Strategic Planning Analogy #551: You Only Sell it Once

THE STORY
Let’s assume that Bob sells his house for $100,000. A few days later, the person Bob sold it to resells the house for $200,000. Then, a few days after that, the newest buyer resells Bob’s former house for $300,000.

Bob gets excited and thinks, “Wow! That house is more valuable than I thought.” So he re-buys his former house for $400,000.

So, in the end, he’s back in his same house as before, but $300,000 poorer. Yet he is happy because now he feels like he is living in a more valuable house than before.

THE ANALOGY
In the story, Bob is happy when the price of his former house keeps going up. But why is he happy? After all, he did not gain any benefits from the price rising. He still only had his $100,000.

In fact, he should have been angry, because he sold out too low and should have asked for a higher price when he sold it. The resellers got the money which could have been his.

And then he re-buys the house and is happy to pay $400,000 for it. Buy why is he happy to be where he started only poorer?

Buying and selling houses is a lot like buying and selling stock. Let’s change the story so that Bob is a company doing an initial public offering (IPO) rather than selling a house. Let’s say the company plans to issue 1 million shares at $100 per share. So, on the day of the IPO (when the stock is first issued to the public), the company earns $100 million.

A few days later, the people who bought that stock for $100 a share resell it for $200 a share. Then, the people who bought it at $200 a share resell it a few days later for $300 a share. The company is so excited that it buys back the shares at $400 per share.

So now, the company is right back where it started, except that it has $300 million less than it did before the IPO. But it is happy, because the company is valued higher than before.

Although not as dramatic as in the story, this type of behavior goes on all the time in business. The company is happy if the stock price goes way up after an IPO, even though the company never sees any of that gain (and missed out on pocketing some of that gain for the company). And then later, the company is happy to do a share buyback, paying more for the shares than their original price.

What’s going on here?

THE PRINCIPLE
The principle here is that once a company sells its stock, most of the benefits/risks of the future price fluctuations go to someone other than the company. In general, the company’s cash flow is not impacted much by what happens to the stock price after it leaves the company’s hands.

When the stock price goes up, the company may feel wealthier, but where is the immediate impact on cash flow? It hasn’t changed. The only one who gained was the second party selling to the third party.

Therefore, strategy should be more concerned with actions that meaningfully impact the cash flow than merely focusing on every little tick of the stock market price.

One Way Relationship

In general, if you pursue a strategy which raises the company’s cash flow with costs below the cost of capital, the company is stronger for the long term and the stock price goes up. But the reverse is not always true. If you play games and tricks to boost the stock price, cash flow does not necessarily increase and the company’s long-term prospects may be worse.

Take, for example, the idea of borrowing money to buy back stock. This typically results in less cash flow, a weaker balance sheet, and less freedom to pursue long-term growth strategies. That doesn’t sound good for the company.

So, why do them? Who benefits from those types of buybacks? It’s the people who bought the stock many transactions past the IPO and did not contribute anything directly to the company in terms of cash flow. Just as Bob got no benefit from the second and third buyer of his house, companies get no benefit from the second and third buyers of their stock. So why pursue strategies that hurt the company and only benefit these people who contributed nothing to funding the business?

The IPO Swindle

And then there is the IPO. Companies set them artificially low and get excited when the stock jumps in the following days. Why are the companies so excited? Just as Bob got no financial benefit when his house kept reselling for higher and higher prices, companies get no cash when subsequent trades raise the stock price.

In fact, the company has a greater justification to be upset when the price jumps a lot after an IPO, because that means they didn’t get as much cash from selling the stock as they could have in the original IPO. The only ones who benefit from the rapid post-IPO rise are the investment bankers and the stock re-sellers. The company is no wealthier.

Years ago, I worked on an IPO. When the investment bankers showed me their suggested IPO price, I almost choked on the numbers. It was far, far, lower than the value produced by my fancy spreadsheets. I told them we could go a lot higher and still leave room for the initial investors to have gains.

The investment bankers tried to intimidate me with academic papers full of arcane words and long formulas which they said “proved” that the price needed to be so low. But those papers had nothing to do with the issue at hand and they did not intimidate me, so I kept fighting for a higher price. I lost the argument.

After the IPO, the price jumped a lot. If the company had listened to me and used my suggested price, they would have gotten a lot more money and the initial investors would still have seen a gain.

