Daily, the Foolish uninitiated arrive at our website, by the thousands, for the first time. We daydream often about these pilgrims, trying to channel their thoughts as they come upon our little corner of this space -- this public experiment we call the Rule Breaker Portfolio.
One scenario plays out very predictably. Let's be a couple of flies on the wall as one of these stereotypical newcomers eyeballs our current holdings.
Hmmm... AOL Time Warner (NYSE: AOL), Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY). OK, dot-coms. Amgen (Nasdaq: AMGN), Celera (NYSE: CRA), Human Genome Sciences (Nasdaq: HGSI). I see. Add biotech to Internet. That certainly covers a chunk of the trendy high-tech world, but where are the enterprise software stocks? Optical networking equipment? Energy? Don't these guys read the papers?
Oh, look, there's one more... Starbucks (Nasdaq: SBUX).
Yes, we get this a lot. My mission today is to assure you, faithful reader, that:
- Yes, we read the papers. And we are beating the bushes searching for Breakers, and our search has overlapped enterprise software, optical networking equipment, and energy.
- Yes, Starbucks fits in our Rule Breaker Portfolio. In fact, I'll argue that its low-priced, consumer-branded products make it the Breaker archetype rather than the exception.
Business models, not technology
This portfolio isn't about technology. In fact, to investors, it's really not all that important that "technology is the future." In the aggregate, this bright future is already priced into the market for technology stocks. We're looking for something special -- companies that will exceed what is currently expected of them, do it handily, and do it for a long time. From this perspective, the world of technology has no special advantage.
Business is not just about increasing revenues. It's about increasing profits on a long-term, sustainable basis, and to do this, a business really has only two choices. It can establish a "light" business model, which keeps invested assets at a minimum while rapidly increasing revenues. Such a business can prosper even with slim profit margins.
All other businesses, though, rely on option number two -- pricing power. This is the ability to charge more than the steady stream of competitors yapping at your coattails, all of whom will eventually have access to the same raw materials and technology. In the face of this competition, pricing power over the long term won't come from technology. It'll come from a strong brand, network effects, or high switching costs.
Technology is the easy part
In our just-completed Quest for Rule Breakers online seminar, participants pooled their research and generated a list of 50 top companies, ranked by group consensus according to their potential to someday wear the Breaker crown. Would you be surprised to learn that not a single dominant consumer brand is represented among this top 50? I bet you can easily guess what is well represented in the list? That's right -- technology.
We're not at all surprised by this, as we four Breaker managers wrestle with the very same dichotomy. We want to be out there on the cutting edge of changing people's lives, which more often than not leads us back to technology. But we just can't minimize the importance of competitive advantage. Without it, high tech is just high tech, and our diet demands a healthy dose of "strong business model" to wash it down. Brand is the simplest way we know to generate this potent elixir.
Content equals commodity
Paradoxically, as our world gets more and more complicated, branding -- the simplest of business advantages -- seems to be getting more and more important. To see why this is the case, let's start out by looking at the world of business-to-business (B2B) commerce, that huge swath of the economy in which companies buy from one another.
The world of B2B commerce is supposed to be moving online. Oddly enough, however, one side of the B2B equation isn't all that excited about the transition. Suppliers -- the folks doing the selling to other businesses -- are not embracing the online commerce concept as readily as business buyers, and this has slowed down the implementation and early growth of online markets.
Why? Consider this: In the world of B2B, the word content stands for online supplier catalogs of everything from office supplies and computer parts to production machine parts and commodity raw materials. In order to leverage the true power of Net commerce, standards bodies and content companies are developing a detailed, analytical breakdown of the entire universe of supplier products.
The idea is that once these identification schemes are developed, all suppliers will share one huge online catalog in the ultimate modular marketplace. Exhaustive price comparisons across all companies selling exactly the part you need will be just a mouse click away, via search engines built on top of these detailed labeling schemes.
No doubt this is a brave new world, but can you see why suppliers might not be too thrilled about it? "You can do business with the whole world!" they are promised, but you don't have to be a rocket scientist to see the catch. At what price the world? At the price of having your entire catalog turned into a line of low-priced commodity products. That's a hefty price.
In a simpler time, a supplier lived by his reputation. Buyers knew that a certain -- usually local -- shop had exactly what they needed, whenever they needed it. They could trust the supplier and that was worth a little extra dough, as uncovering alternatives, negotiating transactions, and shipping goods -- all across wide-open spaces -- was too costly and time-consuming to bother with. These relationships were the B2B equivalent of branding. It's easy to see that these times are now slipping away.
Just find me branded, low-cost consumer products!
Now, let's extend this Internet commerce picture into consumer products -- the stuff that you and I buy from businesses. Having just purchased a new computer, I can tell you that when it comes to big-ticket purchases, the consumer world is following the B2B "content = commodity" model.
Purchasing a computer online is now an entirely modular process. You can build exactly what you want, from very specific hardware and software choices to shipping and service options across a range of national retailers. Brand isn't completely dead yet. Reputation is still a variable in the equation for most of us. But how long can the branded box shops hold on in the face of this commodity wave?
So the world of business and big-ticket consumer purchasing is being overtaken by the "content = commodity" modularization and Internet information wave. What's left? Low-priced, branded consumer products! Which brings us to Amazon.com, AOL Time Warner, eBay, and -- most of all -- Starbucks.
Sure, we're looking at enterprise software, particularly B2B software since it encompasses both network effects and traditional software switching costs. i2 Technologies (Nasdaq: ITWO) is at the head of this list. We're looking at Energy. Enron (NYSE: ENE) is building an impressive B2B moat from market maker network effects. Ballard Power's (Nasdaq: BLDP) totally clean automotive fuel cell is fascinating and could change our lives. But all of these are complicated and hard to evaluate. Sustainable advantages are tough to isolate. It all makes one yearn for the healthy profit-generating ability of a good, ol' fashioned, low-priced, branded consumer product.
The writer broke his costly coffee habit cold turkey by having kids and eliminating his discretionary budget. His stock holdings -- which include shares of i2 Technologies -- are listed in his profile. AOL and Maveron (in which Starbucks Chairman Howard Schulz is a lead investor) are significant investors in The Motley Fool.