CSFB

Thought Leader Forum
2002
Geoffrey Moore
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Concept Cards

This presentation is about the "deep craft" of investing. However, the format of the presentation is a series of mental models about investing on the fault line — investing in disruptive technologies and disrupted marketplaces. I will present four models for understanding shareholder value in the age of the Internet. The first model, developed by Michael Mauboussin and Paul Johnson, is about shareholder value. The second model articulates the meaning of competitive advantage. These two models become more interesting when they are exposed to the third model, which is the technology adoption lifecycle. The fourth model is the investment protocol described by the intersection of the first three models.

Shareholder Value
The first model helps us think about market capitalization. It starts with some very basic principles. Stock prices are set by trading among "dumb agents," like the ants or bees that Norm Johnson discussed. Although patterns emerge, there is no consciousness or control over setting the price of a stock. The trading price then determines the market capitalization of a company. The present value of the company should be equal to all future returns from the company discounted for risk. When you buy a share of stock, you are entitled to that share of all the future returns of that company. In some ways this theoretical construct of "present value" makes a company's equity resemble other financial instruments like bonds.

A share of stock only entitles the investor to the future returns of the company, not its present returns. The present returns serve only as a benchmark of past performance. The CEO's of companies will always promise better and better performance, but investors' need tools and methods to rationalize these promises. The first way to rationalize the CEO promise is to compare the promise with returns already available in the market (an investment in a bond will guarantee a level of return for very low risk). The more important discounting idea, however, is that the company's earnings are based on some kind of capability that will erode over time. Between market competition and general uncertainty about the future, investors discount the CEO promises more and more the farther into the future the promises extend.



Competitive Advantage — Gap & CAP
There are two ways to increase the present value of a company. The first strategy is to increase the distinctiveness of the company — to increase the Competitive Advantage Gap (GAP). This is the differentiation of a company's offering from its competitors. Increased differentiation increases the probability of making the sale and allows companies to charge a premium for their products. Most managers are pretty good at keeping track of the GAP.

The second strategy involves maintaining a competitive advantage over time — increasing the Competitive Advantage Period (CAP). The longer a firm can sustain the GAP, the longer investors can forecast privileged earnings for the company. Technology monopolies tend to have long CAPs, and this is reflected in the market capitalization of powerhouses like Microsoft and Intel. Investors believe that these companies will have a virtually unassailable position in the market for a very long time. Conversely, most equipment manufacturers have a very high GAP because of their innovation, but they have a very low CAP because their competition copies their innovations within a year or two. Managers tend to lose sight of the CAP measurement.

This is fundamentally a model about the power to generate revenue, not about revenue itself. From an investor's standpoint, revenue can be good, bad or neutral. An evaluation can be made by asking if the sale that generated the revenue helped the company's CAP, hurt the company's CAP or was CAP-neutral. In other words, did the company have to sacrifice a portion of their Competitive Advantage Period to get that revenue? Sales to target customers that enhance the customer relationship are good revenue. A sale to a non-target customer off of a price list is good in terms of revenue, but it is net neutral in terms of future power to generate revenue. A deal that commits scarce resources for a length of time to generate a sale to a non-target customer is bad revenue because it reduces the flexibility of the organization. This explains in part the investor pressure on companies to stop diversifying.

Financials in this system are a trailing indicator. Revenue and earnings are measures of last quarter's GAP. When a company misses the numbers, they have a short-term GAP problem. Financials also serve as a credibility test for the CAP promises that CEOs have made in the past. If the promises had been true, then the company would not be having a GAP problem today, or at least the CEO should be able to demonstrate why this GAP problem is temporary. The CEO is required to do this dance, and it is up to the investor to decide how much of the story to believe. Past revenue and earnings have no intrinsic meaning or value to investors except as power or status symbols because the value of a stock only exists in the future. A stock is the present value of the future.

The lesson to take from this model is that companies that manage for shareholder value actually focus on competitive advantage. Unfortunately, most CEOs interpret shareholder value to mean engineering the quarterly reports.

Strata of Competitive Advantage
The primary thing that strategy consultants' talk about is competitive advantage, and clients only come to us when there is a problem. The public relations response to a problem is to send out a press release, but this is only a band-aid solution. You can do five things to actually fix the problem. I will present these five strategies as five different layers, or strata. The deeper the level of the strategy, the more profound the change. This is the geological metaphor that sets up technological disruption as the fault line.

The first strategy is just to refresh your product or service offering. This is a sufficient solution if you are still in the right market with the right brand and distribution channels, as well as a solid company. Occasionally, a company's offers just get a bit stale.

