We Study Billionaires - The Investor’s Podcast Network - TIP 046 : The Innovator's Dilemma (Investing Podcast)

Starting point is 00:00:00 We study billionaires, and this is episode 46 of The Investors Podcast. Broadcasting from Bel Air Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish and Sting Broderson. Hey, how's everybody doing out there?

Starting point is 00:00:30 this is Preston Pish, and I'm your host for The Investors Podcast, and as usual, I'm accompanied by my co-host, Stig Broderson, out in Denmark. And today we've got a book that we're going to be discussing. The name of the book is The Innovators Dilemma, when new technologies cause great firms to fail. And this was written by Clayton Christensen. The reason that we chose this book is because there's a couple billionaires out there that highly endorsed this book, and those two are Mark Cuban and Jeff Bezos. I believe there's a couple more, but those are the two that Stig and I have paid particularly close attention. to. So Jeff Bezos has really kind of taken this book to heart. And I think you'll see a lot of the things that we talk about as things that he has implemented himself at Amazon with the way that he's running the company. So Clayton Christensen is a professor at the prestigious Harvard Business School.

Starting point is 00:01:18 And he's written a bunch of books. But this one here has particularly caught the interest of a lot of people out in Silicon Valley. The book was first originally published, I think, back in 1996 or 97 and it's been a huge success ever since. And I think the terminology disruptive technology, which I think everyone kind of throws that phrase around these days, really originated from this book. So without further ado, we're going to jump into this and we got really three main points that we're going to be talking about. And this was a really short read. Just so everyone knows, like, this is not a long book. It was a really good book, but I found it to be kind of repetitive considering how short it was. And I think maybe he could even made it even more concise,

Starting point is 00:01:58 because the point that he was making with the book was pretty narrow in general terms. I'm assuming, Stig, you agree with me on that. Yeah, and it's actually funny that you're saying it because I guess this is probably the shortest book that we had so far, but still it was actually quite repetitive a few times. Yeah, it could have been even shorter. But no, the point of the book, I think, is very good and very profound. I think it's something that a lot of people in business really need to understand, especially if you're kind of leading a business and you're looking for growth.

Starting point is 00:02:27 It's going to be a really important book for you to understand. So I guess we'll just kick it off. So Stigga, if you want to go ahead and take the first point here in discussing what is disruptive technology. Yeah. So, President, I think this is a really neat thing to discuss because as you're saying, disruptive technologies, that's really a term that everyone talks about these days. But what is it really? And whenever there is a new technology that is not necessarily going to replace the old. And it's definitely changing the way that we are using, say,

Starting point is 00:02:57 communication. So one example that might be that, like 10 years ago, everyone was using cell phones, now we're using smartphones. And it would seem obvious today that, of course, we should use smartphones. But when the first came out, it was for a very limited audience. And the smartphones that did come out, they were not really that good. So to me, that's a disrupt technology. Because you are communicating differently. It's not necessarily better, especially not in the beginning, but it's changing the way we do that. Yeah, one of the things that he talked about in the book, and this was kind of near the end of the book, but I thought it was a really good description of how businesses evolve and what kind of sparks this idea of a new disruptive technology taking place. And he talks about how when a brand new innovative type technology comes out, the company typically has the ability to have more margin or more profit on that technology because it's so revolutionary. It kind of takes the market by storm. There's not many competitors. and that's kind of the first phase.

Starting point is 00:03:56 As you go into the next phase, and he kind of described it as three phases. As you go into the next phase, you have a lot of people that are starting to enter into that market and trying to compete. The margins get a little bit tighter. And typically the original innovator still has an advantage just because of maybe branding and the way that it originally was launched and just kind of the movement that was behind it. And then as you go into the third phase, you have businesses at that point that so many have entered the market. and the margins are pretty much disappear and it's very competitive in nature and it's not really innovative anymore at that point. And so that's really kind of the cycle that he discusses.

