Wednesday, April 26, 2006

Inflexible Enterprises versus Management a la Google

I’d like to highlight a couple of recent noteworthy items that I believe all of us should be thinking about as we assess our investments.

So often, as value investors we get caught up in the purely quantitative aspects of our investments. Our focus in finding companies that generate large amounts of free cash flow can draw us into businesses that are not re-investing in themselves.

My own drawn out experience with Reebok years ago is a great example of a business that became heavily driven by the financial engineering aspects of buying back stock but in doing so, completely lost its focus on its operations and its innovation. As the CEO of Adidas observed in his recent New York meeting, Paul Fireman (founder and former CEO of Reebok) had built a great business that had its origin in innovation (women’s aerobic sneakers and the Pump) yet for some years, failed to capitalize on these innovations, or completely dropped them from the product line.

I highly recommend Geoff Gannon’s blog regularly, but in yesterday’s post On Inflexible Enterprises, he has done a particularly outstanding job. He highlights the mistakes that companies make in entangling themselves in the past. As Geoff points out, businesses do put down roots. Xerox clearly did everything it could to be innovative, having developed all kinds of intellectual property. Yet these innovations were relegated to sideshow status, largely because innovation would distract from what management believed to be the core business of photo-copying equipment. Yet, for some years Xerox created the illusion of being a decent business as it had reasonably high free cash flows that it utilized ineffectively to develop these innovations and also had decent returns on invested capital. The gee-whiz moment for me fortunately occurred as I realized that the number of competitors that were piling into office equipment was very high, the cost of entry seemed low, and ultimately the quality of product and service was similar. This was becoming a commodity business, but it was living on the lure of its brand and its past.

A franchise is more than a brand…franchises have the ability to redeploy their capital by investing in the business. That’s where Berkshire Hathaway franchises have generally shown their mettle. When they can no longer find that opportunity within their franchise, management focuses on the generation of cash flow to feed the businesses that can deploy capital effectively.

There is a terrific article in this morning’s WSJ by Gary Hamel of the London Business School, entitled management a la Google:

WSJ-Management a la Google (subscription required)

Don’t misinterpret me…I do not consider Google to be a value stock, but it is a masterful management. As Hamel points out, “While Google’s growth will inevitably slow, there’s a good chance that its revenues will arc upward for years. Why? Because its novel management system seems to have been designed to guard against the risk factors that so often erode an organization’s evolutionary potential.”

He highlights four evolutionary risk factors:

  1. A narrow or orthodox business definition that limits the scope of innovation.

  2. A hierarchical organization that over weights the views of those who have a stake in perpetuating the status quo.

  3. A tendency to over-invest in “What is” at the expense of “what could be.”

  4. Creeping mediocrity.

Sleepy, tired traditional businesses have often been the fodder of value investors but unfortunately, may turn into value traps. Look at the innovation of the BBC, which no longer regards itself as primarily a producer of television and radio. Contrast that with some of the media companies that we may own.

Charlie Munger’s thinking helped Buffett develop Berkshire Hathaway into a developer and owner of fabulous brands and franchises. Businesses that can innovate in order to make their franchise immutable are stronger than businesses that maintain status quo.

Managements that find ways to strengthen their relationships with their customers by using innovation, that avoid what Buffett refers to as the "Institutional Imperative" or maintaining status quo are businesses that intrigue me. Buy them at reasonably attractive prices and let the returns compound. This is the essence of today's value investing in my view.

Disclaimer: I, my family, and clients have a position in Berkshire Hathaway.


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