#53 A series on companies' Growth: Part III
Navigating "Growth Stalls": recognizing and understanding the warning signs from an investor's POV
In the dynamic world of business, companies, irrespective of their size or industry, experience periods of rapid growth and prosperity, but they can also face periods of stagnation or decline, referred to as "growth stalls". A growth stall is not just a temporary slowdown or a short-term setback; it is a significant reduction in the growth rate that lasts longer than just a few quarters and is often indicative of deeper, structural issues within the company.
In this post, we delve into the concept of growth stalls, explore their common causes, and discuss strategies for detecting and assessing them using real-world examples. By gaining insights into these crucial aspects and understanding how they impact a company's growth trajectory, investors can make informed decisions and support businesses in overcoming growth stalls.
“The most dangerous poison is the feeling of achievement. The antidote is to every evening think what can be done better tomorrow.” –Ingvar Kamprad, founder of IKEA
Welcome to Edelweiss Capital Research! If you are new here, join us to receive investment analyses, economic pills, and investing frameworks by subscribing below:
The Nature of "Growth Stall"
As we begin to unpack the nature of "growth stalls", it's important to note that the underpinnings of this phenomenon remain largely unchanged, even though the study we use as a framework today, by Olson & van Bever (2008), was conducted several years ago. The fundamental principles of business, market dynamics, and organizational structures are timeless, and this makes the findings of the study ever-relevant.
One of the most famous examples of a company experiencing a growth stall is Kodak. The once dominant force in the photographic film industry faced a significant growth stall as digital photography began to overshadow traditional film photography. The company's inability to adapt quickly and effectively to this technological disruption was not just a temporary slowdown; it was a structural issue that eventually led to its bankruptcy in 2012. This is an exemplary case of a growth stall resulting from an external industry shift that a company fails to navigate.
On the other hand, consider Apple in the mid-1990s. The company experienced a slump in growth due to a series of unsuccessful product launches and internal management issues. However, with the return of Steve Jobs in 1997 and a clear vision for innovative products like the iMac, iPod, iPhone, and iPad, Apple managed to reverse its growth stall. This instance highlights a growth stall caused by internal factors, which was eventually overcome by strategic leadership and innovative product development.
Understanding the difference between a normal, temporary slowdown and a structural issue is crucial. Every company experiences periods of slower growth or even temporary declines in revenues or profits. These slowdowns can be due to a variety of reasons such as seasonal fluctuations, temporary supply chain disruptions, or short-term economic downturns.
However, when a company's growth significantly slows down for an extended period, it might be a sign of a more serious, structural issue. These issues can stem from various sources, including shifts in consumer behavior, technological disruptions, poor strategic decisions, or internal problems such as leadership instability or operational inefficiencies.
The key lies in recognizing whether a slowdown is a normal part of the business cycle or a symptom of deeper, structural problems.
Factors Contributing to "Growth Stall"
The factors contributing to periods of growth stall are diverse, complex, and often a combination of many of them. Academics and researchers always strive to create models that can describe reality, although we know that reality is anything but simple.
However, I must acknowledge that the following image provides a synthesis of the majority of reasons why companies cease to grow. The amount of information contained in this simple table is astonishing. Since it is impossible to analyze everything in a single post, let's focus on the most common reasons and factors, particularly those that are within a company's control, that cause businesses to lose their way and make strategic missteps (which are always easy to see in hindsight but harder to predict).
By understanding and addressing these common reasons and factors, businesses can gain valuable insights and improve their ability to navigate growth stalls. While each situation is unique, exploring these concepts can help us develop a strategic mindset and make more informed decisions.
1. Premium-position Captivity
Premium-position captivity expresses the inability of a firm to respond effectively to a challenge posed by a new low-cost competitor or to a significant shift in customer valuation of product features. In all instances, the core problem is the inability of a premium-positioned company to migrate its business model effectively to a new, lower-cost basis.
Disruptive Competitor Price or Value Shift: For instance, traditional airlines like British Airways and Air France faced a growth stall when budget airlines such as Ryanair and EasyJet disrupted the market. These budget airlines offered significantly cheaper fares, creating a new value proposition that appealed to cost-conscious travelers. The traditional airlines, reliant on their premium position, struggled to adapt to this new competitive landscape.
Overestimation of Brand Protection: This is when a company believes its brand reputation alone will safeguard it against market changes. Kodak overestimated the protection its brand name offered and underestimated the shift to digital photography. As consumers rapidly adopted digital cameras, Kodak's market share plummeted, leading to a significant growth stall and eventual bankruptcy.