We all know that the primary reason the investment bankers wanted a low price had nothing to do with those academic papers. It was because the investment bankers (and their investing clients) personally had more to gain if the price started out low. If the investment banker can get a company to do an IPO at a lower price, then they pocket some of that gap rather than the company.

Excuse me, but don’t the investment bankers work for the company? The company does not work for the investment bankers. The company needs to look out for its own interests first, not those of the investment banker.

I was so happy when Mark Zuckerberg fought to get such a high price for the Facebook IPO. Zuckerberg made sure that Facebook got the highest benefit from the IPO, not the subsequent traders or the investment bankers.

Where to Point the Strategy

So given all that was said above, it appears that strategic efforts should not be laser focused only on stock prices. Your business mission should not be “to create the highest possible stock price.” Yes, higher stock prices may benefit someone, but it is not always the company which benefits. Why focus on a strategy which primarily benefits people who contributed nothing to the cash position of the company?

Instead, the strategy should be looking at ways to improve the performance of the business model. If you do that, then pretty much all stakeholders benefit, including (and especially) the company.

This is consistent with the thinking of Warren Buffett and his company Berkshire Hathaway. They don’t try to make their money on constant trading and stock price manipulations. They just try to run good businesses for the long haul. The businesses benefit, and because the businesses are better, the shareholders benefit.

Yes, this is a rather simplistic argument. There are many nuances which go deeper than allowed in the space of a blog. But I still stand by the primary direction of this line of reasoning.

SUMMARY
When a company’s stock goes up and down, the primary loser/gainer is not the company. After all, the company got its money when the stock was first issued at the IPO. That amount does not change based on subsequent trading. Consequently, strategies which only seek to raise stock prices (at any cost) may not necessarily benefit the company (and its long-term viability in producing a cash flow). Therefore, the preferred approach would be to create a strategy which seeks to improve that long-term viability to create a cash flow. That would provide a greater likelihood that not only does the stock go up, but the company benefits as well.

FINAL THOUGHTS
The biggest risk to putting the company first is that there are activist investors out there who want to put themselves first and will intervene to do so. To keep the activist investors at bay, you may need to give a little. Just don’t give in. Better yet, if you focus on running your businesses as well as Berkshire Hathaway, then the activists will have little opportunity to intervene.

Strategic Planning Analogy #527: Wedding Ring Blues

THE STORY
I got married right out of college. Since I was just a poor college student, I didn’t have a lot of money to spend on a wedding ring.

The man at the jewelry store could tell that I was a bit nervous about the big purchase and tried to ease my mind. He told me that they had a lifetime buyback guarantee. If, at any time, I wanted to return the wedding ring, I could do so—no questions asked—and get my money back.

That sounded too good to be true, so I asked a few questions. As it turns out, there was a loophole in his guarantee. I was buying the wedding ring from him at the retail price. I would be selling it back to him at the wholesale price.  That sounded like a bad deal to me.

The salesman reassured me that it was not such a bad deal. After all, wedding rings have been going up in value for centuries. If, years later, I decided to sell the ring back to him, it may have appreciated enough in value to have a wholesale price higher than the retail price I paid for it.

Maybe so, but it still sounded like this was a much better deal for the jeweler than it was for me.

THE ANALOGY
Buying that wedding ring was my first real experience dealing with the spread between retail prices and wholesale prices. As an average consumer, that spread did not seem to be in my favor. If I’m always buying at retail and selling at wholesaling, it is extremely difficult to get ahead.

There has to be quite a bit of appreciation in value to compensate me for that spread. And even then, the broker of the deal benefits more from the appreciation than I do. It doesn’t sound like a good business plan for me. And it probably doesn’t sound like a good business plan to you.

Yet business strategies often fall into the same trap. We end up with strategies which “buy at retail” and “sell at wholesale”.

Take manufacturing…you buy your raw materials at retail prices and sell your finished product to a distributor at wholesale prices.

What if you’re a web site whose profits are based on advertising? The ones advertising on your site may be paying retail advertising prices, but all you get to pocket are the wholesale prices because the advertising broker gets the markup.

What about M&A activity…you pay a hefty acquisition premium over current value to buy the asset (sort of like a retail markup), but when you get it, all you have is the core business (as is) which was valued well below your premium (sort of like the wholesale price). It’s going to take a whole lot of asset appreciation to cover that spread.

