Motley Fool Hidden Gems Investing - How to Win in Business: Be Right, Be Positive

Episode Date: April 28, 2024

Executives like to talk about innovation, but how do you spot the difference between world changing stuff and corporate theater? Elliott Parker is the CEO of High Alpha Innovation and author of, “The Illusion of Innovation.” Parker joins Ricky Mulvey for a conversation about: The power in being contrarian One mega cap that knows how to innovate Why ROIC is not a foolproof metric for investors.  Companies discussed: MSFT, IBM, AMZN, NFLX, BRK  Host: Ricky Mulvey Guest: Elliott Parker Producers: Mary Long Engineers: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

You've got to try breakfast at A&W. You've got to try breakfast at A&W. And what better way than with the delicious Pret Organic Coffee? Starting with just one dollar, all day, every day, now until December 31st. You've got to try breakfast at A&W. At participating A&W locations in Ontario. If you want to win in business, the trick is over time, you've got to be non-consensus contrarian and turn out to be right.

If you're going along with the consensus and you're right, you will go out of business. So you need to find ways to be non-consensus, to be contrarian and turn out to be right. Right now, a really easy way to be contrarian or non-consensus is to have a long-term view, to be optimistic about the future, which right now, uniquely in the last couple of decades, It's also contrary to being an optimist. I'm Mary Long, and that's Elliot Parker, CEO of High Alpha Innovation and author of the book, The Illusion of Innovation. Do you ever get the sense that innovation has become a buzzword, something that a lot of companies talk about, but few actually do? Well, Elliot Parker's had the same thought, but he's a big believer in the idea that genuine innovation can keep companies alive, even in an era of shortening corporate life cycles.

So how can investors separate real innovation from mere theater? Ricky Mulvey sat down with Parker to find out. I'm going to start with an obvious question for you. It might not be an obvious question for our listeners, though. Big companies, they got a lot of the firepower. They got trillions in capital. Why is it so hard for these big institutions to create society-changing innovations? Yeah, it's a very good question. I think it may be one of the most important

questions to ask about our economy right now. Because if you go back 50, 60 years, a lot of the innovations, the important innovations, breakthrough innovations that we enjoy came out of corporations. Now, more often, they come out of startups. And if we think about our large institutions, not just our corporations, but governments, schools, other large institutions, there's this broad sense that these institutions seem less capable than they once were of confronting change and opportunity and i think it's a really good question to ask why that is and then to follow that up with what do we do about it my view is that in a nutshell we've gotten really good at running large organizations in fact we've got better and better at it and we've gotten so good

the problem is that these organizations are optimized in some cases for the wrong thing They're optimized for safety, for predictability, for preserving what exists. And as a result, these organizations are less likely to encounter anomalies and surprises and the inefficiencies and mistakes that lead to learning and that lead to innovation. So it's actually an interesting and ironic byproduct of our proficiency at management that these organizations are simultaneously more capital efficient than ever before, but less capable of producing breakthrough innovation. And you said, what do you do about it?

From your work and your writing, it seems that for a lot of these big companies, the solution, and I think this has a direct tie to the investors listening, it's creating relationships with startups where they can have the firepower, the capital. You can be an owner of the company or an equity partner, but you can let them be inefficient and not have the committee-watching eyes of large institutions. Yeah, that's right. These organizations, these large corporations need to find a way to enable and allow some deliberate inefficiency. Reed Hastings, the CEO of Netflix, stated it really well. He said, chaos, as long as it's productive and fertile, will always beat sterility.

And large companies that are pursuing capital efficiency, if they overdo it, they become really sterile. Sterility is death. You need a little bit of chaos as long as that chaos is productive. And so how do you enable and allow that deliberate inefficiency into the system? You don't want to distract your operators. You want them to continue doing what they do really well. Capital efficiency is good to a point. I think engaging with startups for these corporations, whether that's through investment partnership, or in some cases, building startups from scratch outside the corporation can be a fantastic way to enable and allow some deliberate inefficiency into the system then opens up the corporation to learn. So for a lot of stock investors listening

right now, they hear mergers and acquisitions. They think about de-worsification. They think about a lot of the companies that paid up way too much money over the pandemic period for a lot of small companies. And you have your examples like Meta buying Instagram. But what's your advice to the investors listening to this and thinking, you know what? I don't like seeing the companies I own doing a lot of mergers and acquisitions. What should we be looking for when they're taking these stakes in startups? How should we be judging and evaluating this? Yeah. Here's maybe a counterintuitive and perhaps a controversial idea. But my view is that these large corporations haven't really changed their approach over the last several

