Saturday, July 30, 2005

Innovation still pays

That’s the conclusion of an analysis I did of a Boston Consulting Group (BCG) survey of the Top 20 Innovative Companies in the World.

I reached this conclusion although – to paraphrase Justice Potter Stewart’s quip about obscenity – I can’t define innovation but I know it when I see it.

BCG surveyed 940 senior executives in 68 countries and asked them to pick the most innovative company. BCG recorded the votes and I calculated the profits and investment returns of the 16 companies on the list which are publicly traded in the US.

I found that these 16 companies significantly outperformed their peers. On average they earned five-year returns on equity that were 2.2 times their industry levels; their net profit margins averaged 10% compared to a slightly negative net margin for their industries; and their stock prices surged 34% over the last five years while the S&P 500 tumbled 18%.

The most popular company with survey respondents is far from the best performer from a financial or investment perspective. Apple Computer got the most votes in the BCG survey but its return on equity (5%) and its net margin (3.4%) trailed its industry and its stock price (+70%) put it in the middle of its innovative peers.

While the stock market rewards these innovative companies’ profitability, it seems that the most profitable firms have generated disappointing stock market results. For instance, Dell whose 40% return on equity led this pack of innovators; saw its stock price fall 8% during the last five years. And Microsoft, whose 28% net margin trounced the competition, watched its stock lose 27% of its value during the period.

The stock market winner from this group of innovators was actually eBay which earned a 21% net margin and saw its stock soar 225% over the last five years. I think the key to eBay’s stock market success has been its profitable growth – after all eBay’s sales have grown an average of 60% a year for the last five years. That is an exceptional performance for a company with $4 billion in sales and a market capitalization of $57 billion.

Despite recent customer frustration, eBay enjoys substantial barriers to entry due to its market leadership. But eBay and Microsoft are
losing talent to another one of the innovators – Google – whose stock has soared 190% since its IPO last year.

Investors recognize the flow of talent as a canary in the coal mine for a company’s prospects. Shareholder value will flow out of firms that are losing the talent and into those that are hiring it. At the moment, Google offers the intoxicating potion of big impact on millions of users, cutting edge technical challenge, the most brilliant professional colleagues, and a culture that pampers innovators through touches such as giving them a day a week to work on pet projects, gourmet cuisine, and digital toilets. As I noted in my 1997 book,
The Technology Leaders, this kind of entrepreneurial leadership is a critical ingredient of innovation.

But ultimately this talent transfer suggests that the magic elixir that draws top talent is fated to shift from established companies to new ones. Ironically, Microsoft –
which used to mock competitors who resorted to the legal system when they could not win in the market place – is suing Google to stop this flow of talent. While Microsoft held the magic wand for two decades – between 1975 and 1995 – that power to draw talent has shifted to Google.

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