Gross Margin Captivity: Companies fall into this trap when they're too reliant on high-margin products and are reluctant to shift to lower-margin products, even when market trends indicate they should. IBM experienced this with its mainframe computers. Despite seeing the shift towards personal computers, IBM was hesitant to cannibalize its high-margin mainframes. What happened afterward is well known.
Innovation Captivity: This happens when a company is so tied to a successful product that it struggles to innovate beyond it. Microsoft experienced this with its Windows operating system. The company was so focused on protecting its Windows monopoly that it missed the shift to mobile operating systems, resulting in a significant growth stall.
Missed Strategic Inflection in Demand: This occurs when a company fails to recognize a significant shift in market demand. Blockbuster, the video rental giant, missed the strategic inflection point in demand from physical rentals to online streaming, leading to its decline.
2. Innovation Management Breakdown
The second largest stall factor identified was Innovation Management Breakdown, chronic problems in managing the internal business processes responsible for renovating existing products and services and creating new ones. The root cause challenges that present most commonly concern the nature of R8D investment (and therefore its resource allocation and focus between incremental and breakthrough innovation) and the self-cannibalization challenge inherent in the conflict of new innovation with existing technology and business models.
Curtailed or Inconsistent R&D Funding: In industries where R&D is crucial, inconsistent funding can lead to a lack of new products and a subsequent growth stall. Many pharmaceutical companies, such as Merck, have faced this issue. Without a consistent stream of funding, these companies struggle to develop new drugs to replace those with expiring patents, leading to growth stalls.
Slow Product Development: In fast-paced industries, slow product development can be fatal. Nokia, once a leader in mobile phones, suffered from slow product development. As competitors like Apple and Samsung quickly introduced new, innovative products, Nokia's market share declined.
Overinnovation: Overinnovation occurs when a company develops innovative technologies but fails to commercialize them effectively. Xerox is a prime example. Despite developing many groundbreaking technologies, such as the graphical user interface, Xerox failed to effectively bring these to market, leading to missed opportunities.
3. Premature Core Abandonment
Premature Core Abandonment, the third most common factor contributing to multiyear revenue stalls, refers to the failure of executive teams to fully capitalize on the growth opportunities within their current core business. Despite extensive evidence from academia and consulting, there is still a persistent temptation among executives to shy away from challenges in their core business and pursue seemingly easier opportunities elsewhere. However, decades of experience have consistently shown that the core business holds untapped potential and offers greater rewards compared to new ventures, reinforcing the notion that "the grass is not always greener on the other side".
Financial Diversification: Companies like GE have faced growth stalls due to excessive financial diversification. By moving away from their core industrial businesses into financial services, these companies were hit hard during the 2008 financial crisis, leading to a significant slowdown in growth.
Misperceived Market Saturation: This happens when a company wrongly believes that its core market is fully saturated, leading to a lack of investment in that area. Toys "R" Us believed that the market for physical toy stores was saturated and failed to invest adequately in its online presence, leading to a growth stall when online retailers like Amazon gained market share.
Misperceived Operational Impediments: This occurs when a company overestimates the operational hurdles of its core business and shifts focus elsewhere. For instance, IBM in the 90s thought that maintaining its PC business was operationally intensive and less profitable, which led to a shift in focus and eventually selling the division to Lenovo, missing the future value of this segment.
Core Problems Masked by International Growth: Some companies experience growth stalls when issues with their core business are concealed by expansion into international markets. Starbucks, for example, faced a growth stall in 2008 due to overexpansion (and the previous step down of Howard Schultz). The company had been rapidly expanding internationally, which initially masked issues with its domestic business. However, when the financial crisis hit, the company's growth stalled and they were forced to close hundreds of stores.
Earnings Growth over Core Reinvestment: This happens when a company prioritizes short-term earnings growth over reinvestment in its core business. An example is Sears, which prioritized share buybacks and dividends over reinvesting in its stores and online presence.
4. Talent Bench Shortfall
The lack of adequate leaders and staff with key skill sets to execute the firm's growth strategy. Although relatively small in number from the perspective of the overall stall points taxonomy, this category should flash perpetually amber in today's climate of growing talent shortages.
Internal Skill Gap: Companies like Yahoo have faced growth stalls due to a lack of internal skills. Yahoo lacked the technical talent to keep up with competitors like Google and Facebook, leading to a decline in user engagement and advertising revenue.
Narrow Experience Base: This happens when a company's leadership lacks diverse experience. BlackBerry, once a leader in smartphones, suffered from a narrow experience base. Its leadership failed to recognize the importance of apps and a diverse ecosystem, which competitors like Apple and Google leveraged for success.
