7 Powers

by Hamilton Helmer

  So let’s turn to the complementary question. Now it’s time to answer “When?”

  Appendix 8.1: Equity Investing and the 7 Powers as a Strategy Compass

  In addition to my career as a strategy advisor, I have also been an active equity investor for decades, utilizing the understanding of business value I have gained from Power Dynamics, the full Strategy toolkit I have developed which includes the 7 Powers. The Power Dynamics Toolkit is described in Appendix 9.1. My investment results over this extended period have some relevance to the themes of this book. I have made investments predicated on the differential acuity of the 7 Powers framework in correctly characterizing the prospects for Power in high flux situations. But assessing Power prospects ex ante in high flux situations is also what drives the business person’s need for a strategy compass. Let me give you some details.

  First, to summarize the strategy compass thesis:

  I have made the foundational assumption that Strategy and strategies are about only one thing: potential fundamental business value. I refer to this as the Value Axiom, and it is the bedrock of Power Dynamics and the 7 Powers. This assertion represents an intentional narrowing on my part. The last several decades have proven to me that much acuity and usefulness results from adopting the Value Axiom.

  By far the most important “value moment” for a business occurs when the bars of uncertainty are radically diminished with regards to the Fundamental Equation of Strategy, market size and Power. At that moment, the cash flow future makes a step-change in transparency.

  It is the period of invention, with all its high flux, that gives rise to this “value moment,” offering the potential for traction in both market size and Power. High uncertainty persists during this interval because these transitions are typically not linear and quite difficult to forecast accurately.

  Strategy (the discipline) can only contribute in this period if it serves as a strategy compass to guide on-the-ground “inventors,” increasing their likelihood of finding a path to satisfy The Mantra.

  To serve as such a cognitive guide, a Strategy framework must be simple but not simplistic. That is the objective of the 7 Powers.

  So what relevance does this bear to active equity investing?

  To the best of my knowledge, the 7 Powers applies to all businesses, everywhere. Furthermore, it is founded on fundamental business value, which also concerns a large class of investors. Does this mean that utilizing the 7 Powers can result in alpha99 for investment in any company? Of course not.

  In nearly all cases, both the potential for Power and the size of the market are sufficiently evident to astute investment professionals. In particular, they can often be found in the markers of historical financials. Alpha depends on exceptions to the semi-strong form of the Efficient Market Hypothesis: you need material informational advantage. In these cases the 7 Powers offers no such advantage.

  The only places one might expect alpha from applying the 7 Powers are those situations in which such transparency is not the case—opacity in other words—and that such opacity is penetrable by the 7 Powers.

  A primary driver of opacity is high flux: if a business is in a fast-changing environment, then the information facing investment pros tends to have much higher uncertainty bars regarding future free cash flow. But high flux also attends the sort of conditions which orbit the “value moment.” So if the 7 Powers can lead to alpha by identifying Power in these situations ex ante, it also promises to be useful in doing the same for those inventors on the ground trying to find a path to satisfy The Mantra.

  So how have I done following this approach? Have I been able to deliver alpha? My active investing records go back twenty-two years, but I will be brief in answering those questions. I have daily portfolio returns data for all the 4664 trading days I was in the market, dating from the beginning of 1994 through 2015.100 My year-by-year annual gross returns are shown in the chart below.

  Figure 8.10: Annual Helmer Active Equity Gross Returns (1994–2015)

  So for these 22 years, I was fully in the market for seventeen years, partially for three years and fully out of the market for two years. For the twenty invested years (seventeen full years and three partial years), my gross returns exceeded those of the market for fourteen years and underperformed the market for six. Over these trading days in which I actively invested, I achieved an average annual rate of return of 41.5% per year versus 14.9% per year for the S&P 500 TR. So on average I outperformed the S&P 500 TR by 26.6% each year.101

  However, my highly concentrated approach results in a different risk profile than that of the market overall. So we should also look at a risk-adjusted return. One way to do so is to take out the effects of the market overall (beta). This yields an average annual alpha of 24.3% (9.1 basis points of alpha per trading day, on average).

  Figure 8.11: Risk/Return of Helmer Active Equity Investing

  Years Invested

  Because of the high concentration,102 my approach has higher volatility: 31.6% versus 15.8% for S&P 500 TR when annualized. An informative way to assess the risk/reward associated with this is to calculate an investor’s prospects of “beating” the market. To do this for all 4664 trading days, I calculated the risk/return profile:

  Risk. What was the probability of underperforming the market if an investor had stayed with my approach for one, two, three and four years?103

  Return. What would have been the average annual rate of return over those one, two, three and four year periods?

  Figure 8.11 above displays those calculations. This chart would indicate that, historically, if you had invested based on this approach and continued with that investment for 4 years, you would have had about a 3% probability of not outperforming the market (this was your “risk”), and the average return for a four-year hold outperformed the market by about 30% per year (this was your “return”).

  So based on both these measures, utilizing the 7 Powers has historically delivered unusually attractive returns over an extended period. I know of no other Strategy framework with this outcome. Thus the 7 Powers seems to have been differentially acute as a tool for identifying the potential for Power ex ante in high flux situations. This provides additional assurance in its utility as a cognitive frame for business leaders in their crucial “value moments,” which are also inevitably high flux.

