If someone offered you shares in a dominant company or an innovative company, which would you choose? Long-term dominance, which can be found in companies like General Electric (NYSE:GE) or Microsoft (Nasdaq:MSFT), usually provides predictable profits and growth. Innovation, on the other hand, has driven the spectacular growth companies like Pfizer (NYSE:PFE) and Google (Nasdaq:GOOG). It is a bit of a trick question to answer though; dominant companies can be innovative and innovative companies can become dominant. In this article, we'll show you how to assess and evaluate both dominance and innovation in the market and your portfolio.
A Question of Maturity
Not all markets are created equal. In mature markets, things move much more slowly than in an emerging market or a cutthroat market. Dominance in a mature market, as represented by the Big Uglies in the industrial sector, can be measured by market share and valued in dividend payments. This may not be the best system of valuation (although it's easy to calculate), but mature industries are much more forgiving when it comes to off-the-cuff summaries. This is because the benefits of innovation are usually limited in scope. For example, the oil refining process is well-trodden ground, with research and development (R&D) going mainly to improving the effectiveness of existing methods. Short of a revolutionary invention, innovation in the oil refining industry is likely to be slow and steady.
In younger markets, however, innovation has a much larger effect on a company's fortunes. Young markets tend to see more money being spent on research and development projects and very little, if anything, paid out in dividends - as can be seen in the technology sector. This is because most of the free capital is being reinvested in growing the business and vying for the dominant spot in the market. (To learn more about dividends, see The Importance Of Dividendsand How Dividends Work For Investors.)
There are, however, sectors that will always have significant R&D costs regardless of how mature the industry is. Software, medicine and fashion firms must constantly add to and improve their product lines, because once a product is released, the competition can begin making similar products and selling them more cheaply.
Markets mature over time because of a type of natural selection between competing companies. Young markets have a wider range of players with varying degrees of dominance and innovation. It is the companies with the right combination that survive and, as a result, bring stability and maturity to the market. Often these companies continue to innovate as they grow in dominance, but the room for innovation is limited as more pathways become explored and rejected, and product lines and branding campaigns solidify.
Warren Buffett has spent most of his investing career measuring dominance, at least in mature markets, in terms of economic moats. When Warren Buffett looks for an economic moat, he looks for companies in mature markets that have achieved dominance via brand recognition, competent leadership and a strong financial structure. (Find out more about Buffett's investing style in Think Like Warren Buffett, Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)
Classic example: Coca Cola
The classic example is Coca Cola (Nasdaq:COKE). Its economic moat is its strong brand-name recognition that was derived by its being the first soft drink to expand into almost every part of the globe. While Coke faces domestic competition from Pepsi, it has many global markets sewn up. More people grew up drinking Coke than any other brand, and as more people are born, Coke's sales expand accordingly. (To learn more about economic moats, see Economic Moats Keep Competitors At Bay and Advertising, Crocodiles And Moats.)
The fastest way to find dominant companies is to look at the market leaders, the companies with the greatest market share, and then check whether other positive factors are present. Nobody knows Buffett's exact calculations, but it is a mix of book value, CEO compensation, ROE and a high profit margin sprinkled with items from the rest of the financials, no doubt including R&D.
Folly example: Ford
A large share of the market alone doesn't indicate a continuing ability to dominate. Ford (NYSE:F) nearly went under shortly after it gained a dominant market share. In the early 1900s, Ford was way ahead of the market in terms of production methods, capacity and pricing, but the company stayed with the original Model T long after the market caught up. As a result, Ford's market share slipped and it had to rework its production lines to recapture some of the market it had once dominated. This trend has repeated as the American automotive industry has tried to compete with more innovative foreign companies. Although American companies still dominate in the niche of big vehicles, they've lost considerably in the area of smaller cars, which have a far larger worldwide market.
There is no single measure that will guarantee continuing dominance, but large cash reserves help. Even if an industry is revolutionized by new products or techniques, it is the cash-rich companies that will be able to implement change the fastest. Cash can even be used to buy innovative startups before they grow to become competitors.
Whereas the measure of dominance comes from all over a company's financials, the measure of innovation is compiled from the slim data set of R&D figures and press releases. A company's R&D expenditures must be measured against the average for the industry to get any meaningful figures. Similarly, the results of that R&D - patents, products and otherwise - must also be compared to other companies to assess their quality. Consumer and trade magazines can be very useful if you don't know how to compare the products in an unfamiliar industry.
Remember that spending more money on R&D than a competitor doesn't guarantee an edge in innovation. Some companies may be getting a lot more quality and/or quantity from a modest R&D budget. Companies with a high amount of capital invested in R&D should be releasing new products or improvements and updates to established products - this is where the company press releases come in. (To learn more about R&D, see Buying Into R&D.)
Pharmaceutical companies offer the clearest example because it is very difficult for a company to achieve dominance in an industry that depends on medical discoveries. The primary measures for pharmaceuticals are how much they spend on R&D, what they have in the pipeline and how long it takes them to get new products out on the market. These questions can also be applied to software companies, sports equipment makers and many other highly competitive industries where brand loyalty is secondary to the quality of the product.
Stalwarts And Tenbaggers
With dominance, you get what you pay for: a big company using its economies of scale to stay on top. Many of these companies enjoy modest growth and pay regular dividends. By contrast, innovative companies in volatile markets can carry huge returns, but there is also more risk. Buying stock in an innovative company isn't a complete leap of faith, however. An investor can look back in the financials at their commitment to innovation and their history of successfully marketing those innovations. This allows an investor to compare and choose those innovative companies with the most successful histories.
So, which is the better investment? It's a tradeoff. An innovative company comes with higher rewards and risks, but also requires more due diligence. A dominant company tends to have lower rewards and risks, but may be generally easier to identify. In the end, it comes down to how much research the investor is willing to put in. Warren Buffett sticks to dominant companies, Peter Lynch takes a mix of both (his tenbaggers and stalwarts) and many day traders deal only in rising stars. Now that you can identify dominant and innovative companies, you can find the balance that works for you and your portfolio.
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