Loss of Key Talent: Losing key talent can lead to a growth stall. Apple experienced a growth stall after the departure of Steve Jobs in the mid-80s. It wasn't until his return in the late 90s that Apple was able to innovate and return to growth.
Key Person Dependence: This occurs when a company is heavily dependent on a single person. Tesla, for instance, is heavily reliant on Elon Musk. While Tesla hasn't faced a growth stall yet, such key person dependence can be a risk factor for future growth stalls.
Detecting "Growth Stall"
Let’s explore the tools and key indicators that may let us differentiate between temporary setbacks and more profound structural issues for the 4 categories we have described before:
1. Investor's POV on Premium-Position Captivity
As investors, we know the value of a company's position in the market and its ability to command premium prices for its products or services. However, we also need to examine if the company is making false assumptions about its customers, competitors, and market evolution.
Customers: A company may believe that its core customers will not trade away product performance for a lower price. However, it's crucial to consider market examples like the rise of budget airlines such as Ryanair and EasyJet. Traditional airlines believed customers wouldn't compromise on comfort and service quality for cheaper fares. Yet, the success of budget airlines proved otherwise.
Companies may also assume that their pricing premiums earned through incremental product enhancements will withstand pricing challenges from "lower-performance" products. A classic example of this fallacy is the downfall of BlackBerry. They believed customers would continue to pay a premium for their secure, high-performance smartphones, but they were undercut by the arrival of cheaper Android devices offering good enough functionality.
Competitors: A company may underestimate low-end players' ability to meet core customers' performance demands or match the company's rate of improvement in product or service features. Investors should consider cases like Kodak, which failed to anticipate the rise of digital photography and the capabilities of new entrants in the market.
Companies may also falsely believe that their brand equity, sales force size and sophistication, and distribution networks will protect them from inroads by low-end rivals. However, we've seen how companies like Amazon, with its efficient distribution system and customer-centric approach, managed to topple established retail giants.
Market Evolution: The company may falsely assume that losses of market share due to erosion at the bottom of the market can be limited and isolated from mainstream market segments. The rise of Netflix, which started as a low-end DVD rental service and then disrupted the entire movie and TV industry, is a perfect example of this fallacy.
The company may also focus its competitive efforts on traditional rivals and ignore the threat from new entrants with different business models. As investors, we need to look at how the company is diversifying its competitive benchmarking beyond just its traditional, at-scale rivals.
Finally, an investor needs to evaluate the company's leadership strategies. Does the company have a structured approach to tracking shifts in key customer groups' valuations of their product and service attributes? Do they refresh this information frequently enough? Are they tracking the market share held by new entrants with different business models?
It's essential to investigate if the company has demonstrated the ability to self-cannibalize its existing product and revenue streams with lower-cost alternatives. A classic example is Apple, which wasn't afraid to launch the iPhone, knowing it could cannibalize iPod sales.
Lastly, does the company honestly test its core customers' willingness to pay a premium for superior performance or brand reputation? This assessment can help an investor determine whether the company's premium position is sustainable or whether it's at risk of a growth stall.
2. Investor's POV on Innovation Management Breakdown
Innovation is the lifeblood of any company that wants to stay competitive in today's rapidly evolving market landscape. As investors, we must scrutinize how well a company manages its innovation process and whether there are signs of a breakdown in this area.
Innovation Funding: The first question we might consider is how the company budgets for R&D and other innovation resources. Ideally, we want to see a separate process for corporate-level innovation funding that goes beyond incremental changes driven by individual business units. This approach would suggest a commitment to transformative, next-generation ideas.
Moreover, we need to check whether the company maintains adequate visibility into business unit-level funding decisions. Such visibility can help balance incremental improvements with investments in next-generation innovations. Amazon, for instance, is known for its ability to balance improvements in its core e-commerce business with investments in new areas like cloud computing (AWS) and digital streaming (Amazon Prime).
Innovation Focus: We also need to assess whether the company allocates a portion of its innovation funding to lower-cost versions of its products and services. This strategy can help capture a broader market segment and guard against disruption from low-end competitors. Consider the case of Toyota, which introduced the lower-cost Scion brand to attract younger, more price-sensitive customers without eroding the premium positioning of its mainline Toyota and Lexus brands.
Coordination and Exposure to Trends: Another crucial aspect is the coordination between the market research and R&D departments. Real-time coordination can ensure the company's innovations align with emerging market trends and customer needs. For example, Netflix's success can be attributed to the tight integration of its data analytics (a form of market research) and product development teams, allowing it to create highly popular original content based on viewer preferences.