decades when the outside environment has changed pretty dramatically. If you go back 100 years, Ronald Coase won a Nobel Prize for explaining why corporations exist. He said they exist to pull assets and resources into the corporation to manage the transactions between those inside the corporation and to do it at a lower cost than could be done outside the corporation. Well, you fast forward 100 years and because of changes in technology, communication, Often the transaction costs, in other words, the ability for individuals and small teams to work and to craft deals, the transaction costs outside of corporations are quite often lower than they are inside. Yet corporations in many cases are still playing that old song, which is bring it all inside. That's not necessarily the best way to do it.

I think corporations need to understand that in a decentralized world, and we are becoming more and more decentralized, the name of the game is coordinating outside resources to their advantage rather than trying to collect it all within the walls of the corporation. We use the analogy of an old medieval walled town was the old analogy for corporations. The new analogy is something much more porous. Are there any large companies impressing you then with their ability to work with these startups and create those partnerships that allow them to innovate in ways that they couldn't inside their company? I think Microsoft is a great example right now in terms of the experiments

they're running through startup engagement, peppering investments, small investments, large investments across the ecosystem as a way to create some learning back to the core business, as well as some strategic optionality for the future, right? We tell corporations we work with all the time, the best way in the face of an unknowable future, the best way to maximize returns and minimize risk is to run as many experiments as you can at the lowest possible cost per experiment. So I look at those corporations that are really good at experimentation and especially experimentation outside the walls of the corporation as being better positioned for that unknowable future that's coming really quickly. Yeah. What was the example with Bing,

their search engine where I forget how many experiments they ran, but they ran a bunch of them. And then what was it like 2% of the experiments end up driving like a Pareto level of change for how their search engine improves. Yeah. That's the thing. If you think about a corporation has to learn, they do that by gathering insights. You think about those insights as a power law asset where one or two insights can lead to dramatic change in the trajectory of a company. The problem is you don't know ahead of time which insights matter most. And so these corporations that are running lots of experiments, gathering lots of insights are just mathematically better positioned to survive the future. Yeah. So you're someone who's watched

large corporations try to innovate, seeing smaller organizations help them innovate. One thing that happens, and we see this a lot in presentations from big companies, is innovation theater, where it's something that might look like an innovation, but it's a small change that doesn't really matter. What are some flags to you? How do you spot innovation theater? It's so prevalent. It's so common. And when you look across corporations, what you often see is there's obviously a sense that we need to be innovating. We recognize that the business model needs to transform over time. Everybody knows about the innovator's dilemma. And it's The thing that's ironic is we've gotten worse at addressing the innovator's dilemma over the last

30 years since Clayton Christensen wrote his book. So the signals, I'll give you a good example. I once worked with a company that had a 200 plus person innovation team. They were investing over $50 million a year in their innovation efforts. And this is in the tens and tens of billions dollars company. So it's a large organization, but they were investing over $50 million a year in innovation. And after seven years, that effort had not produced a single dollar of incremental revenue. Now, they could point to places where they had saved some cost in the business. And that's important. That's a really important type of innovation. But that's not what the team was set up to do. The team was set up to drive fundamental transformation in the business model.

And they obviously weren't doing that. It's so, so common. In fact, when you look across examples of large companies and when large businesses have successfully transformed their business model in the face of a changing future, there are kind of really two paradigms. You've got companies like IBM, where maybe five or six transformations over their long history, and in each case, it was driven by an existential threat. If the company didn't transform, they were going to go out of business. So that's one paradigm. Companies back against the wall, they have to transform or they're going to die, and

And often that transformation happens through M&A or some Hail Mary type of acquisition. The other scenario is where you've got a founder still in place running the company. And the founder who's willing to take big swings hasn't shifted to professional management yet. The founder is still there, the company is generating cash, they're willing to make some big bets and try things. A good example of that would be Amazon going to AWS, Netflix shipping DVDs to digital, to then production.