Starting point is 00:04:33 And so when you're talking about something that's disruptive, you're talking about new technology or a new type of protocol or whatever terminology you really want to use is coming into that last phase and it's totally disrupting the way that society has pretty much said this is how this type of business is done. So when we're talking about the cell phone business, you know, you talk about cell phone technology alone when you go back to like the early 90s was huge. That was a disruptive technology. Then as things progressed through that decade, there was no smartphones. You just basically had these companies that really kind of figured out how to make and produce cell phones and everyone was, you know, on that train. And then all of a sudden smartphones came along. Totally disrupted that technology once again. And now, What's really interesting, and this is kind of a unique dynamic, is you have iPhone is still such a dominant player in this space. And we could really get into all the reasons why that might be. I think iTunes is a huge piece of it.

Starting point is 00:05:36 And I think that their ability to really deliver a quality product over everyone else up to this point in time is another reason. But really the point that we're trying to get across here is that this disruptive technology takes place. A lot of competitors come in. and it's just this evolving cycle that takes place. So that's really what we're trying to discuss here. And what's great about this book that Mr. Christensen outlines is, how does a business invest in disruptive technology in the most fruitful and risk-adverse manner and have the best results? Okay.

Starting point is 00:06:08 So let's talk about why do businesses fail to really implement disruptive technology successfully? And I think that that's really the essence of what he's talking about throughout a majority. of this book is that discussion. So let's go ahead and talk about that. So Stig, I'm going to throw that over to you and see what you think about. What was the main theme that you pulled out of the book for why businesses fail at implementing disruptive technology correctly? Yeah, I think that there was like three or four that I'd like to highlight. But I think the first one is focus. And like when we study billionaires and we started successful companies, and like everybody talks about focus. And what focus means here is that when you have like a traditional technology,

Starting point is 00:06:50 and then you have disruptive technology. You can't keep the same type of focus. And that's actually quite clear why you can't do that because you will have another kind of branding, another type of customer, simply another market. And typically, you will build up your business due to a certain business model, which is outlined from the products that you're selling at the beginning

Starting point is 00:07:10 and the successful products that we get later on. It's really, really hard to do that, for instance, if you're selling, say, cell phones, so then you're just switching to smartphones because it's just a complete another ballgame. Clearly it's related but the customers are different and so on. So I definitely think

Starting point is 00:07:29 that focus, that's one thing. Another thing that Clayton Christ has talked about a few times, that was the values. And I think that's really important. So you might have like a really visionary leader and that leader would be saying, no, we should go in this direction. But

Starting point is 00:07:46 if the product, the new technology is not true to the values of the existing business. And there might definitely be a discrepancy between the values of the assistant business and the news business, because by definition, it's new. Then those employees, perhaps even some of the managers, they will, but gradually, they will stay and keep doing what they're doing because the products that they already have, that's more consistent with the values and the new products that might be inconsistent listen to that. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer.

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Starting point is 00:12:43 And what argument he makes is this emerging disruptive technology typically needs a different culture or a different set of values in order to be successful. And what happens is a lot of these companies try to basically copy and paste their previous values and organizational habits into this new. a emerging technology role or organization that might be small and might need to have a lot of agility in the way that it's being set up and being managed. And whenever they bring this architecture from the old to the new, it's typically very debilitating for them to be successful.

Starting point is 00:13:24 And so he's basically promoting the idea that this disruptive technology that you're investing and really needs to have a new foundational level established from the root and that it can't really adopt the previous organization's architecture. And I think that that's a fantastic point. And I think that that's one of the reasons why when you look at Warren Buffett and the fact that he's been adding all these bolt-on companies into his organization and he's never really pushed a Berkshire corporate mindset or fundamentals down to those

Starting point is 00:13:56 companies that he's purchasing is one of the reasons why he's been so successful for so long. And that's really important. I think you see the same thing happen with Amazon. And you see the same thing happen with all these companies that are having these major acquisitions and they do it successfully. They don't try to come in and change the architecture of that preexisting organization. They really kind of let them do their own thing and let them exist kind of as their own microcosm outside of their overall architecture of their headquarters. One other thing that I want to highlight then I think this was a great discussion in the book was the idea that he says that a lot of these higher level managers, whenever they're looking at, looking for growth within their company, they failed to recognize the power and the importance of