And if you want to dump a troubled asset that doesn’t work for you, others will know you are dumping and it becomes a “fire sale”, where people pay you less than you think it is worth (like selling a wholesale price).

And even if you have a desirable asset you can sell at a premium, it seems like the investment bankers and lawyers are the ones who rake in all the cash. The brokers of the deal get a much better return on the sale than you do.

So maybe business strategies aren’t all that different from my early experience with that jeweler after all.

THE PRINCIPLE
The principle here is that the wholesale-retail spread is a reality. Depending on how you build your strategy, you have that spread either work for you or against you. We’ll look at three strategic angles to minimize the negative or accentuate the positive aspects of the spread.

1) Creating Value Vs. Waiting for Value

There are two ways to attempt to profit from assets. The first way is by trading the assets (buying and selling). This method only works if you are successful at buying low and selling high. But as we’ve seen, trading assets often works in reverse (buying high at retail and selling low at wholesale). And usually there is some kind of broker or middleman in the transactions who gets a cut of the money when you buy and when you sell. Therefore, your only hope is that prices for the asset will greatly appreciate to cover these spreads.

The second way to profit from assets is to hold them and use them to create value. In this second way, the primary value comes not from selling the asset, but by selling what the asset produces, year after year after year.

Over the decades, Warren Buffett has been telling the world that the second method (hold and create) is a far superior path to profits than the first (buy and trade).  Hold and create is what had made Warren Buffet so wealthy. He regularly earns money from these companies by what they do, rather than what he can trade them for. By avoiding the churn of trading, he avoids dealing with the wholesale-retail spread found in trades and avoids paying out all the money to the brokers who facilitate all the trades. He explains it well beginning on page 18 of his 2005Berkshire Hathaway shareholder letter.

So building a strategy like Berkshire Hathaway (Buy-Hold-Create) is one way to avoid the mess of the wholesale-retail spread.

2) Own the Supply Chain

As I mentioned earlier, the supply chain creates an adverse wholesale-retail spread. You buy things upstream in the supply chain at retail and sell things downstream in the supply chain at wholesale. This can be disadvantageous. One way to get around this is by owning a larger share of the supply chain.

Take the fashion world, for example. Nearly every fashion brand owns a portion of its downstream retail channel, with company-owned stores. Why? It helps them better control pricing at retail and wholesale, which helps keep the brand value from deteriorating. It also helps the fashion brand capture a higher portion of the value of the brand whether it occurs at the brand level or the store level. When the brand sells to its own stores, it doesn’t get cheated by the wholesale-retail spread because it owns the whole transaction.

Similarly, most fashion retailers have gone upstream and own a meaningful proportion of the brands sold in their stores (called controlled brands, or private label). Retailers like Macy’s and Kohl’s own more than 40% of the fashion brands they sell. Why? By going upstream they can capture more of the value of the product without it getting lost in the transaction between brand owner and retailer. They get everything across the spread because they own both ends.

This is not to say that vertical integration is without risk. I talk about those risks here. But at least if you vertically integrate, you have greater control over pricing and are less likely to be on the losing side of the spread.

3) Be the Broker

One of my favorite movies is Trading Places, a comedy about commodity brokers. Here is a quote from the movie:

Randolph Duke: We are 'commodities brokers', William. Now, what are commodities? Commodities are agricultural products... like coffee that you had for breakfast... wheat, which is used to make bread... pork bellies, which is used to make bacon, which you might find in a 'bacon and lettuce and tomato' sandwich. And then there are other commodities, like frozen orange juice... and GOLD. Though, of course, gold doesn't grow on trees like oranges.

Randolph Duke: Clear so far?

Billy Ray: [nodding, smiling] Yeah.

Randolph Duke: Good, William! Now, some of our clients are speculating that the price of gold will rise in the future. And we have other clients who are speculating that the price of gold will fall. They place their orders with us, and we buy or sell their gold for them.

Mortimer Duke: Tell him the good part.

Randolph Duke: The good part, William, is that, no matter whether our clients make money or lose money, Duke & Duke get the commissions.

Mortimer Duke: Well? What do you think, Valentine?

Billy Ray: Sounds to me like you guys a couple of bookies.

Randolph Duke: [chuckling, patting Billy Ray on the back] I told you he'd understand.

Brokers get their money regardless of the fortunes of those around them. They take their cut from the spread which is there for both good deals and bad. Therefore, if you want to get the spread to work for you, then you have to become more like the broker.