stages of transformation. That is pretty rare. The hardest thing is for the companies that are doing relatively well, generating profits, professional management in place, not facing any existential dire threat yet. It's really hard to think of any examples of companies in that position that successfully transformed their business model. That should provide some fodder for thought for investors as they consider where to place their bets. This was also at a time where those companies were significantly smaller, at least by market cap, than they were today. It's hard to, at least I think right now, it'd be really hard for Netflix to completely shift their business model again if they needed to go away from streaming or some physical media thing,

not that they would have to do that, but to make some transformational pivot. That's a lot more difficult when you have institutional investors and trillions of dollars of capital bet on your company and a shift and not not to denigrate the professional managers running that company are incredibly capable and smart but the founders aren't running the show anymore uh it's it's much it's much they're in a much harder position to execute the next transformation when you've got things like digital gaming you've got ai generating real content in real time you've got global competition much much harder position than they've been in the past yeah i think there's there's a positive place. I think like most people, my brain split between the positive and negative of

artificial intelligence. But when we're talking about innovation theater, it's hard not to think about artificial intelligence right now. And a lot of the companies that are absolutely rushing to get out of the gate to prove that they have something, anything about AI transforming their business. Maybe it's a dressed up chat bot. Maybe it's just something to show and have the buzzwords hit for the control F people on the earnings calls? If you think about it, there are three ways large companies can use AI to drive transformation right now in the business model. One is by increasing efficiency in their operations, cutting out costs. Number two is improving the customer experience. Number three is creating entirely new business

models that only are able to exist because of AI. You think about the first two corporations are positioned to do those first two things really well. And we see examples of corporations doing that. They're now experimenting using AI to reduce costs, improve customer experience. Those are great forms of innovation. The thing is that relying solely on those types of innovation is a path to going out of business because those things become table stakes. The third, creating entirely new business models is what turns out to be really, really

hard. corporations are not optimized for that, which is why we see startups coming in and doing so much of it. One of the things you've, you've written about as well as how corporate lifespans are getting shorter, even though the companies are significantly bigger, there's more trillion dollar companies right now than, than there were 10 years ago. I don't think there were trillion dollar companies a few decades ago. Why is that? And how, how do we know that these companies essentially, honestly, like this is a weird way of putting it, aren't functionally immortal. It's hard to think of a world without Amazon right now. It's hard to think of a world

without Apple. Why do companies need lifespans the same way that living and breathing things do when they're not living? They're an organization. Yeah. Amazon's a great example. I don't know if you remember this. A few years ago, when Jeff Bezos was still the CEO, he came out at a company meeting, I believe, and told the employees that Amazon would one day go out of business. And this sparks huge controversy. How could the CEO of Amazon say something like this? But of course, he's right. Of course, Amazon one day will go out of business. And what he explained to the employees of Amazon was that their job was to put off the demise of the company for as long as possible by continuously experimenting in the service of customer needs. so as long as these corporations are able to experiment in the service of customer needs find new and better ways to to to help customers they should continue to exist when they stop doing that they they're not serving society as well as they ought to and they should be replaced by new

upstarts that come and take take a hold and move up so why are corporate lifespans shrinking i think it's a signal that corporations are less capable of innovating than they used to be there yes, competition is harder in a more globalized world. As we talked about, more things are decentralized. You've got more power in the hands of individuals and small teams who now have access to more capital, communication, technology-building blocks than they ever have before. It's much easier to start a new business than it's ever been. It's harder for corporations to compete. That's the irony. There's more money on corporate balance sheets than ever in the history of the world, and yet corporate lifespans are shrinking. We see more share buybacks right now. There

are plenty of good reasons to do share buybacks, but when we see them at the level at which they're happening in the market right now, I think it's a signal that in many cases, corporations have lost their ability to dream big dreams and do big things. They don't know how to innovate as well as they once did. You talk about these corporations that are built for longevity, built for endurance. You've got a timeline of them, of the longest lasting corporations going back to more than a few thousand years ago. But a lot of them that have come up in the past 100 years that we know on the US stock exchange, they're financial. JP Morgan, Cigna, Citigroup. It's hard to think in the case of these huge

financial institutions that, I'll say in the case of JPMorgan Chase, it's almost like it's hard to think of a version of the story where that company goes completely bankrupt, kaput, without the entire country of the United States going down along with it. Are those companies, when you look at that timeline, are they even capable of being disrupted? 100% they are. Yeah, and the theory would tell us that they are. And in fact, when you think about Clay Christensen's idea around disruptive innovation, what he said was, in a nutshell, what that theory says is executives can do everything right and their companies will inevitably go out of business. And by everything right, meaning serve their best customers ever more profitably in the pursuit of capital efficiency,

