"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 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 is expected to close this summer.
Why did Toys "R" Us
In the days of old, you might have visited a fortune teller and, for a princely sum, learn 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/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
Christensen illustrates this principle in some depth by examining the case of Charles Schwab
| 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 utilized the Internet in a disruptive way relative to industry leaders such as Merrill Lynch. 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. 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 ensconced in the upmarket niche, selling its financial products to consumers with high net worth.
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 Innosight, his own consultancy. For $40,000, Innosight will visit your firm and put on a two-day innovation-themed workshop. For approximately $400,000, it might perform a highly detailed analysis to determine whether your firm possesses a potentially disruptive product.
In the interview, David asked Christensen about such topics as biotechnology and the future of the health-care industry -- topics addressed every month in David's Motley Fool Rule Breakers newsletter advisory service.
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 the companies 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 uses nurse practitioners, located within Target stores and Cub supermarkets, to treat such illnesses as strep throat, sinus infections, and earaches. 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 (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 in the next 10 years. By my reckoning, at least half of our 17 current Rule Breakers stock picks are disruptive innovators. And I recently heard from the CEO of one of these innovators that his company is ready to go mano a mano with the industry leader in what was once believed to be a one-company market.
Want to join us in our search for disruptive companies? David Gardner is offering a 30-day trial -- for free. If you'd like to kick the wheels on a one-year subscription, we're offering a free copy of Professor Christensen's The Innovator's Dilemma, which should help you identify some disruptive companies on your own. Despite all this free stuff, you are under no obligation. I promise.
This article was originally published on Feb. 23, 2005. It has been updated.
John Reeves does not own any companies mentioned in this article. Schwab and Dell are Motley Fool Stock Advisor recommendations. The Motley Foolhas a disclosure policy.