Look at Google. The company appears to make a lot of money from doing a lot of things. But when you boil it down, Google is basically an advertising broker. Pretty much everything else they do is vertical integration into the places where they can control the brokering of ads. Google search is a place for brokering of search ads. Android is a place for brokering of smartphone ads. Driverless cars are a place where the former driver can now look at ads rather than look at the road.

Google avoids a lot of the wholesale-retail spread by owning the company that brokers the ads. The spread goes into the broker’s pocket. Then, by also owning the place where a lot of those ads appear, they cut out the spread between them as well. Google profits from the spread rather than losing to it.

SUMMARY
Although we like the idea of buying low and selling high, we are often forced to buy high and sell low due to the wholesale-retail price spread and the use of brokers. There are three strategies you can use minimize these disadvantages. First, you can use a buy-hold-create approach rather than a buy-trade approach to your assets. Second, you can vertically integrate. Third you can become the broker in the transactions.

FINAL THOUGHTS
I did a buy and hold on that wedding ring. My wife and I are still married after more than 35 years.

Strategic Planning Analogy #521: Abdication

THE STORY
There’s an old science tricks kids love. First, you take a glass bottle and put a lit piece of paper in it. Then you place a peeled hard-boiled egg on top of the bottle.

Eventually, the flame will go out on the paper in the bottle. Shortly thereafter, the egg will get sucked into the bottle.

The kids are amazed because the mouth of the bottle is so much smaller than the egg. They can’t push the egg through the hole, so how did it get in there?

THE ANALOGY
The science experiment works on the principle of air pressure. The flame on the piece of paper uses up the oxygen in the bottle. This causes the air pressure in the bottle to be so low in comparison to the air pressure outside the bottle that the vacuum inside sucks the egg into bottle.

Businesses seem to be creating a vacuum as well. It is caused by not spending enough time working on strategy. The lack of strategy effort creates a “strategy vacuum” within the business. This vacuum then sucks in strategic alternatives offered from the outside. Like the egg that doesn’t fit but still finds a way in, alternative strategies from the outside often do not fit the company, yet still find a way in.

And then you are stuck with a strategy that doesn’t belong and hard to get rid of, like that egg in the bottle.  

THE PRINCIPLE
The principle here has to do with abdication. If you abdicate your responsibility for developing and implementing a strategy, someone from the outside will fill the vacuum and supply a strategy for you. Sometimes it will come from an activist investor like Carl Icahn, Bill Ackman or Nelson Peltz. Sometimes it will come from another company which starts a hostile acquisition of your firm. Other times, a big private equity firm will decide to step in and make a lot of changes. Or maybe your debt holders step in with a strategy if your strategy vacuum causes you to break your debt covenants.

Many times their strategic suggestions make about as much sense to you as having an egg trapped in a bottle. But there it is…that egg is in the bottle anyway. And with these outside strategists, once they start filling your strategic vacuum, they are hard to get rid of—like that egg. And now you suffer the consequences.

Narrow Perspective

So what’s wrong with getting strategic help from outsiders? Isn’t help a good thing?

The problem is that these outsiders tend to be more interested in what is best for them than what is best long-term for the business. Occasionally, what they perceive as best for the outsider is also best for the company long-term. But in most cases, it is not.

For example, activist investors and private equity funds are usually looking for a very quick way to take a lot more money out of a business than they put in. All that money they take out has to come from somewhere. Often, it comes out of the balance sheet. They suck out the cash and fill the balance sheet with tons of debt.

Then the outsiders leave with their cash and you are stuck trying to move the company forward with all the debt. Rarely is a company’s strategic position improved when overburdened with high risk debt.

Remember, all that cash the outsiders suck out had to come from somewhere, and the cash they take out is cash no longer available to invest in a strategy for the future (once the outsiders leave). Yes, the company may temporarily get a bump in its stock price during the outside intervention. But once the dust settles, the price usually falls back (and then some).

And the debt holders tend to be even worse. They really don’t want to run the business and don’t care that much if the business continues to run. They are not even necessarily looking for a big profit. They just want to find enough cash to settle what’s owed them. This can lead to selling off and liquidating whatever is salable, no matter what the strategic implications. The result is that the company is often left as a hollow shell of only the properties that were difficult to sell because they aren’t worth much. How’s that for a strategy?