increasing return on invested capital. And as they move up market to better address the needs of those most profitable customers, they leave themselves exposed at the low end for a new entrance to come in with good enough products and services, grab a foothold, and eventually move up market themselves and displace the incumbents. It's a really hard problem to solve. And the only way you solve it is by effectively disrupting yourself over time. And so those organizations that aren't continuously running those forms of experimentation that challenge the status quo, are in fact dying. The theory tells us that they're on their way down. It may not be obvious right now, and it may take a long time, but the trend line is not moving in the

right direction. For those big, huge banks we're talking about, or are you talking about corporations as a whole? Because I'm thinking about these- I'm talking about all of them. You've got situations where you've got large banks where the government is stepping in and saying, we're going to preserve this. That's going to exist no matter, as long as the United States of America exists, this is going to exist. That's a different situation. We'll see. We'll see. But even there, I would argue that even those organizations at some point have to be producing enough societal surplus for society to deem them worthy of continuing to exist. There may come a point where society says they're not producing enough surplus, even with government backing.

And it's a precarious position strategically to be in where you're depending on the government to be there to support you in the end. A government can change its mind. Yeah. So you say, what is it, companies say there's a lot of reasons companies say they go out of business. They go out of business for one reason. That's because they run out of money. One goal of the folks listening, they want to find those companies that can endure, that can exist, not go bankrupt for hundreds and hundreds of years. What are some signs then that one is looking at a company that's built for endurance? Yeah, such a good question. And I think this is a fascinating topic because as you alluded to, there are companies in operation today that have been in existence

for over a thousand years. The oldest company in the world was founded a hundred years after the fall of the Roman empire, a construction company in Japan that was just acquired in the last 25 years. And I think all the time about the guy who was managing that business when it ultimately succumbed, right? After like 70 generations of family ownership, the stress he must've felt. That's a tough one. But yeah, but I don't know about you, but I love the idea that an individual can start something that endures for 1500 years and helps solve problems for that long. That is an amazing thing. I want to do that. And when you look at these organizations and what they all have in common, there are many features that they have in common, but what it

really boils down to is what Jeff Bezos told his employees at Amazon. Your job is to prolong the demise of this company for as long as possible by continuously experimenting in the service of customer needs. Now, what these really long-lived organizations have that's different is they are continuously thinking not only about their current stakeholders and customers, owners, society, they're thinking about the stakeholders past, present, and future. And this is a longer timeline. There's a company in Japan during COVID, a researcher was looking at some of these companies in Japan that had been around for a long time and asked them, are you going to be okay during COVID? Do you have enough in reserves to be able to survive the crisis? And it's kind of

the common consensus was that, look, a big crisis comes every decade or so. We've been in existence for hundreds of years. So we plan for this. One business told the researcher they had enough capital on hand to last for 17 years without revenue. That's like a degree of safety that's probably beyond what's necessary, but it's an interesting perspective. They're thinking about past, present, and future over long periods of time, what they're going to pass on to future generations. They're thinking about what it means to be a good ancestor. And I think that the world would be in a better place if more executives were thinking that way. It's a hard thing to do. But it's actually, it's a contrarian view right now, having that long-term perspective.

If you want to win in business, the trick is over time, you've got to be non-consensus contrarian and turn out to be right. If you're going along with the consensus and you're right, you will go out of business. So you need to find ways to be non-consensus, to be contrarian and turn out to be right. Right now, a really easy way to be contrarian or non-consensus is to have a long-term view, to be optimistic about the future, which right now, uniquely in the last couple of decades, it's also contrarian to be an optimist. So a couple of easy ways to be contrarian and to turn out to be right. Well, one of the things when you're talking about the basically cash without revenue, Berkshire Hathaway is an example of a company

like that where they have tremendous amounts of cash on their their balance sheet relatively lean as an operating company and a lot of investors have kind of you know what are you doing with all that cash and it's it's that extreme long-term vision of munger and uh buffett the late munger and buffett that um have allowed them to to sort of i think pull that off in many ways and not listen to those outside voices yeah if you go to the opposite go to the alternative right which is A company, I went to business school that learned that as an executive, your goal is to push for monopoly status. That's how you extract the most profits. Winning in business is to achieve monopoly status, not get all your competitors.

Monopolies don't endure. They're overdoing it. They might benefit over a short period of time from maximum profits. But when you look at the long arc of time and total profitability under the curve over decades, over centuries, they're not performing as well as some of these organizations that are taking a more careful approach. And again, I think that's an interesting thing to consider for investors who are looking which companies they want to be placing bets.

So why do you think that is? I mean, I think about a utility company, which for a lot of people, that's not the worst place to place a bet. You get a high dividend, you have a relatively steady return. That's a monopoly, and it seemed to do okay for quite a number of people. Yeah, I think that may be. It's an interesting question. It's one to dig into more and do more research on.