Starting point is 00:14:41 investing in disruptive technologies because at that present time, they don't recognize the value of the return that it could potentially give. They're only looking at the current return and the current market cap of what that technology is. So let's go back and use our cell phone example. So I'm sure if you went back to the point in time when smartphone technology or the the smartphone market was emerging. At that infancy stage, I'm sure the market size was like next to nothing. And so you had a lot of companies like call it Motorola or whoever that are looking at this market and saying, hey, there's no market size here that's going to add any type of percent gain to our bottom line

Starting point is 00:15:21 because the market's too small. Let's just say Motorola. I don't know what their revenue size is per year. But let's just say that it's $500 million. I don't know what it is. I'm probably way off, but let's just say it's $500 million. So whenever they look at that smartphone market, let's say that at that time during the infancy stage, they might say that it might add, you know, 500 million of revenue to their top line, assuming they took the entire market.

Starting point is 00:15:46 So that's a big assumption, and that's something that they probably said that that's not even possible. And if they would do that, that's only going to add 10% of revenue to their top line with a huge amount of risk potential. And that's how a lot of these higher executives, are looking at things in that perspective, hey, this isn't adding much to my top line, but I'm assuming a lot of risk because this technology isn't even proven. The market size isn't big. And so they immediately turn off and then they're late to the game.

Starting point is 00:16:13 And that's where Christensen is really saying that these companies are making big mistakes because they're not looking at, I guess, the exponential growth of an impossibility of a disruptive technology. So that's the hard thing here that he's really talking about as the innovator's dilemma is do I invest in this emerging technology that has a huge upside but tons of risk? And is it going to be a disruptive technology? And that's really the struggle that a lot of these business leaders have. And I think that when we get into the third segment of this episode, we'll talk about how you go about that in the most risk-adverse way that's really thoughtful.

Starting point is 00:16:52 But I want to throw it back over to Stig to talk through some more of these issues that caused this dilemma. So basically, I think this is a leadership issue. And I can also hear that you were talking about that present. But I think the key here is really to have the right leaders in place. And this is not the same as saying that top leaders, top executives aren't doing the job the right way. Because it's very logic why they do as they're doing. For one thing, these disrupts technologies, they are new markets. And by definition, new markets are very, very hard to analyze, perhaps because there is.

Starting point is 00:17:27 basically no market. Another thing, I also think that was probably also one of the thing that you're aiming at Preston was that you need to get the man just excited. So like in Christensen, he takes an example in the book and he's saying something like a billion dollar company, they won't be happy about a one million dollar order. But if you have a small 10 million dollar company, that will mean the world to them. And you need to have leaders in place that will get excited about new orders. come in from this new disruptive technology. They should be judged completely on the performance of that new technology and not on the

Starting point is 00:18:06 overall performance of the business. Otherwise, it will never thrive. So he doesn't say this exactly in the book, but this is the way I took it. I think that the leaders that go about this investing in this disruptive technology in a manner that they're successful really comes down to this kind of fundamental point. the guys that do it wrong are the leaders that are investing because they don't want to be left behind and they don't want to lose market cap. The guys that are doing it successfully, they're doing it because they want to invest and shape the future for the good of their customers and they really want to be at the forefront of that emerging movement and they want to make a difference. I think that when you compare those two contrasting points of view, the guys that are just playing catch up because they don't want to lose market share versus the guys that are really trying to make a difference in the world, that's what separates.

Starting point is 00:18:55 And that's what makes the difference. And that's really hard to gauge, especially if you're an investor from the outside and a non-controlling share of a company. It's kind of hard to gauge that. But I really think that that's the difference of a company that is going to be really successful in the future with implementing disruptive technology versus one that's not. And I think that that's one of the reason when you look at Apple and you look at Amazon, this guys aren't playing catch up. They're shaping the future. And I think that they really have that mindset really bred into the culture. of those companies, and I think that's one of the reasons they've done so well.

Starting point is 00:19:28 So let's talk about the solution. So that would be the third and the last segment. And Clayton come up with a few different suggestions of how to solve this problem. And I think probably the most important one that I took away from the book was to have the right-size company. So when we're talking about right-sized company, it's typically a very small company because this is disruptive technology. It's a very new market.

