Predicting the Next Wal-Mart

I know no way of judging of 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 combined with 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 2005, our former market leader is now considering selling all of its stores.

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

In the olden days you might go to a fortune teller and, for a princely sum, you would learn that something bad is going to happen to someone you know, somewhere down the line. Nowadays, you go to Harvard Business School when you want to see what the future has in store. With this in mind, David Gardner of Motley Fool Rule Breakers sat down with Harvard's Clayton Christensen, a professor/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, 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 get transformed and prior market leaders (like Toys "R" Us) are toppled. Christensen described disruptive innovation to David as:

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 it 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. Dell (NASDAQ:DELL) captured the computer market in much the same way, thereby undermining former leaders such as Compaq and Hewlett-Packard (NYSE:HPQ).

Christensen illustrates this principle in some depth by examining the case of Charles Schwab (NYSE:SCH). Below I've included a table depicting a somewhat typical lifecycle for a disruptive firm:

Schwab was a discount broker that utilized the Internet in a disruptive way relative to industry leaders like Merrill Lynch (NYSE:MER). As Schwab gained market share, it was faced with a dilemma: Go up-market in search of higher margins or remain down-market, 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. Ironically, 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 well-ensconced in the up-market niche, selling its financial products to high-net worth individuals.

The price of experience
By studying disruptive innovation, Christensen has learned to recognize certain patterns, and this helps him to determine the future course of a company or industry. The title of his most recent tome, Seeing What's Next: Using Theories of Innovation to Predict Industry Change, provides a useful shorthand for his work. Apparently, corporate America sees a lot of value in Christensen's ideas. The demand for his insights was so strong that he started up his own consultancy named Innosight. For $40,000, Innosight will visit your firm and put on a two-day workshop focusing on innovation. For approximately $400,000, it might perform a highly detailed analysis in order to determine whether or not your firm possesses a potentially disruptive product.

In his interview with Christensen, David took advantage of this valuable opportunity to ask him about biotechnology and nanotechnology, two areas that are covered in our Rule Breakers service. Christensen provided a very illuminating discussion of these areas. If you would like to read the complete analysis, sign up for a free trial to Rule Breakers and download the transcript of the interview.

Seeing what's next
Christensen considers biotechnology to be disruptive relative to big pharma, and he sees the future of the entire pharmaceutical industry being turned upside-down. Companies that tap into the fundamental changes affecting the industry will win out.

In the area of nanotechnology, Christensen advises investors to go slow. He explains how understanding the dynamics of the value chain will allow investors to identify those companies that are more likely to be successful.

One of the more tantalizing parts of the interview is when Christensen discusses the future of the health-care industry. Unlike most experts, he sees significant potential for innovation in this industry. The Minute Clinic in Minneapolis, for example, represents the type of model that might transform the entire industry. This innovative company utilizes nurse practitioners, located within Target stores and Cub supermarkets, who treat such illnesses as strep throat, sinus infections, and ear aches. Apparently, 80% of all health-care events in a family's life consist of 14 very common ailments. Patients can visit the clinics and receive immediate treatment for a modest fee of approximately $45. Needless to say, business is booming. As David Gardner remarked, "when you combine lower cost with more convenience you have a killer app in the business world."

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 since he thinks disruptive technology will be playing an even larger role during the next 10 years. By my reckoning, at least four of our 10 current Rule Breaker stock picks are disruptive innovators. And I recently heard from the CEO of one of these innovators that it is ready to go manoa mano with the industry leader in what was once believed to be a one-company market.

Now that we have a better grasp of Professor Christensen's model, our Rule Breaker team will be looking for more disruptive companies to recommend to our community of investors. If you'd like to join us in this hunt, why not try a risk-free trial for 30 days?

John Reeves does not own any companies mentioned in this article. The Motley Fool has a disclosure policy.