Just ask TWA how that type of dismantling worked for them. Oh, that’s right. You can’t ask them because they no longer exist.

Who is the Customer?

These outsiders also have a different opinion about who the customer is. For example, activist investors see themselves as the company’s customer—the one the company should focus on pleasing.

Private equity funds tend to see the next investor in the company (the one the private equity fund wants to eventually sell its equity to when it leaves) as the customer. They dress the company up for resale rather than invest in strategic projects with long paybacks. These private investors are like the people who “flip” houses for a living. They buy distressed homes and fix up only the cosmetic things most pleasing to the next one to buy the home—their customer—and ignore the structural issues.

The bankers tend to see the customer as whoever will take an asset off their hands and put money in their pocket.

As you can see, most outsiders never give much attention to the customer of the on-going business strategy—the one buying the goods and services being offered by the business model. I don’t see how ignoring or downplaying this customer improves one’s strategy.

Solution

So what is the solution? How do we keep these bad eggs from getting sucked into our bottle? How do we keep good strategies in place? There are three things one can do.

First, don’t abdicate your responsibility for designing and executing a great strategy. If you don’t create a strategy vacuum, then those eggs can’t be sucked in. Make having a great strategy a high priority. That way, you will be so successful that outsiders will be hard pressed to find excuses for why your strategy should be replaced with theirs. Even if you don’t like doing strategy, think of it as the lesser of two evils when compared to outside intervention.

Second, target the right partners. Not all investors are created equal. Some want a quick grab and run. Others want to be associated with enduring companies over the long term. Seek out the second type and court them. Make them your primary investor.

It can be done. There are people like Warren Buffett who invest for the long term. Amazon has cultivated an investor base which is willing to forego near-term profit bursts and instead prefer a longer-term strategic perspective. If you surround yourself with partners who want your long-term strategy to win, then they are less likely to try to replace your strategy.

Third, if you are a professional strategist, perhaps you should consider spending more time working with these outside private equity people. After all, if companies are willing to abdicate their responsibility for strategy and let it fall into the hands of outsiders, then the best way to influence strategy is by working with the outsiders.

One of the largest sources of income in my strategy consulting practice comes from the private equity sector. They often seem more interested in talking strategy than the companies. I try to help them see the bigger picture better. My desire is to help them see that they are better off if they help build enduring businesses rather than just grab and go.

SUMMARY
If a company abdicates its responsibility for strategy then an outsider will step in and provide one. In most cases, you will not like the strategy imposed upon you. Therefore, keep them out by doing it right in first place.

FINAL THOUGHTS
There’s an old saying that “Nature Abhors a Vacuum.” You should, too, especially when it comes to strategy.

Strategic Planning Analogy #510: Overcoming the Spread

THE STORY
Awhile back I was trying to help my mother liquidate some of her assets. One of the things she had was a collection of old coins. I went to a dealer in coins to find out what they were worth.

I was shocked by the spread between the wholesale price (the price the dealer pays to acquire my mother’s coins) and the retail price (the price the dealer charges when he resells the coins). I felt like I was being cheated.

It looked to me like collectable hobbies were a big rip-off. You are stuck buying at retail (high) and reselling at wholesale (low). Even if your collection appreciates in value, you may never see any of that gain because it gets lost in the spread between buying high (retail) and selling low (wholesale).

If you advocated dealing in the stock market in that same way (buy high, sell low), you’d be seen as crazy. But collectable hobbyists do it all the time. I guess that’s why it’s called a hobby instead of a business.

THE ANALOGY
In the business world, there are essentially three ways to make money. One is to be like a collectable hobbyist. You trade in assets (like coins) which you hope will appreciate in value, so that you can resell them at a profit. We’ll call that the “Appreciation” strategy. The appreciation strategy includes a lot of the business approaches used by those who do a lot of M&A activity, private equity funds, and stock traders.

The second way to make money is by being like that coin dealer. You make money by helping people using the Appreciation strategy make their transactions. Your profits come from the spread between retail and wholesale. We’ll call this the “Mediator” strategy. It is the approach used by brokers, agents, investment bankers and retailers, among others.

The third way is to make money by adding a new element of value that wasn’t there before. We’ll call this the “Creator” strategy. The value can be created by taking raw materials to make a new product (i.e., manufacturing) or by taking raw ideas and processes to make a new service (which is like a form of intangible manufacturing).