The next level of challenge is in execution. If your differentiated offers are highly variable in quality, then focus on value disciplines. You may need to focus on operational excellence, product leadership or customer intimacy.

The third strategy is to strive for dominance in a market segment. This position's a company in such a way that if its execution flagged, customers would still buy from it. Flagging execution in this market position manifests itself in lower margins because customers will not pay as much for lower-quality products, but market share will be retained. The better a company is wired into its customers, the more information it can gather from them about their future needs and the more the firm can stretch its CAP. This is the classic niche market strategy for securing competitive advantage.

The fourth strategy is for a company to design itself into the fundamental value chain of its industry as a category leader. If you can position yourself as Microsoft, then the entire industry will reinforce your leadership because it will not want to support a second operating system. The only thing worse than having Microsoft is not having Microsoft. This position gives the firm industry power, where other companies' revenues and earnings depend on their alliance and interoperability with the top gun and vice versa.

The final card that trumps all of the strategies described above is catching a new technology wave. A new wave of technologies can make all of the competition's brand and execution and industry power irrelevant.

Of these different strategies, the first two give you GAP power, or the ability to differentiate. The bottom four layers describe how you extend your CAP. First, internal to the company, there is execution power. Second is customer power where your customers help to reinforce your position. Third is industry power. The final and deepest power is category power, where you have harnessed the genie in the technology bottle. As you move forward with the genie, you create industry power, customer power, and execution power. Market disruptions start at the bottom and reshape the entire market. The deeper in the market the shift happens, the bigger the "earthquake."

Mature and Disrupted Markets
In mature markets, you see only half of this model because the lower levels do not often shift from year to year. Mature markets, like the automobile industry, see very little change. While today I could drive a car made in 1946, I couldn't use a computer made in 1980 with a CPM operating system. It would be a useless artifact. In mature markets, when no major changes take place in the lower levels (category, industry, and technology), the CAP variable essentially becomes fixed. Any GAP will have a fixed duration in the market, so CAP will no longer be a variable considered by investors.



The history of General Motors serves as a useful example. This was a terribly managed company in a terribly managed industry that retained its position as market share leader for 65 years. CAP was fixed, so companies competed on GAP. Changes in GAP do not affect market share, but they do affect margin share — customers buy from the same vendor, but they will demand a lower price.

In this setting, earnings are the only variable that will change, and only through differentiation. Differentiation can occur through execution and occasionally through customer power. Industry power and technology power are never a part of the game in mature markets.

Strategy and investment are very different in technology disrupted markets. A new market can emerge as an innovation proceeds through the Technology Adoption Lifecycle. This totally destabilizes the old hierarchy, and creates a whole new set of real options and real risks. At each stage in the lifecycle, we reach a real option decision point.

Technology Adoption Strategies
When a disruptive technology is introduced, a community spontaneously organizes into five segments that represent five different strategies. The first two and the last groups are much smaller than the third and fourth groups. The first strategy is defined by technology enthusiasm. The people in this group want to try out the innovation, use it and promote it, even though they are not sure it will work. There is a lot of intellectual curiosity.

The second group is the visionaries. These people will buy into this technology as if it is the next big wave. They cannot predict exactly what the next wave will be, but they know that they want to be the first to invest in it so that they can revolutionize their industry. These people are willing to take big risks to position themselves ahead of everyone else.

The next and largest group is the pragmatists. The pragmatist's strategy is to be third, but a very fast third. They want to be part of the next wave, but they want to protect themselves against the potentially false promises of technology.

Conservatives prefer to get the most they can out of the last technology that they adopted. They feel they just got through a round of adoption and learning. They want to continue using a system that works well enough for them.

The last strategy group is populated by skeptics. They believe that there is no new wave, that the technology is a false positive, and that the effort is not worth pursuing.

All five strategies are legitimate, and different personalities tend to gravitate to different strategies. As an investor, however, the best strategy to take is that of the pragmatist. Pragmatists' make decisions by asking other pragmatists about the innovation in question; and if they get the same answer three times, then their decision is made. They trust the feeling of sticking with the herd. They want to tap into the hive mind. This induces cascade effects in the market, where something no one has heard of is suddenly on everyone's mind. The pragmatist's decision process creates a pattern in the development of high tech markets.

