The Board’s role in innovation – ‘explore’ or ‘exploit’ or both?

8 02 2012

Chris van der Hoven wrote:

Companies considered by investors to be yield stocks are typically ‘safe bets’. They are managed for cash and focus strongly on dividend growth. The boards of these companies are expected to be conservative and to focus their innovations on dimensions that improve efficiency, reduce errors and keep costs to a minimum. Their business model is a source of competitive advantage because……it is stable and understandable (from a customer perspective). The investment is predictable and typically has a lower price earnings ratio.

By contrast, growth stock investors expect the board to take some forward looking ‘bets’. These companies may either have changing business models (they are flexible) or multiple business models under one roof. Their competitive advantage comes from an ability to create new business models when a truly customer needs focussed value proposition requires something different from the business model(s) of the current product portfolio. In this sense, the focus is on sustainable longer term growth rather than shorter term returns.

A difficulty occurs when executives in a yield focussed business attempt to switch innovation dimensions from an ‘exploit’ orientation to an ‘explore’ orientation. Particularly in larger more mature businesses, this requires careful planning and expectation management.

The good news is that the ‘exploit’ and ‘explore’ innovation focus can co-exist. Investors need to be kept informed and the balance in the portfolio well explained. Internally, the focus must be on expectation management and a careful regard for the thresholds between enough risk for growth and enough efficiency for yield.

In my view businesses with a myopic focus on yield end up in sectors that die out after a number of predictable phases. They grow at first, then they optimise (often focussing on costs), then they consolidate using mergers and acquisitions. In between various permutations of new products and markets and processes are exploited to the limits of what they have to offer. Oh, and then they die!

Think about camera film, CDs, circusses, airlines, travel agencies, and various others with structurally low profits and high levels of consolidation. Retail banking will go this way, as will insurance if they don’t understand their customers better. These businesses rely on volume and efficiency and compete on price. Could they be turned into growth stocks – not without some radical social and commercial engineering.

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