Chapter 2: Rising Expectations, Diminishing Returns
Maybe you're in one of those hot, young companies with millions in revenue and billions in market cap. That's cool, but you'd be foolish to mistake Internet investment fever for a rock-solid business concept. Sure the new economy demands some new math-companies can grow more quickly than ever before because they are less constrained by physical capital than ever before. But sooner or later you company's earnings performance will have to match its valuation, so you'd better be damn sure your company has a business concept that will live up to that implicit promise. If it doesn't, I'd hold off on pledging those stock options as collateral on a multi-million-dollar house.
If you're under 30, you may not remember that the personal computer industry spawned dozens of "hot" companies-Osborn, Kaypro, Commodore, and AST Research to name a few. But only one, Dell, was a wealth-creating superstar throughout the '90s, and even its share price sat on a plateau for most of 1999. So is your company going to be Kaypro or Dell? Are you going to join the ranks of Yahoo!, AOL, and Amazon.com, or get washed down the drain of companies that were unable to recognize and change a decaying business concept? Let me be clear: there are even more poorly conceived, ultimately uneconomic, me-too business concepts in the new economy than there are in the old. And even the best ones decay rapidly in the fetid environment of the Internet. If you're not extraordinarily adept at perpetual innovation, that e-business wave of hype your company is riding on right now is going to crash.
The Revolution of RisingExpectations
Every year investors raise the bar. Read an annual report from a decade ago, and you're likely to find a company chairman bragging about exceeding the prior year's performance. Back then you just had to beat yourself. Then investors began demanding more: "We don't care how you did against yourself. We want to know how you performed against your bestin-class peers." So the bar went up a few feet. Every diversified industrial company was pressed to meet the standards set by General Electric. Every retailer was expected to match the returns achieved by Wal-Mart. And every software company was measured by Microsoft's yardstick. Navel gazing was out; financial benchmarking was in.
Then the bar went up again. Investors said, "Wait a minute. You may be doing okay when compared to your peers, but what about the absolute standard of 'economic value added'? Are you actually earning more than your cost of capital?" Amazingly enough, the idea that a business should earn its cost of capital struck many executives as a new thought. Clearly more than a few had slept through Finance 101. So diligent executives across the planet began weeding out projects that couldn't promise a positive net present value. J. C. Penney, Toys "R" Us, Siemens, and dozens of other companies signed up for the EVA diet. Investors said, "Make those assets sweat".
As investors became more demanding, and less patient, CEOs felt the heat. John Akers (IBM), Kay Whitmore (Kodak), Roger Smith (General Motors), Bob Allen (AT&T), Gil Amelio (Apple Computer), Eckhard Pfeiffer (Compaq), Doug Ivester (Coca-Cola), and dozens more got the boot or slunk off into early retirement as investors grew weary of empty promises. The message of this bloodletting wasn't lost on the survivors: deliver or else.
Today's investors have an unquenchable thirst for ever higher returns. Cisco, Charles Schwab, AOL, Lucent, Amazon.com, Gap, Yahoo!, Dell, and Microsoft. None of these companies is more than a generation old. Yet their collective market cap at the beginning of 2000 was nearly $1.5 trillion, or close to 10 percent of the total market cap of all publicly listed companies in America. These companies were the stock market stars of the 1990s. But the bar is going up get again. There's a new crop of wealth creators whose eye-popping returns are once again resetting the gauge of investor expectations: CMGI, Terra Networks, Akamai, Ariba, Conexant, COLT Telecom Group plc, Sycamore Networks, and Scoot.com plc are just a few of the come-from-nowhere chart busters that started the new century with $20 billion-plus market caps. Sure, some of these companies will crash and burn, but their stratospheric returns, however temporary, have further fueled investor passions.
There are no more widows and orphans. With a new economy aborning and billions of dollars of potential wealth up for grabs, every investor wants a piece of the action. Forget the high jump, investors expect you to pole vault. No longer are they fretting over whether or not you're earning your cost of capital. Nor do they care how you're performing against your equally underwhelming peers. Instead, they're asking whether you're likely to join the pantheon of wealth-creating superstars. Perched atop their IRA and 401(k) nest eggs, millions of investors are obsessed with beating the market. If you can deliver outstanding shareholder returns, you're a god. If you can't, you're a bum.
I can already hear you making excuses. "That's fine for Amazon.com or Cisco," you say, "but we're in a mature industry. We're not a start-up. We're not some Internet comet." I don't buy it. Wealth creators come in all sizes, can be found in all kinds of industries, and must often overcome the inertia of tradition and precedent. Scan the list of companies that delivered record-breaking returns during the 1990s, and you'll see companies such as Gap, Harley-Davidson, SunAmerica, Clear Channel, The Home Depot, Progressive Insurance, and Merrill Lynch hardly high-tech shooting stars.
It's not easy to become a stock market supernova, and it's even harder to stay one. At the same time that petulant investors have been demanding edge-of-the-atmosphere returns, the percentage of companies that have been delivering better-than-average returns has been steadily declining. In 1999 only 30.8 percent of the S&P 500 companies outperformed the S&P average-in terms of total return to shareholders. That was down from 58 percent in 1992, and the second lowest percentage in more than a decade. (In 1998, 27.6 percent of the S&P 500 did better than average.) Put simply, 7 out of 10 companies underperformed the market in 1999. By definition 50 percent of the S&P 500 outperformed the median, but fewer than 1 in 3 outperformed the mean. The discrepancy between the mean and the median is evidence that a few outstanding performers are simply outdistancing the rest of the field.
The brutal truth is this: there is an ever-growing population of mediocre companies and an ever-diminishing population of truly great performers. The explanation for the performance gap is simple. Companies that spent the past decade trying to wring the last ounce of efficiency out of tired, old business models have now reached the point of diminishing returns. Their strategies have become virtually indistinguishable from their competitors'. And with top management's attention focused internally on process and systems, they've left themselves wide open to unorthodox innovators. Only a few companies have escaped this writhing mass of mediocrity. Only a few companies have been successful in inventing entirely new business models, or in profoundly reinventing existing business models. These are the companies up there in investor heaven.
It is impossible to meet the rising expectations of shareholders without actually creating new wealth. To create new wealth you must innovate-in ways that competitors are not or cannot. You can't buy your innovation "off the shelf" from the same tired, old consulting companies your competitors are using. Cisco, The Home Depot, Pfizer, Charles Schwab, Yahoo!,...