Starting point is 00:19:56 There are very few customers. So you need to have a company that's well suited for that segment. And I think that, to me, that made a lot of sense. So for one thing, when you are acquiring new customers, that takes a lot of energy from you. I don't know if you guys are familiar with the 7 to 1 rule, but we have this rule that it takes seven times as much resources to get a new customer as to get one of the existing. And one of the problems by not spinning it off into a new company is that you will lose some of your original customers if you change focus. So what Clayton is saying as a solution is not to change a focus, but I have a brand new focus for a very small, growing company that is completely aligned with the new audience for that company.

Starting point is 00:20:46 And that's really the heart of his solution. So, I mean, it's a short book and it could be shorter, but I think Stig and I are just going to summarize this. What he's really suggesting is that these larger companies, if they want to invest in disruptive technology, they basically have to birth a new company and set the right conditions with the right leader in charge in order for that person to basically go at it alone and out on his basically own microcosm company. And that's how he's suggesting that they go about this correctly. He really, and he gives a lot of evidence and a lot of case studies on why companies that don't take that approach, typically fail at the venture and they give up and they basically take their resources back and basically handicap the venture when they don't have quick returns and quick progress in shaping that emerging technology. And from what I've seen with other businesses,

Starting point is 00:21:39 I totally agree with that thesis that he has for the book is the company has to be basically started off on its own. And if we look at the empirical evidence for is Clay Christensen's right, then I need to look at spin-offs. So if you look at spin-off in the stock market, it's very, very clear from empirical evidence that spinoffs are better for the existing company, but it's also better for the spin-off company. It's very clear, and just to be completely specific

Starting point is 00:22:13 about what is a spin-off, that would be if Apple, they were spinning off the iPad division. So everything it has to do with iPad, that would just be in another business, with a new leader, having their own accounting. That would be a spin-off. And it just turns out to be the spin-offs are doing really, really well because they can have this focus.

Starting point is 00:22:33 It's really, really hard for big companies. And if you are going to do that as a big company, I think you need to look at companies like Johnson & Johnson or Berkshire Holloway, either buying new companies and just leaving them alone or having bold on companies that is completely aligned with the existing business model. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up,

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Starting point is 00:26:41 people in charge in order to run with it. And it's pretty amazing idea, but you see very few people actually implement it appropriately. One of the companies that we previously mentioned, which is Amazon led by Jeff Bezos, who's the person, the reason why we're reading this book is because we know Jeff Bezos likes this book. But with Jeff Bezos in the way that he runs Amazon, he set up these teams, these competitive advantage, basically like a board where this competitive advantage team would go out and look across the market and say, who's kicking off?

Starting point is 00:27:11 our butt. Who out there is beating us at whatever? I learned this whenever we read the everything store. There was a story about this in the everything store where there was this company that, I forget the name of the company, but they were basically taken Amazon to the cleaners on selling baby diapers. I can't remember the name of the company. But anyway, this competitive advantage team saw that this company was taking them to the cleaners and they basically said, hey, this this is our target. Either they're going to continue to beat us or we've got to beat them or we've got to buy them. And so that's what they did. They basically went to war with this company because they knew that they were outperforming them. And so Jeff Bezos's company, Amazon basically cut all their prices on diapers to compete with them price wise. And they went toe to toe with them. And then what they actually figured out was that somewhere in their distribution, and it's been a while since I read this, but somewhere in the distribution of this company that was kicking their But they were distributing their diapers in a much more efficient manner. And so Bezos basically learned this, adopted their distribution technique, and then went toe to toe with them.

Starting point is 00:28:23 I believe he ended up buying that company out and then basically bolted them onto his company, kept everything the way it was, let them continue to operate. And then he adopted the methods that they were using into his own organization to improve his own organization. So it's really fascinating to see him almost take the exact opposite approach of what you see major corporate leadership typically do where, you know, most of these companies will buy them and then force the Amazon name down on them. And, hey, this is how you're now doing business. He took the exact opposite approach. He purchased the company. He learned why they were better than him. He adopted those principles into the larger Amazon company and then kept them operating in the way that they were.