Just as I saw collectable hobbies as a rip-off, I see similar flaws in strategies primarily focused on the Appreciation or Mediator approaches. As we will see in this blog, the Creator strategy approach has inherent advantages over the other two approaches, because it tends to avoid the problems I saw in collectable hobbies.

THE PRINCIPLE
The principle here is that the approach you take for gaining profits makes a difference, and the creator approach tends to have the most solid foundation for success.

1) Problems With the Appreciation Strategy

As we saw with the coin collecting, there is a big spread that needs to be overcome in order to profit from any appreciation. This same problem applies to all who operate under more of an appreciation approach. If you are a private equity fund acquiring assets or a business doing a lot of M&A, you are familiar with this problem, although you may call it something else.

There is something called an “acquisition premium” when you buy companies or businesses. It is the price you pay over the current ongoing value of the business as is. This is most easy to see when a publicly traded company is acquired. The acquirer always pays a lot more than what the company had been previously trading for. Supposedly, the public trading price on the stock market is a fair assessment of the value of that business pre-acquisition. So the premium means that you are paying a lot more than the market thinks it was worth.

The fact that one has to pay a premium over the trading price is like the spread at the coin dealer. You acquired the company high, sometimes as much as 30% or more over the pre-acquisition valuation. And often, the company is resold via an IPO, where the price is intentionally set relatively low, to appeal to the initial buyers of the IPO stock, who want to achieve a quick appreciation on their investment.

As a result, a whole lot of appreciation has to occur in order to cover that spread and make money. That can be hard to come by in this slow-growing economic environment. This is compounded by the fact that those attempting to acquire are finding more savvy sellers who are demanding a larger premium (just ask Michael Dell in his attempt to take Dell private). So the gap may be getting larger while the opportunities and tricks available to get an appreciation over the gap are getting more difficult. This is why many private equity funds are having difficulty finding ways to effectively invest all that money.

A second problem for those using the Appreciation strategy approach is that they tend to have less control over their strategy than those using the other approaches. Commodity prices can fluctuate rapidly. As we saw in the great recession, prices on mortgage devices can plummet quite quickly. And the strategy only works if you can find another set of buyers to pay you more than when you first bought the asset, which is not guaranteed. With less under one’s direct control, the harder it is to make sure the Appreciation strategy succeeds.

2) The Problems With the Mediator Strategy

Mediators, like my coin dealer, also have problems. The largest problem has to do with market disruptions and disintermediation. In the past, agents, brokers and the like held special power because they were about the only way to connect buyers and sellers (the power of mediation). Now, thanks to disruptive digital business models, buyers and sellers can approach each other directly. Instead of going to the coin dealer, I could have sold those coins directly to consumers on Ebay and kept some of the spread for myself.

Travel sites have eliminated most of the need for travel agents. Why use an expensive stock broker when you can trade directly online? And in the retail space, there are so many digital ways for consumers to beat the spread, that retail stores are at risk of being showrooms for digital competitors. The ability to go direct makes many Mediators superfluous.

And even those Mediators who are keeping their positions are finding out that the spread between wholesale and retail is shrinking. The digital explosion is making knowledge available to everyone. This eliminates friction, makes markets flat, and reduces the power of the Mediator (who used to thrive by having special information other did not). As a result, the Mediator adds less value to transactions, thereby cutting the commission they can demand.

3) The Benefits of the Creator Strategy

The Creator approach avoids many of these problems. First, instead of getting caught in the trap of buying high and selling low, Creators are more likely to buy low and sell high. Why? Creators buy raw materials and sell finished products. Raw materials tend to cost a lot less than finished products. And buying the services of an engineer can be a whole lot cheaper than selling the cool stuff dreamed up by that engineer.

The Creator strategy, by its very nature, is converting lower cost inputs into higher value outputs. This conversion creates real economic value. You are not trying to take a relatively similar object and artificially create a spread between two transactions for that same object as is done in the other strategies. No, you have two different sets of objects—raw inputs and finished outputs—and the difference between the two causes a natural bump in value.

This Creator bump is easier to protect and is more in your control than the type of spread attempted when working as an Appreciator or Mediator. This gives the Creator strategy approach many advantages.

The Warren Buffett Way

These are not necessarily new ideas. This is essentially the philosophy behind Warren Buffett and his approach at Berkshire Hathaway. Warren Buffett has tried to steer clear of the problems in typical Appreciator of Mediator approaches. For example, instead of doing a lot of rapid buy and sell, Buffett holds for the long term. That way, he has fewer spreads to cover (less buy high, sell low). Instead, he tries to get the value out of the long-term output of what the company creates.

