Rule Breakers vs. Rule Makers [Fool on the Hill] August 4, 2000

FOOL ON THE HILL: An Investment Opinion
Rule Breakers vs. Rule Makers

With huge growth in the tech and Internet sectors, why would anybody even want to look at Ben & Jerry's-type companies with Amazons around? Perhaps that's the wrong question. Both can be an excellent investment if well executed, and which one is preferable depends on your investing style. But just as investors sometime need to choose between high risks with high rewards versus steady, sustainable growth, companies need to figure out which business model will serve them best.

By Rob Landley (TMF Oak)
August 4, 2000

In today's Rule Maker portfolio report, we're running an article from a software expert named Joel Spolsky. Joel operates a website called Joel on Software, where he publishes his opinions on business, technology, and the software industry. Anyway, the article is a brilliant analysis of the difference between the growth strategies of Ben & Jerry's ice cream and online conglomerate (Nasdaq: AMZN).

I suggest you head over to the Rule Maker and read it right now. Seriously, go ahead. I honestly think reading Joel's article would be a better use of your time than even reading the rest of THIS article. It's THAT GOOD. But come back for some more analysis here, too. It's the weekend, isn't it? Don't have some extra time on your hands?

Okay, now that you've read Joel's article, let's see if we can apply what we've learned. It becomes immediately obvious to me that Joel's analysis is right on the money. Here are two quick examples:

Anybody remember Iomega? Back when the Rule Breaker Portfolio was called the Fool Portfolio, Iomega (NYSE: IOM) was it's star stock, outperforming everything else. These days, Iomega is a sad also-ran, and Joel's article is the first clear explanation why. Iomega had an Amazon growth model that started worrying about profitability too soon. It lost its relentless focus on growth, and along with it lost its "category killer" status as the replacement for the floppy drive. The company didn't bring the price of its drives, or its disks, down fast enough to flood the market and keep competitors at bay.

Anybody remember Boston Chicken? Another classic train wreck of a stock, making the same mistake from the opposite direction. It was a company in a Ben & Jerry's industry that tried to grow by the Amazon model, and all it got out of it was a ton of debt. Rather than claiming empty wilderness, their expansion efforts had to push into hostile territory full of entrenched competition. In any case, the benefits of being big scaled only linearly: there was little in the way of network effects or economies of scale to be had, so there was no point in spending more than absolutely necessary to get there.

So which of the two models makes a better investment? Or more bluntly, why would anybody even want to look at Ben & Jerry's companies with Amazons around? I think that's the wrong question. Both can be an excellent investment if well executed, and which one is preferable depends on your investing style. The Amazon model appeals to Rule Breakers, the Ben & Jerry's model appeals to Rule Makers. High risks with high rewards, versus steady and sustainable growth. (As one of the co-managers of the Rule Maker portfolio, I must admit my bias towards Rule Makers up front has probably colored the rest of this analysis. You have been warned.)

The Amazon model is extremely attractive to investors who like to see 200% annual growth from market leaders with a fierce head start on the competition. Most of the "dot-com" companies take after this to some extent -- not just Amazon but eBay (Nasdaq: EBAY), Yahoo! (Nasdaq: YHOO), and a thousand others. Spotting one of these early and being smart enough to hold on can produce unbelievable rewards.

At the same time, that growth comes at a price. First of all, it's almost impossible to get in on one of these at a sane valuation. Price-to-earnings ratios of over 1000 have been spotted out in the field (eBay anyone?), which require four or five consecutive doublings just to break even. No matter how great an opportunity is, there logically must exist a price at which it is simply not worth buying. The free market strives to find that price through trading, averaging out the risk tolerances and time horizons of millions of individuals to arrive at a consensus estimate. It's not perfect, but it's not usually full of gift-wrapped bargains, either.

The other problem with companies growing along the Amazon profile is that their insatiable desire for more cash to fuel their growth tends to dilute existing investors' ownership. Since debt is out of fashion in the investing world, many of these companies fund their growth with equity instead. They issue new stock through stock based acquisitions, pay employees with stock options, and regularly go back to the equity well for additional financing, either through venture capital or a secondary offering.

While this is exactly right in terms of what's good for the company, it may not be the best deal for each individual investor in that company. Would you rather own 2% of a $1 million dollar company or 1% of a $2 million dollar company? Also, the stresses of growth can break a company, as Joel hints when he discusses transmitting corporate culture. The classic example of a company growing itself to death is covered in the book Liar's Poker, which I reviewed for the Rule Maker portfolio some time ago.

Finally, at some point an Amazon-type company has to settle down and BECOME a Ben & Jerry's company. Once it saturates its market, it has to mature. A company that starts out life "as an adult" doesn't have to make that painful and dangerous transition. More importantly, it doesn't have to figure out WHEN to make that transition, which can be the really painful and dangerous part if it happens too early or waits too late.

The main disadvantage of the Ben & Jerry's model, on the other hand, is that it's less likely to produce triple digit annual growth for five consecutive years. Not impossible, mind you. I'm not quite sure, but I think Dell (Nasdaq: DELL) has been a Ben & Jerry's-type company. Although its growth has slowed recently, and generally stayed below triple digits, it still managed a meteoric rise funding the growth of its direct order PC manufacturing almost entirely from operating profits.

On the other hand, Dell may actually have been an Amazon-type company that thought it was a Ben & Jerry's company and luckily had enough cash from operations (and enough of a head start) to pull it off. Its direct order model has now been copied (with varying degrees of success) by everyone from Compaq (NYSE: CPQ) to IBM (NYSE: IBM) to Gateway (NYSE: GTW). It had a finite window of opportunity to exploit, although most of its competitors were not remotely prepared to switch over to Dell's model quickly or easily.

The growth of Dell's Web-based ordering also strikes me as fertile ground for an Amazonian "get big now" approach, one it possibly hasn't taken full advantage of. Dell is certainly big in online ordering, but it's not close to "category killer" status the way Amazon is. On the other hand, this is a diverse enough industry with enough established competition (and enough manufacturing infrastructure required behind the website) that one player was unlikely to dominate after the dust settled anyway, so perhaps Ben & Jerry thinking was correct after all. I don't know.

There's a thousand other companies this approach can be applied to. Cisco (Nasdaq: CSCO) is another company remarkably similar to Dell, except it's clearly an Amazon model that just happens to be profitable enough to stay ahead without going into debt. (Cisco fudges this a little bit by issuing new equity through its employee stock option plan. See this New York Times piece (free registration required) for more on that. I've also written on the topic a couple of times for the Rule Maker portfolio. Dell is starting to do this as well, by the way.)

Red Hat (Nasdaq: RHAT) is another "sort of both" company, but with a clear dividing line: the market for Linux (and Open Source in general) is growing via the Ben & Jerry's model of slowly and surely building on the established base. (Or in this case, rapidly and surely building, but it can get away with it because the infrastructure costs of scaling are almost zero -- it's a free download.)

Yet Red Hat's position WITHIN the Linux market is Amazon all the way: they want to be bigger than SuSE and TurboLinux and Corel and Mandrake and everybody else. Again, like Dell, this is not really a "winner take all" kind of market, yet there are distinct advantages to being one of the biggest (if not the biggest) player, above and beyond the linear increase in revenues that comes with the larger size. So Amazonian growth before the competitors get there can be a very lucrative thing to do.

Obviously, I've barely scratched the surface of the implications of Joel's article. (Which if you still haven't read, you should do so now NOW. I mean it.) This insight is an analytical tool we'll keep using for years, possibly forever. Well, I will, anyway.