Starting point is 00:29:08 So truly taking what everyone else does, flipping it on its head and improving his organization, becoming more efficient. And I really think that that's a great example of really the power of this book because I would argue that he learned those techniques and those ideas from this book. And I think that's where it's all coming from. Okay. So that's all we're going to really talk about for the rest of the innovators dilemma. Like we said, it's a very short book. I think it could even be shorter. That's really the essence of what he was talking about.

Starting point is 00:29:37 Really, really good read, though. If you're a business owner or if you're a person who's interested in this idea of disruptive technology, I really think that you need to come and read this book because this is probably the root of where all that discussion and all that thought is really kind of emerging from. So if you're that kind of person, you'll probably eat this up. But what we're going to do right now, this is the point in the show where we go to a question from a member of our audience. And this week's question comes from Daniel Revis. Hey, Stig and Preston. This is Daniel Revis from Reno, Nevada.

Starting point is 00:30:06 and first and foremost, thank you guys for your podcast. It's very valuable to me, and I know that you guys are giving a lot of value to many people, so please keep up the good work, and thank you. So my question is, I know that Warren Buffett has an average return on his investments of about 19%. And I was wondering, because I know that's a lofty goal, but I was wondering if I can translate over to creating your own business. Should you want to, after your expenses and at the end of the day, want to have a 20% return on your investment or is there a whole other a whole other parts of creating a business that I don't know about? Thank you.

Starting point is 00:30:46 Wow. So I really like this question and I like the fact that you're really talking about starting your own business and that's really where the question is stemming. So I'll tell you, a 19% return is a fat margin. That's really good and that's pretty amazing over such a long period of time. And I think that's the thing that makes Warren Buffett so successful and has really led to why he is such a famous person in the business world is because he sustained that over 50 years, which is just totally crazy. So here's what I'll tell you. If you start a business and you created a product or you have some type of proprietary service that no one else has, you can fetch a higher margin. You can get 30, 40 percent on whatever it is that you created because you have some sort of. something that's very unique and that no one else can compete with you on. But if you don't have that intellectual property of whatever that might be, you can't get the larger margin. You've got to

Starting point is 00:31:44 settle for something a lot less. So when we look at like the car industry, if you own a car dealership, the margins in that are like next to nothing. It's like five to 10 percent if you're doing extremely well. And that's because there's so many competitors. If you buy a car on one street, you can go right across the street, probably buy the same car. So there's so much. much competition and the margins go down. When you talk about something like Google, for example, how many people out there go and search off of Bing versus Google? Well, the numbers show you that it's something like 60 or 70 percent of people conduct all their searches on Google. That's a competitive advantage. That's a huge competitive advantage and that will fetch you a very large margin.

Starting point is 00:32:25 And so when you look at Google's income statement, their margins are like 20 to 30 percent from their revenues down to their net income, it's really fat. So when you talk about a business and you look at it from that context, that's kind of where you need to start and really kind of understand what value do I have with my product or service and then how much of a margin can I receive. I also want to throw out this idea when we were talking about Jeff Bezos this whole episode. So Jeff Bezos has a quote.

Starting point is 00:32:53 He says that your margin is my opportunity and my competitive advantage, which I love that quote because it basically is his way of saying, if you're charging a lot, I'm going to take you to the schoolhouse, which is a really kind of neat idea. And it's the same thing he really learned that from Sam Walton. He's taking on the same approach of Sam Walton with Walmart. But Stig, I'm real curious to hear what you have to say about some of this stuff. Yeah, so I really like pressing that you talked about margins. One thing I do want to also talk about is the return on investment. So when we're talking about Warren Buffett and we're talking about his margins, we were typically talking about. the margins in his business, or we can also talk about his stock market returns, which is also perhaps closer to these, let's call the return on investment. So if you're sitting and, you know, comes to plating, starting a business with a thousand dollars, you might be thinking, so will I get a 19% return on that, or should I aim for like 50% return on that? And I think that's a genuine concern.