Second, Warren Buffett prefers to invest primarily in businesses where clear and simple creation is going on. Businesses based on fancy financial trade maneuvering or businesses where the path to value creation are more vague (like social media) tend to be shunned.

This approach has worked quite well for him. So maybe a more creator-based strategy is better for you.

Implications

The implication is that the more real value you can create through asset conversion, the better off you tend to be. Even if you are doing acquisitions or acting as an intermediary, there is room to become more of a creator and less reliant on merely trying to beat a spread. As an intermediary, you can be the disrupter of your industry and create the leading substitute for the status quo. As an acquirer, you can become more like Berkshire Hathaway.

And, as a manufacturer or service provider, you can best break out of the commodity mode by creatively adding more and more value into your conversion from input to output. That differential advantage through superior conversion (in speed, cost, quality or innovation) provides more room to find a profit.

SUMMARY
Businesses attempt to make their profit in one of three ways: by Asset Appreciation, Transaction Mediating, or Value Creation through Asset Conversion. The first two approaches tend to be more problematic, because they tend to rely on more of a buy high, sell low methodology. The third approach is more solid, because it creates more value in a more controlled manner.

FINAL THOUGHTS
We covered a lot of economic territory in a very small blog. There are lots of nuances here that we did not address. But the basic idea of trying to create natural value bumps by converting cheaper inputs into more valuable outputs is a key place to focus one’s strategic energy.

Management by Growing

THE STORY
Once upon a time, the there was a small little boy who hated being so small. “Nobody pays any attention to me or gives me any respect because I am so small,” he lamented to himself.

One day, a fairy godmother came to visit the little boy and offered to grant him any one wish. Well, that was an easy choice for this boy. “I want to grow and grow and become BIG!” he replied.

The next day, the boy woke up and was big and tall, like an adult. The boy was ecstatic! People, finally paid attention to him and gave him respect. It felt great.

Unfortunately, his growth did not stop there. Every day he grew a little bigger. At first, it wasn’t such a big deal. But eventually he was so big that he was taller than large buildings. Everywhere he stepped, he ended up crushing something with his gigantic feet. The respect he used to get from others turned to fear, as people were afraid to be near him for fear of being crushed. It made him feel like the monster Godzilla.

“I guess it’s possible to grow a little too much,” the boy finally admitted.

THE ANALOGY
One of the most popular phases in a business life cycle is the growth phase. It can be a lot of fun. Your position is relatively well set and desired by a lot of consumers. Your only problem is growing the company fast enough to take advantage of all the great potential you have. It feels like you can do no wrong.

Shareholders seem to love growth companies as well. They give the stocks high multiples. Suddenly, the company is worth a whole lot of money, and everyone is smiling.

It’s like the boy in the story. When he was small, he was ignored and not given any respect. However, once he started growing, everything started to change for the better. He started receiving the love and respect of others.

It feels so good that you want it to continue forever. However, as we saw in the story, sometimes too much emphasis on growth for too long can backfire on you. Continuing the push for growth long after you’ve reached your optimal size can cause all of your friends to turn on you.

In the business world, maturity will eventually come, causing additional rapid growth to no longer be appropriate. Too much growth for too long can result in investments which are no longer needed in the marketplace, causing returns below your cost of capital. You may be merely spreading your relatively constant sales over a larger, more costly infrastructure, which reduces overall profitability.

Growth is good, but other factors also need to be considered in your strategic planning, so that your company does not turn into a hideous monster like Godzilla.

THE PRINCIPLE
In the last three blogs, we talked about how different companies require a different approach to strategic planning depending on where they are in their lifecycle and how many barriers there are to entry/exit in their industry. In the blog “Same Title, Different Jobs”, we said that there are three major steps in strategic planning:

1) Positioning: Determining what you will stand for (own) in the marketplace—the solution you are providing, the place where you can win.

2. Pursuit: Determining the path to achieve (or improve) your desired position. This usually involves acts which allow you to gobble up market share so that you can build a strong claim to your position.