The Technology Adoption Lifecycle Model
In the Early Market, there will be two players who will adopt the technology well ahead of the herd. Investors should primarily be interested in events that happen later, but there is important information to gather in the Early Market stage. Investors should look to see how much excitement is being generated about the technology. Is a market even possible? The key indicator is a few big hairy deals (BHD's) with flagship customers. These must be major customers because they will help to celebrate and promote the idea. Their function is to help gain visibility for the idea and the market, and gain category power for the company selling the technology. The challenge for investors is that these early adopters do not demonstrate that there will be any enduring market for this technology. These early implementations represent a series of projects that were pulled together to solve a particular company's visionary agenda but the pragmatists have not bought in yet. Investors should start learning about the category here, but unless you are a venture investor you should not invest at this time.

The next stage in the adoption process is the Chasm. This is the phase in which a few visionaries have adopted the technology, but most pragmatists are still holding back. Visionaries love the Chasm because this is their opportunity to get farther ahead of the herd. Pragmatists are still distrustful of the technology because there have not been enough adopters. Many technologies die in the Chasm. The Chasm is a kind of Darwinian selector for false positives.

In order for the technology to become marketable on any kind of scale, it must get a position on the other side of the Chasm. In order to do this it must get some number of pragmatists to support it. This is a junior high dance problem. The girls are on one side of the gym, the boys are on the other side of the gym, and the dance can't get started. How do you get the technology dance started? It is easier to start the dance in a niche market than in a mass market? It's best to nurture an environment in which increasing returns will create a new market. The idea is to target a niche market in which the pragmatists are experiencing some kind of pain. This is typically a departmental application in a vertical industry, and the department in question is the bottleneck for the entire industry. Pragmatists in pain will help drag a technology out of the Chasm. In our experience as technology consultants this is invariably the only source of Chasm exit. This is a niche marketing strategy where the incumbents still have mind share with most of the pragmatists. These pragmatists, however, are saying that the incumbents can't solve the problem. In this example customer power creates a new and viable value chain and market.

Leverage customer power, and around that customer segment build a complete value chain. That is the model we use for determining if there is a market. Is there a set of product and service providers that can deliver to the end customer the end result that they need, and can they make money doing it? These customers tell their friends, and that is part of the Bowling Alley Effect. If this technology catches on, then we will have what accountants call a "going concern", meaning that there is a good chance that the company will still exist in ten years. An entire value chain now reinforces their survival.

The real wind in technology investing comes from the next stage of the model, called the Tornado. The Tornado creates entirely opposite effects from the Chasm using the very same pragmatic decision-making process. As more pragmatists see other pragmatists adopting the technology, a stampede or cascade of new adopters occurs. Because the dynamics are different in the complex Tornado system than they are in the Chasm, a different strategy is called for. In technology based markets, there are generally higher costs to the customer associated with switching from one technology platform to another. The best strategy then, is to capture as many customers as possible as fast as possible because most customers will stick with their initial choices for life rather than face switching costs. There is a huge land grab mentality in a Tornado to get the first deal with as many customers as possible. Competitors are trying to get maximum market share through industry power. The big successes in a Tornado are the companies that are able to design themselves in as the category leader in the value chain early on. Once Cisco owns the router thing, the Internet phenomenon just sucks routers out of Cisco. Cisco does not have to market routers because the demand just pulls the products out of the system. This is the moment when market caps go into hypergrowth. The dynamics of the pragmatist decision-making process drives up the market caps of an entire technology sector, but this is amplified by the same dynamics for a single company. The market privileges one company, like Oracle, because other pragmatists favor Oracle. Not only does the category get sucked in the Tornado, but also one company gets a gorilla boost and is super-accelerated through the Tornado. That is the philosophy behind the book about technology investing called the Gorilla Game.

The fourth and final stage in the model is called Main Street. Now the Tornado effect has effectively dispersed the new innovation, and it has now been diffused or dispersed across the planet. For example, we all have cell phones now. We will buy more cell phones and we will replace them, but we will no longer adopt cell phones. Instead, we are now replacing and buying more. This looks a lot like standard industrial models from other sectors, where a mode of mass customization exists in order to maximize profit.

High Tech Investing Model
The investment thesis in high tech is a little bit different than standard. In a Main Street business, you invest in a going concern that has an earnings profile, and volatility is considered dangerous or threatening. You would like to have a stock that has low risk or change associated with it. In high tech, it is the opposite.



In high tech, you have the following investment thesis: We are willing to accept a company losing money in the Early Market window because we expect to ride the Adoption Lifecycle through the Bowling Alley and into the Tornado. We will have a lifetime franchise that is going to be worth gazillions.The two basic units of mathematics in Internet investment in 1998 and 1999 were one and a gazillion. The outcome was expected to be binary.

