the most business on holidays and birthdays, which is its unique point in time and space, while Home Depot does the most business on weekends, which is its unique point in time and space.

Investing 101 and "Cheap is Good Enough"

The quote “cheap is good enough” comes from a very successful value investor named Walter Schloss. Schloss, along with Warren Buffett, formerly worked for Benjamin Graham, the father of value investing. Graham believed that if you always held low PE stocks with conservative balance sheets, ideally trading close to tangible book value (the balance sheet value of the hard assets, less total debt and preferred stock), then you would do pretty well as an investor. See Concepts page and discussion of Benjamin Graham. High PE stocks aren't cheap relative to trailing earnings. The danger of a high PE stock is that anticipated earnings growth won’t materialize and the stock will tank.

The danger of a low PE stock is that earnings will disappear, the company will go out of business, and the stock will tank (also known as a “falling knife”). Graham tried to address this risk by investing in low debt companies with strong working capital positions — i.e., companies with low credit risk and plenty of money to pay the bills. He also dealt with it by looking for companies trading at or below tangible book value, which gives some downside protection in the event of liquidation. Warren Buffett deals with downside risk by looking for companies with great brands, wide competitive moats or barriers, and highly predictable future cash flows, like Coca-Cola. See Concepts page and discussion of Benjamin Graham and Warren Buffett.

So which of these approaches makes more sense?

Scenario One

A company with a high trailing PE, say 30, is like a guy coming to you and saying, “my business earned $1,000,000 last year, but it’s growing like crazy and should continue to do so, so I’d like you to pay $30,000,000 for it.” As an investor, you should ask whether you’d really be interested in this kind of deal. The initial earnings yield in this scenario is 3.33% (1/30), slightly above the 2.47% yield currently available from risk free 30 year Treasury bonds.

Scenario Two

A company with a low trailing PE, say 10, is like someone coming to you and saying, “my business earned $1,000,000 last year and I’ll sell it to you for $10,000,000.” With an earnings yield of 10% (1/10), well above the risk free Treasury rate, you might be interested. But you’d also want to know if the company is going to be around for a while, so you’d look at whether earnings are growing, flat, or declining, whether earnings are steady and predictable, whether the company has plenty of cash to pay bills, whether there’s a lot of debt to pay down or very little, and what the hard assets of the company are worth after subtracting total debt.

You probably wouldn’t be interested in a company with declining earnings, unless you felt the situation was temporary or the company’s tangible book value was well above the asking price (suggesting you could make a profit by liquidating the hard assets and paying off the debt; this would have to be verified by estimating the fair market value of the hard assets, instead of just relying on the assets’ stated book value). If the company’s earnings were flat or growing, and relatively predictable, you might be interested, since your undiscounted payback period (the time it takes to recoup your initial $10,000,000 investment) would be around 10 years.

To summarize, a Scenario Two company typically has: (1) an unleveraged, low debt balance sheet; (2) a strong working capital position; (3) steady and hopefully growing earnings; and (4) a low price relative to earnings. Investors who are fans of Graham, Schloss, and Buffett generally prefer this type of investment. They’re unwilling to pay a big premium for earnings growth, because high growth rates frequently disappear (often unexpectedly) as competition increases and markets saturate. And it's better if a Scenario Two company isn't facing a low end or new market disruption, a la Clayton Christensen. See Concepts page and discussion of Benjamin Graham, Warren Buffett, and Clayton Christensen.

Low end or new market disruption is often the reason low PE companies go out of business. Amazon has disrupted thousands of brick and mortar retail businesses through new market disruption. Brick and mortar retailers have difficulty matching Amazon’s online, low cost business model. Leveraging its low cost model, Amazon has helped create a vast new market of online consumers who shop at their computer (the new context/situation) instead of shopping at a brick and mortar store. See Concepts page and discussion of Clayton Christensen.

Amazon currently has no meaningful trailing PE, because its EPS for the past 12 reported months is negative. Its forward PE based on estimated earnings for the next 12 reported months is 333, making it a Scenario One stock. Amazon investors seem to believe the company can deliver higher future earnings with no material, concurrent impact on its sales, growth, and ability to compete with other low margin retailers like Wal-Mart, Costco, Sam’s Club, eBay, Target, Alibaba, and Google Express. Applying Michael Porter's five forces, retail industry profits are constantly pressured by: (1) high rivalry (lots of competing retailers doing the same thing -- reselling goods made by others); (2) high buyer power (buyers with lots of information and the ability to comparison shop); and (3) a high threat of new entrants (it's easy to start an online store or brick and mortar store). See Concepts page and discussion of Michael Porter.

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