3. Productivity: Discovering ways to leverage your position so that you can optimize the return on your investment.

During the rapid growth phase of an industry, most of the attention is on growing the business (I guess that’s why it’s called the growth phase). The key area of strategic focus in this period is on pursuit. The idea is to grab as much of the market potential as fast as you can, so that nobody else can gain a stronger foothold at that position.

The success of your position is what is making the growth possible, so there is not much need to reassess the position. Regarding productivity, you greatest contribution at this point is the productivity which is a natural outcome of rapid growth—economies of scale. Hence, if you focus on the growth, productivity will be a natural byproduct at this stage of the lifecycle.

That being said, one still needs some balance. Positioning and productivity cannot be ignored. Success usually causes imitators to crop up. These imitators may create a need to tweak your positioning strategy in order to stay one step ahead of them.

In addition, the growth phase usually leads eventually to a consolidation of the industry, as a greater percentage of a company’s growth comes from acquiring competitors. If you are not an efficient, productive operator, it is likely that you will be the one being acquired rather than being the one doing the acquiring. Efficiency helps give you the edge when the intra-industry warfare begins, to see who will survive and make it to the mature stage. When the sporting goods retail industry recently went though its consolidation phase, it was the blander, but more efficient Dick’s Sporting Goods which acquired the flashier, but less productive Galyan’s.

Thus, although pursuit is the most important concern at this stage, the other factors should not be ignored.

The pleasure which comes in the growth phase causes pressure to want to continue the growth phase, long after that phase in the industry is over. It seems like everyone wants to be a growth stock forever.

If you want to be a growth stock forever, one probably needs to abandon industries as they mature and move on to new evolving industries. This is pretty much what GE has done over the decades. The growth comes from shifting one’s position, rather than continuing growth in an industry that no longer requires it. At that point, it is an emphasis on positioning, rather than pursuit which continues the growth (We’ll talk more about that in a blog at a later date).

Last month, Wal-Mart finally started coming around to seeing this conclusion. They announced that they were cutting back on new store growth, because it was no longer as productive as in the past. The sales for the new stores were coming largely from other Wal-Marts, so the net increases were shrinking.

Here is what the Wall Street Journal had to say about it on June 2nd:

“Wal-Mart Stores Inc. plans to sharply curtail future U.S. store openings, amid disappointing results for the world's largest retailer and growing investor pressure to curb its aggressive domestic expansion. Friday, it promised to cut more than a third of this year's planned store additions, delay some openings and restrict future U.S. store expansion.

“The move will cut the retailer's capital expenditures by $1.5 billion in 2007 to $15.5 billion for the year and help fund a large share buyback that investors also have been urging the company to pursue. Wal-Mart has been under pressure on Wall Street to slow its U.S. expansion and use the savings to prop up its stock price.

“Wal-Mart, based in Bentonville, Ark., isn't the only retailer to retreat on its store-building boom. AutoZone Inc., Home Depot Inc. and McDonald's Corp. have pulled back on expansion in recent years to improve store operations and boost shareholder returns. 'This is what everyone's been clamoring for,' said Goldman Sachs retailing analyst Adrianne Shapira.

“News of the capital-spending cutback and share repurchase cheered investors, who sent Wal-Mart shares up 3.9%, or $1.87, to $49.47 in 4 p.m. composite trading on the New York Stock Exchange Friday.”

So as you can see, sometimes it is wise get out of a single-minded approach to planning focused only on growth and move to a balance which includes productivity (such as stock buybacks or reinvestments in making current assets more productive, as McDonald’s has done).

SUMMARY
Growth is good, but too much of the same kind of growth for too long is often not one’s wisest move. One needs to have a balanced approach which also looks at potential repositionings or focuses on productivity in order to keep the profit wheels moving.

FINAL THOUGHTS
For some people, the thought of no longer being a growth stock is like a fate worse than death. Trust me, there is life after rapid growth. By no longer pumping all that money into pursuit, those years can be some of your most profitable. Yes, the stock might initially fall when growth-minded shareholders leave, but keep this in mind. Those same people will also leave if they see your rapid growth as no longer productive. And in that case you have nothing.

At least if you stop the unnecessary investments and start doing things like buying back stock or raising dividends or improving efficiencies, you can attract other shareholders who will still reward you. All of the retailers mentioned in that Wall Street Journal article saw their stock rebound when then quit the unnecessary growth. And finally, keep in mind that Warren Buffett did pretty well refraining from the lure of rapid growth, and instead focusing his investments in a lot of more stable businesses.