Phil's accounting article Wednesday was about impatience -- companies that want to recognize revenue when they ink the deal rather than when the customer accepts the finished product. Richard's Tuesday article was about fear -- how the false benefits of secrecy are really a security blanket some people think they need so monsters won't get their market share. (This is a topic dear to my own heart as a card-carrying member of the Open Source movement in software. I'm going to have to steal his Carl Sagan quote.) Matt's Monday article was about persistence -- bad patches are inevitable in any endeavor, but defeat only comes when you stop trying.
Today's article is about sustainability -- how growth must build on a firm foundation of sustainability. A lot of companies focus on profitability and growth. There's nothing wrong with that, but in the absence of sustainable existing business, they have to run very fast just to stay in place, developing new lines of business to counteract the shrinkage of the old. While this can be a very lucrative way of doing business, it also carries a lot of additional risk. A company constantly discarding the known for the unknown is at a disadvantage when it comes to predicting the future.
Over the years, most of the Rule Maker Portfolio managers have called Microsoft (Nasdaq: MSFT) the ultimate Rule Maker. I've always disagreed. I think Berkshire Hathaway (NYSE: BRK.A) is probably the ultimate Rule Maker, and within our portfolio I'd probably give the honor to Coca-Cola (NYSE: KO).
My reasoning for denying Microsoft the honor is simple: I question the sustainability of its core business. Long before it wound up in antitrust court, I pointed out that its perpetual upgrade strategy centers on persuading people to replace something they've already bought, and which (in theory) works for them. Why buy Windows 98, Windows 98 second edition, or Windows Millennium if your software works just fine on Windows 95? Same for office suites. Are word processors or spreadsheets really any different than they were 10 years ago, or have they simply sprouted bucket seats, chrome hub caps, fuzzy dice, and fins? (Microsoft has recently been trying to change the nature of its business to become more sustainable, with mixed results, but that's a topic for another column.)
Coca-Cola has never had this problem. You drink a Coke, it's gone. You're going to get thirsty again eventually. That right there is about half of Coke's business model. The rest is marketing, infrastructure, and efficient execution. It persuades customers to choose Coke when they inevitably get thirsty (building ongoing relationships with customers), and it ensures a ready supply of Coke around the world so that this choice is not just feasible, but as convenient as possible.
Even when Coke goes through a bad patch (such as the 1970s when its CEO had Alzheimers but refused to step down, or the more recent fiasco where a well-meaning accountant took control of a marketing company and totally screwed up the "ongoing relationships" part of things for a while), the inherent sustainability of the business carries Coke through until management comes to its senses again. For God, Country, and Coca-Cola by Mark Pendegrast details the first 100 years of the company's history. I highly recommend it to all investors interested in Coke.
Warren Buffett's strategy for running Berkshire Hathaway is very simple. He buys stable revenue streams such as See's Candy and Borshiem's Jewelry. He goes for businesses that produce the maximum surplus revenue with a minimum of capital investment required. He allows their revenues to collect centrally within the parent company, Berkshire Hathaway, and every once in a while he pulls the trigger on a new acquisition, spending some of that revenue pool to add a new business that will contribute more revenue to the pool. However, he's not buying finite new chunks of revenue, he's buying sustainable revenue generators.
The problem with pursuing growth at all costs is that unsustainable growth can lure a company to disaster. The Innovator's Dilemma discusses the easiest way for competition to kill an established company, by luring it into an "upward retreat." A company's natural tendency is to focus on the most-profitable niches, so a competitor attacking its least-profitable areas can often succeed. The victim's own desire for increased profits leads it to focus on its most-profitable areas at the expense of market share, and soon it finds itself reduced to a niche player.
Companies have even been known to do this to themselves, as Silicon Graphics (NYSE: SGI) did with the acquisition of Cray. Blinded by the potentially lucrative supercomputer market, it abandoned its core base of graphics workstation customers. Microsoft snuck in with a low-end solution based on NT, and SGI fell for it. The mistake was caring more for growth than sustainability, like an army that invades a foreign country and returns home to find itself the victim of an occupying force. Luckily, SGI's business had enough inherent sustainability for management to come to its senses before bankruptcy caught up with it, but it was a close thing and the company still has not fully recovered.
I consider sustainability the number one aspect of any Rule Maker. Our drug companies have patents protecting their discoveries for years. American Express (NYSE: AXP) and T. Rowe Price (Nasdaq: TROW) are financial services company cultivating ongoing relationships with their customers, to keep their accounts. Even poor, plastered Yahoo! (Nasdaq: YHOO), the ultimate dot-com when dot-com has fallen out of fashion, has built its entire business around repeat visitors who click through its site every day and consume its services.
A roadmap for the future is good, but that's short-term sustainability -- five years, 10 years, not forever. If the upgrade path ends some day, you have to worry about selling out before other people do. Or, you have to hope the company can find a new business model to replace the old, as American Express did when its stagecoach-era financial courier service gave way to becoming the kind of financial services company it once delivered messages to before the telegraph rendered that business obsolete.
In either case, a sustainable, defensible business is less for a part-time investor like me to worry about.
- Oak