3. Investor's POV on Premature Core Abandonment
Prematurely abandoning the core business can be detrimental to a company's long-term growth and success. As investors, we need to assess whether a company is effectively managing its core business and avoiding the temptation to prematurely label it as "mature" or overlook its potential for further growth.
Revenue and Earnings Growth: One crucial consideration is whether the company has significant revenue growth and earnings growth goals for its core businesses. These goals demonstrate a commitment to continue driving the performance and expansion of the core operations. For example, Apple's sustained focus on revenue growth in its core iPhone business, despite the introduction of new product categories like the Apple Watch and AirPods, illustrates a dedication to nurturing its core revenue streams.
Avoiding the "Mature" Label: It is essential to evaluate whether the company avoids using the term "mature" to describe its product lines, business units, or divisions. This approach reflects a mindset that encourages ongoing innovation, improvement, and market expansion. Despite being a well-established brand, Nike continuously strives for innovation and evolution in its products. The company invests heavily in research and development to introduce cutting-edge technologies, design advancements, and sustainable materials. Nike's commitment to staying ahead of consumer trends and preferences has enabled them to maintain their market position and appeal to a wide range of customers. By avoiding the "Mature" label and embracing a culture of innovation, Nike remains a dominant player in the competitive sportswear industry.
Core Business Reinvestment: We also need to examine the core business reinvestment rate, which encompasses R&D, capital expenditures, and advertising, divided by revenue. The reinvestment rate should at least be consistent with historic levels, if not higher, to ensure ongoing innovation and competitiveness. And if we talk about reinvestment, there is no other option but to mention the flagship of reinvestment. Amazon's massive investments in fulfillment centers, infrastructure, and research and development have enabled the company to continuously expand its core e-commerce operations and explore new growth opportunities.
Redefining Core Market Boundaries: A forward-thinking approach involves regularly redefining the core market boundaries outward. This strategy positions the company to capture a small share of a large addressable opportunity, rather than limiting itself to a narrow definition of the market. Google's expansion beyond search and advertising into areas like cloud computing, autonomous vehicles, and healthcare initiatives demonstrates its ability to redefine core market boundaries and seize new growth avenues.
4. Investor's POV on Talent Bench Shortfall
Companies are more than just structures and products; they are comprised of the individuals and cultures that shape their identity. Investors play a crucial role in assessing a company's talent management strategies, recognizing that the people within an organization are the driving force behind its success.
Recruiting the Best Candidates: It is essential to evaluate whether the company has the flexibility to recruit the best possible candidates for key positions, regardless of whether they come from internal or external sources. Embracing a diverse talent pool enables companies to tap into fresh perspectives and expertise. Netflix has a reputation for actively seeking outstanding individuals to join its team. They prioritize talent over experience or credentials and focus on identifying individuals with exceptional skills and a strong cultural fit.
Engagement and Retention Strategies: We must assess whether the company dedicates resources and senior attention to ensuring that these critical assets, the talented individuals, are internally engaged and protected from external poaching. Patagonia, known for its culture and environmental activism, creates a whimsical and relaxed atmosphere that attracts like-minded individuals. Their employees enjoy flexible work schedules, on-site childcare, and the freedom to express their activism. Now, imagine an investment bank trying to implement these same strategies. Picture bankers in tie-dye shirts (and Patagonia vests), practicing yoga in the office, and discussing environmental sustainability during board meetings. While it might bring some humor, the reality is that engagement and retention strategies vary across industries, and an investment bank might focus more on financial incentives and professional growth opportunities.
Integration of Future Competencies: An investor should evaluate whether the company's policies for identifying high-potential employees (HIPOs) consider the required future competencies in addition to the capabilities needed for the current business model. This approach ensures a pipeline of talent prepared for future challenges and opportunities. Facebook's focus on hiring individuals with expertise in artificial intelligence (AI) and machine learning early on demonstrated its anticipation of the future needs of the social media landscape.
Indeed, everything we have discussed today provides valuable food for thought in our journey as investors. Reflecting on the factors that contribute to growth stalls, understanding how to detect them, and how management address them can significantly enhance our ability to make informed investment decisions.
If you enjoyed this piece, please give it a like and share!
Thanks for reading Edelweiss Capital Research! Subscribe for free to receive new posts and support our work.
If you want to stay in touch with more frequent economic/investing-related content, give us a follow on Twitter @Edelweiss_Cap. We are happy to receive suggestions on how we can improve our work.
Olson, M., van Bever, D. (2008). Stall Points. Corporate Executive Board. Yale University Press.
Olson, M., van Bever, D., Verry, S. (2012). When Growth Stalls. Harvard Business Review. Link.
as always, great stuff here.
Thank you, as always very original takes and informative for both new and experienced investors ... have a great week!