In the process, by the way, the value of the incumbent is diminished. In other words, some of value of the new company comes from an expanding value pie, but some of it also comes from taking pieces of pie away from the old guys.

The investment game is played by many different kinds of players, and the kind of player you are determines where in this process you want to invest. Early stage investors and venture investors invest before the Early Market stage. Later stage venture investors tend to get into the game after the technology has its first few adopters. Prior to the last few years, companies normally had to cross the Chasm, create a market and generate positive earnings before they could go public.

There are milestones for each of the phases of the Technology Adoption Lifecycle. The first milestone is visibility. If an innovation cannot attract those first few customers, perhaps the company should be shut down. Visibility creates viability. Next, can the company become a going concern by gaining a dominant market share in one segment somewhere on the planet? Investors want the company to become at least cash flow neutral so they no longer have to fund operations. Once the company has achieved niche market dominance, then the next milestone is to check the progress of how far and fast the company gains scale. Once the market is no longer is dispersion or diffusion mode, then how profitable can the company become? These are the major milestones for investors and what is happening is that venture investing has now become a sub-component of public investing.

Public investors have begun to behave like venture investors. This trend has probably peaked and will recede. There are good reasons to leave this kind of investing to venture capital funds. In 1999 the public markets were acting like venture capitalists because almost the entire Internet segment was in the Early Market phase of development. Today, most of the B2B exchanges sponsored by industry leaders in automobiles, aerospace, pharmaceuticals, and petrochemicals, are all in the Early Market phase. Most of the independent B2B exchanges, however, are in the Chasm. Investors are asking if they really have a market and if they really have liquidity.

I would argue that the applications that can be bought by a single company or in a single sector (supply chain applications and customer relationship management applications) are in the Bowling Alley. They are not yet in the Tornado. All the infrastructure guys like Cisco and anybody who is building the pipes for the Internet are in the Tornado. On Main Street are my dog's web site and all the browsers. With this model, you can begin to calibrate the Internet and figure out what the game is. For each stage of Adoption, you will have different markers.

Real Options in the Adoption Model
In the last piece of the model I am trying to incorporate Martha Amram's ideas about Real Options. I will suggest that at each point in the Technology Adoption Lifecycle Model investors have a real option on whether or not to invest.

First round venture investing takes place before there are any adopters, but the milestone for the second round of funding is the recruitment of one or more flagship customers to a blockbuster deal. This is the game: an innovative firm has to land these kinds of customers or the company will be shut down. If it cannot do this, there is no reason to go forward. This is a decision based on category power - is this category feasible and interesting?

The second question is whether the company can cross the Chasm and achieve a market position that is sustainable and can keep it in business going forward. Can the firm win a market, or can it create a market?

The third decision point comes in the Bowling Alley. How is the firm positioned in the industry pecking order? As it starts to scale, is it number one, number two, number three, number four, number five or lower? If it's number one, investors are piling in all the investment dollars that are available. If the company is number two, it's probably still going to be a meaningful player. If it is number three or lower, it will probably try to figure out a way to team up with somebody else it it will have to change the category. High tech rewards number one wildly, number two modestly and numbers three and below not very well. Relative position is very important in terms of industry power.

The reason I think real options apply here is because you make a choice as to whether to buy, hold or sell the equity. These are the markers or the checkpoints that I would use. CEOs can also use this model to figure out where they are in the model and what they should focus on to get the next higher evaluation.

In disruptive market categories, market leader CAPs are destabilized by the new category CAP. The new category destabilizes the old competitive advantage periods. Early investors in particular devalue the incumbents and not because of their GAP. The truth is, in the first few years the incumbents have much better offers than the challengers. The new categories win on CAP, on the future, on the potential that they have. In this way the new category migrates some of the value that was in the old category to the new category.

Investors in the new category are first attracted to an idea (the price to vision ratio) because there is no number anywhere that means anything. It is a story. In 1998 Hewlett Packard had no Internet vision and the stock price was getting hammered, and they announced the Internet vision and their stock price went up 33%. We know that vision plays some sort of role in all investors' decisions. What is weird about the Early Market is that vision is all there is. There is no numerical basis for investing at all. If you are a venture investor, vision is what they send you. Vision is what you value when you invest in a company. You invest in the people and in the vision.

As quickly as possible, you want to move your company into the Bowling Alley and then the Tornado. Price to sales ratios in this phase are far more important than price to earning ratios. You are in a market share capture battle, not a margin optimization battle so you want to use sales, not earnings, as your metric. You will be willing to sacrifice earnings to capture more market share.

