Predicting the Next Wal-Mart

"I know no way of judging the future but by the past."
-- Edward Gibbon

It earned the name "category killer," a term used for large companies that put less efficient merchants out of business. When this retailer went public in 1978, it soon became No. 1 in the market, as independent shops closed their doors, unable to compete with the growing colossus.

The future looked bright for the new industry leader in the 1980s and 1990s. The absence of competition and increased demand led to revenues of more than $10 billion per year by the late '90s. Alas, it never saw the competitor in the rearview mirror. In March 2005, the company bowed to the inevitable and accepted a $6.6 billion buyout offer from a consortium of investment firms. The deal was completed later that summer.

Why did Toys "R" Us fail to see the gathering threat posed by Wal-Mart? Perhaps it was unable to adequately predict future trends in its market. An ability to anticipate the future is perhaps the most important skill a manager or an investor can possess (which is kinda like saying "an ability to know the final score" is the most important skill required of a gambler). So where do you go to learn about the future?

In the days of old, you might have visited a fortune teller and, for a princely sum, learned that something bad is going to happen to someone you know somewhere down the line. These days, you go to Harvard Business School when you want to see what the future has in store. With this in mind, Fool co-founder David Gardner sat down with Harvard's Clayton Christensen, a professor and consultant who uses innovation to predict business growth and industry change.

When being disruptive is a good thing ...
Christensen has identified the concept of innovation -- either sustaining innovation or disruptive innovation -- as crucial to determining the direction of a particular company or industry.

Sustaining innovation is when, say, a computer company introduces a faster chip in its product. As a result of the improved product, margins should increase, thereby strengthening the company. Disruptive innovation takes root at the low end of the market. According to Christensen, disruptive innovation is the mechanism by which industries are transformed and prior market leaders (such as Toys "R" Us) are toppled. Christensen described disruptive innovation to David as follows:

A disruptive innovation is a new product or service or a new business model that doesn't attack the core market by bringing a better product to established users in direct competition with the leaders in an industry, but rather it comes into the low end of the market, either through a business model that can compete at much lower costs, can compete profitably at lower costs, or brings to the market a product or service that is so much more convenient and simple to use and affordable that a whole new population of people who previously couldn't afford or didn't have the skill to own and use a product can now own one.

There are countless examples of this business principle. Target (NYSE: TGT  ) and Wal-Mart rose to dominance in discount retailing as former leaders tried to concentrate on higher-margin items. Early on in the computer industry, Apple was disruptive to the likes of IBM and Digital Equipment. More recently, (Nasdaq: AMZN  ) has mounted a formidable challenge to brick-and-mortar booksellers such as Barnes & Noble (NYSE: BKS  ) and Borders (NYSE: BGP  ) by providing an alternative model for selling books and CDs.

Christensen illustrates this principle in some depth by examining the case of Charles Schwab. Below I've included a table that depicts a typical life cycle for a disruptive firm.

The Life Cycle of a Disruptive Firm

Early Life Cycle

Mid Life Cycle

Late Life Cycle

Disruptive company enters the market via the low end.

Company meets with success and gains market share.

Company moves upmarket in search of higher margins.

Schwab was a discount broker that used the Internet in a disruptive way relative to industry leaders such as Merrill Lynch (NYSE: MER  ) . As Schwab gained market share, it was faced with a dilemma: Go upmarket in search of higher margins or remain downmarket, slugging it out against low-cost competitors in a commodity market. At the moment, the jury is still out on which way Schwab will go. Notably, Merrill Lynch started out as a disruptive innovator itself. According to Christensen, Charles Merrill began his business with the aim of bringing Wall Street to Main Street, and his approach made it easier for average folks to own stocks. Now, Merrill Lynch is ensconced in the upmarket niche, selling its financial products to consumers with high net worths.

The hunt for innovators
As someone who once thought the whole personal computer thing was a fad, I should be listening to Professor Christensen, especially because he thinks disruptive technology will play an even larger role in the next 10 years. By my reckoning, almost half of our current Rule Breakers stock picks are disruptive innovators. One of our more disruptive selections, Intuitive Surgical (Nasdaq: ISRG  ) , a maker of surgical robots, is up 120% since we selected it back in March 2005. Another recommendation, Steiner Leisure (Nasdaq: STNR  ) , a leading cruise ship spa operator, is up 103% since it was chosen.

Want to join us in our search for disruptive companies? David Gardner is offering a free 30-day trial to the service -- full privileges included. Your trial gives you access to the two growth stocks we like best right now and all back issues, buy reports, and interviews. If you don't like the service, just cancel. No questions asked. To have a peek at the future, just click here.

This article was originally published on Feb. 23, 2005. It has been updated.

John Reevesdoes not own shares of any company mentioned above. and Charles Schwab are Motley Fool Stock Advisor recommendations. Wal-Mart isan Inside Value recommendation.The Motley Foolhas a disclosure policy.

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