Starting point is 00:33:54 And I know I have some students, they're thinking about. apps. I don't know what's happening about apps lately, but it seems like if you're 20 years old and you're starting economics, you just want to do an app. You know, guys, that's completely okay. So, you know, they would, you know, show me this spreadsheet and then we would say, so we invest $1,000 or $5,000 in the app and we think we can get 5x on that in two years. So they would be looking at me and saying, why do you think I should invest in the stock market and get 8% or 10%? Now, there are a few things I'm always saying to my student. And one thing is that you need to not only invest your money, but also you need to invest

Starting point is 00:34:34 sweat equity. And that's, I mean, that's extremely valuable for you and that's really awesome. But you know, you will be spending a lot of time developing this app. And if you can't do it yourself, you will spend a lot of time designing it, speaking to a programmer, marketing it. There's all these different things that is not included in those $1,000. or $5,000 or whatever you're paying. Yeah, I want to see what kind of app they're developing for $1,000.

Starting point is 00:35:03 I'm jealous. I'm over here like dying, laughing. People can't see this, but your comments are really making me smile because this whole app thing is quite amazing to me. And I hear a lot of this as well, Stig. So most people don't realize if you're going to build probably a cheap app, you're talking like $5,000 to $7,000. And then it's like, well, what competitive advantages your app have and what

Starting point is 00:35:25 value is it adding over the millions upon millions of apps that are already out there? And what's your marketing strategy to distribute the app? But keep going. I'm sorry to interrupt, but I'm over here dying. Yeah. And I think it's a great point, Preston. And also for these students, and it's not that I wanted to discourage students from ever going to start their own business, because I think that's probably the most important thing in the world that we have students that want to start their own business. But what they often don't see is, is also the downside. And I'm not talking about the downside about spending all this time

Starting point is 00:36:00 because that's amazing, I learn a lot. But the downside of starting an app or starting an app company is typically that there's a really good risk that you'll end up with zero dollars. And I think this is actually very relevant to the next book that we're talking about the Black Swan, which will help next week, which is about things that are extremes. Because sometimes I hear something like, you know,

Starting point is 00:36:22 I can get 5x or I can get zero. So that might be on average, I'm just making this simplistic, but they might say on average, you know, they were going to have two and a half X. But that's not how this works. I mean, like 99% of all apps are not going to return any kind of profit for you. So you can't do it like that. So there's a huge downside if you invest $5,000, which is a lot of money for most students. There is a great risk that you end up with $0.00.

Starting point is 00:36:49 Now compare that to a stock investing. I say that you invest in index. Now you might lose 50%, which would be. horrible. But I don't think you will ever have, you know, with zero dollars if you, if you buy the S&P 500, plus if we're talking about stocks and people always know that I'm pretty bull on stock as an asset class, but you know, there's, they're liquid, it's truly passive. There are all these different things that is just very different when you're having your own business. So really to answer your question, Daniel, you can't really compare like 19% if we're talking about

Starting point is 00:37:24 channel investment to Warren Buffett. That's just another discipline. Yeah, it's, it's really hard discussion, especially when you're talking about like a really small and immature business that you're talking a couple thousand dollars. I mean, your returns could be 150% on your principle when you're talking those small of numbers. And it could be absolutely nothing. It's, it's typically very polarized at that level where you're not talking about like the difference between a 10 to 30% margin. you're typically talking about a zero to a 300% margin when you're talking about small numbers. But really fun discussion. Sorry to interrupt you the few times there.

Starting point is 00:38:00 Stig with the app discussion. I could probably talk about that for a few hours. But that's our two cents. So Daniel, that was a really fun conversation. We're really glad that you asked that. We're going to send you a free sign copy of our book, the Warren Buffett Accounting book. And for anybody else out there, if you want to get your question played on the show like Daniel,

Starting point is 00:38:18 go to AsktheInvesters.com and you can record your questions. there. So we've really had a fun conversation this weekend. We're really happy that you guys tuned in to the Innovators Dilemma discussion. So that's all that we have for you and we'll see you next week. Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.com.com. Submit your questions or request a guest appearance to The Investors Podcast by going to www.com. If your question, is answered during the show, you will receive a free autographed copy of the Warren Buffett

Starting point is 00:38:55 Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application. TIP!

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