Finally as the market matures into Main Street, price to earning ratios become the important metric.

Summary
Financial markets are best understood as dynamic systems around the notion of competitive advantage. Investors fund competitive advantage. If you are a technical investor trading the ticker tape, then you do not care about competitive advantage at all. If you are a buy-and-hold fundamentals investor, however, then you care about this deeply no matter what sector you are in. In mature markets, the lower levels of competitive advantage are frozen and do not concern investors. In a technologically disruptive market, however, it is important to follow the development of the market, and to apply the competitive advantage hierarchy at each of the decision points in the future.

Industrial vs. Consumer Model
There is an important distinction to make between this model applied to industry and to consumers. B2B technologies will pull themselves out of the Chasm by targeting painful problems in supply chains and specific vertical markets. By addressing these painful issues, many of these companies will make it out of the Chasm, but many will also fail.

Consumers are in a very different mode. There are two kinds of consumption — fad consumption and hygiene consumption. Fad consumption — like Britney Spears fashion — is probably out of the Chasm in the US. Hygiene consumption — the stuff we have to buy — is not quite there. One challenge is that the number one brand gets far more attention than the number two or three brand. This trend has been abused so much it could be Brian Arthur's Myth #6 — the First Mover Advantage.

Continuous and Discontinuous Innovation
All industries at one time or another have gone through the Technology Adoption Lifecycle. While most innovation is what Clay Christensen calls continuous innovation, every sector has experienced some form of discontinuous innovation. Even the automobile industry went through technology adoption in the 1920s — but like the damage caused by a past earthquake, they have been stable so long that the grass and trees have grown back over the disruption.

Dumb Agents Getting Smarter


So what happens when the dumb agents in the investment world learn the rules of the complex adaptive system called the market? This clearly affects the performance of the system, but not in ways we can predict. Obviously lots of people are trying to use these ideas and models to manipulate investor perception, but these machinations are corrected over time by the quarterly report, even if it is a trailing indicator. If you think about all of the lies that have passed through the financial markets since 1987 without corrupting the system, there must be a number of corrective mechanisms inherent to the process to maintain its stability.

CAP Estimates
Are the CAP estimates that we see worth anything? Microsoft's competitive edge period is said to be about 13 years, and that is probably about right. Microsoft will probably never be deposed as long as their category is viable. So the big question becomes the viability of the category and the degree to which the Internet marginalizes the category in the future. These numbers (13 years) are valuable rough guesses in more mature markets. Where they get screwy is in Early Market valuations based on some sort of fantasy CAP. The CAPs for these companies were not even close to realistic, and this helped to cause the mania in the market.

Public Markets as Venture Capital
Competition and Darwinian selection forces us to pursue increasingly competitive investing behaviors, including more and more predictive investing. As more and more investors are accepting these ideas about disruptive technologies, you have to invest earlier and earlier in the lifecycle to generate competitive returns. Public markets will never move entirely out of venture investing. But to borrow a phrase from Martha Amram, I am nervous about whether the public markets are an "efficient risk-bearing mechanism."

Linear Models and Non-Linear Systems
Where does the non-linearity that we see in the market take place in these linear models? Norman Johnson described a system which started very linear and discrete, became chaotic, and then settled down into a different discrete structure. Most mature markets are very rigid. Technological disruption generally shifts one rigid system into a different rigid configuration. The non-linearity in my models starts in the Bowling Alley and takes off during the Tornado. The incredible growth rates we see in the Tornado are the result of the very simple rules that pragmatists use to make decisions. Before and after the Tornado, this is basically a linear model. It is mature, discrete industries—like the book retailing business—that are most susceptible to getting a big whack.

Prediction in Models
Most of the models that have been presented here are not fundamentally predictive. They are trying to tell you about the future, but they are all based on data from the past. The decision points in this last model, however, are intended to be predictive. In the Early Market, if you do not get two or three blockbuster customers, the model predicts that the company will fail and investors should get out. In the Bowling Alley, if you do not get market share leadership in a single, vertical segment, then the model predicts that you will have very low returns, and investors should get out. (By the way, this is not a very popular prediction.) Next, there are several predictions associated with the Tornado. First, if you are number-one in the category, then you will go into hypergrowth and create tremendous market capitalization. If you are number two, you will get about half of that market cap. If you are numbers three or below, then you will have minimal returns and investors should get out. Once you reach Main Street, the model predicts that as your offers go up or down, your stock price will go up or down, but the volatility has been removed from the market.
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