And it may be, in the end, I would say that that's a monopoly that is constrained in their ability to maximize profits. They're still producing societal surplus, and society is looking at that saying, we will allow you to continue to operate with this model because we benefit. The problem you run into with companies where they're extracting too much profit is society then says through lots of means, through government intervention, through other ways, we don't want you to do this anymore and we're going to shut you down and we're going to constrain your ability to operate the way you have in the past. So it's constrained versus unconstrained monopolies. That might be what's might be playing out with Ticketmaster right now with the antitrust suit they got. We'll see if anything happens there. One of the things that I think is going to be a little controversial for some of those listening is, I'll say you're beef with return on invested capital.

In business school, that's a metric that everybody loves. Hey, a lot of market beaters over a long period of time have a high return on invested capital. You seem to have beef with this specific investing metric. Why is that, Elliot? Why the hard feelings? So return on invested capital is not a bad thing in and of itself, but I think companies can overdo it. And the way that this manifests itself in corporations is companies being overly careful, trying to eradicate variance from the system entirely. If you go back, I think it was in the 1980s, Jack Welch was the CEO of GE and famously said, variance is evil.

And what he meant by that was the job of the leadership team at GE was to root out any possible error making. We want to make things as predictable and safe as possible and preserve what we've got. Well, the reality is that people don't thrive in a system like that that is so hyper-efficient. And also, when crises come, those systems turn out to be pretty fragile. We saw a lot of this during COVID with supply chains, right? You have these amazing, incredibly capital-efficient, high ROIC supply chain operations. And when one piece in that system broke, the whole thing would crash down. And so over time, over a longer period of time, yes, in the initial quarter, that might have been very capital-efficient.

But over time, when the thing breaks, it turns out to not be efficient at all. And so ROIC is good. What I would question is the time period over which we're applying the metric. And the problem is that the incentives all drive managers right now, again, to be focused on that near-term output. It produces really fragile companies that don't endure and don't produce, over long time periods, sustainable returns. I mean, but over a long time period, it seems, from the data I've looked at, companies with a high return on invested capital tend to outperform the market. It may be a question of what's the optimal ROIC, right? Yeah. And again, I think that it just can be overdone. When you think about capital efficiency

drives ROIC, what's the appropriate amount of capital efficiency, there has to be some inefficiency in the system. For organizations that are trying to root it out entirely, those organizations are going to fail to learn. A 100% capital efficient organization doesn't learn. They're really good at executing and operating. As long as the world stays static, that's fine. But as the situation changes, and it inevitably will, that corporation is going to find that they're not positioned to endure and survive the shift. Or, I mean, maybe it's different. So I think if you have a young, innovative company, ROIC is not a great metric because you don't have that time horizon. If you have an older, mature company, I'll use Home Depot as the example I'm

going to use. Maybe ROIC is a good metric. I think for the next, I would say, 10 years, it's going to be intensely difficult to disrupt the Lowe's Home Depot duolopoly. And in which case, all right, we're going to transform into a cash cow and reward our shareholders because we kind of have the business down and we're not going to fundamentally change. And we also know that 10 to 20 years from now, people are going to need to go to a big store because they can't figure out, myself included, what exactly size screw I need to put into this picture frame.

Yeah, maybe. It's hard to predict the future, is what I would say to that. There have been plenty of situations that look stable and turned out not to be. But I think there are certain situations where you look at a company and say, yeah, they've got a pretty stable position. Innovation's not so important. And the managers should just be managing this thing for cash. But what you have to do is recognize the trade-off. And the trade-off is that when the disruption comes, they're going to crash pretty quickly. They're not going to be ready at all. So the argument is, in that situation, is that a company that needs to endure? Or is that a company that should just manage it for cash and say, hey, over the next 10 years, we're going to

extract as much capital out of this thing we can? That's a fine strategy. The problem most companies make is they find themselves somewhere in the middle, right? And this is the illusion of innovation. It's, well, we need to be innovative. We're going to pursue activities that look like we're doing important things, but don't produce any meaningful output. There are plenty of companies in situations like that where really the best strategy would have been just manage it for cash, manage the downturn, right? Famous story is Kodak. How much money they spent at the end of that company's life focused on last-ditch efforts and innovation. In retrospect, they should have just managed that thing for cash. But again, that goes against all human nature. That's very hard

to do. But there are situations where it does make sense to do that. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.