  C H A P T E R 9

  THE POWER PROGRESSION

  TURN, TURN, TURN

  Intel Starts from Scratch

  In my Introduction I used the case study of Intel to demonstrate the primacy of Power in value creation. Their experience proves particularly revealing because their failed memory business provides a perfect “control” case against which to counterpoint their lucrative microprocessor business.104 All of Intel’s considerable advantages applied in equal measure to both these businesses: unexcelled leadership and management, technical depth, manufacturing prowess, an exploding market, and so on. But the outcomes were utterly different: a painful exit in memories, versus an enduring high-margin business in microprocessors. The difference? One had Power, while the other did not. These two case studies underscore the point: your business must attain Power. Operational excellence by itself is not enough.

  In the previous chapter, I addressed the first question of Dynamics: “What does a business have to do to reach that position of Power in the first place?” The understanding reached in that chapter applies full force to Intel—it all started with invention. More specifically, the invention of the microprocessor in fulfillment of a chip design contract with the Japanese calculator company Busicom.105

  In this chapter I tackle the second question of Dynamics: “When can you reach the position of Power?” To start, I will answer this question for Intel’s microprocessor business. Building from there, I will go on to derive The Power Progression, a framework for answering the “When?” question for every type of Power. But first, on to Intel.

  Intel’s route to Power in microprocessors was a slow and
tortuous journey. As with most transforming products, the microprocessors business at Intel was marked by dissension and uncertainty. Internally, corporate antibodies were in full force. Bill Graham, the company’s gifted head of sales and marketing, threw his full weight toward squelching the microprocessors push—he could not imagine how this business would have the volume to merit draining Intel’s scarce cash. The board, too, worried that the diversion would prove too costly, but CEO Bob Noyce and Chairman Arthur Rock carried the day, and Graham lost his battle.

  As mentioned above, Intel had originally designed its seminal microprocessor for the Japanese company Busicom, so first they had to buy back the rights to that invention. They succeeded at this, and before long, Intel offered up its earliest commercial microprocessor, the 4004. Then, after some further foot dragging, Intel finally gave its design group full funding, resulting in the 4004’s successor, the 8008, in 1972. Further development efforts followed, culminating in 1978 with the breakthrough of the fully 16-bit 8086.

  The external challenges were every bit as daunting as the internal ones. On the customer front, the 4004 showed little commercial traction. Semiconductors are a component, not an end product. In such cases, purchase commitments depend on other manufacturers assessing the new component, designing it into their products and then offering those products to consumers. These lags, always significant, were accentuated for microprocessors simply because the product was so radical—not an incremental improvement, but a completely different way of providing computational functionality.

  Competitors also proved unexpectedly challenging. The long adoption lead times for the technology gave rivals ample time to build on Intel’s experience and develop products of their own. In late 1978, Intel was rocked on its heels to find that, rather than leading the pack, they were losing design wins. Even Intel insiders conceded that the Motorola 68000 was a superior product. The competitive dynamic that was wrecking their memory business now threatened microprocessors as well.

  Intel responded with the aggressiveness forged into the company by Andy Grove, launching Operation Crush, an audacious frontal assault in sales and marketing. Intel leadership set a wildly aggressive target of 2000 design wins within the year, and the company set to work executing this corporate-wide crusade.

  The intense push motivated Inteler Earl Whetstone to try a long-shot sales prospect: IBM. Up until then, most had assumed that IBM would internally source any significant semiconductor needs. The company had its own microprocessor, the IBM 801 RISC, which was far more powerful than the 8086, plus its own internal semiconductor manufacturing system, which was larger than any of the stand-alone semiconductor firms.

  But times had changed for IBM. They had missed the minicomputer boom; their overall share of the computer market had shrunk considerably, and their stock was off. This chastening opened minds to new methods of doing business, eventually resulting in Project Chess, a well-funded effort to develop a personal computer within only a year.

  To keep costs low and minimize delays, IBM abandoned all sorts of usual practices, and so it was that Intel’s Whetstone found, to his immense surprise, a welcoming attitude in Don Estridge, the newly tapped leader of Project Chess in Boca Raton, Florida.

  With a herculean effort Estridge and his team met their one-year deadline, developing the revolutionary IBM PC, which included the Intel 8088, a dumbed-down version of the 8086. No one could have anticipated the market explosion that followed. The IBM PC rolled out on August 12, 1981. Over the next year, it sold 750,000 units.106 Every one of these came with an Intel 8088. Here, at last, came the mother lode application for Intel’s microprocessors.

  From Invention to Power

  Below is a chart of Intel’s stock price from the time of the 8088 design win until the end of 2015.

  Figure 9.1: Intel Stock Price vs. S&P 500 TR (Index Value: 3/17/1980 = 1.00)107

  Over this period, Intel’s market cap soared to the rarefied air of over $100B and stayed there. Its stock price increased more than 8500%, compared to the approximate 2000% increase of the S&P 500 TR. All of this value came from their microprocessor business. More specifically, it resulted from three of the 7 Powers:108

  Scale Economies. Piggy-backing on the rocket ship of the IBM PC, Intel achieved a large advantage in scale that it has never given up. This enables lower per-unit costs in several ways: Fixed cost of chip design. The costs of semiconductor design are high. Intel is able to prorate this fixed cost over a far higher volume, dramatically lowering the per-unit design cost.

  Fixed factory design costs. Semiconductor plants (fabs) are complex and expensive. Intel’s approach utilizes a single design, so fab design cost is prorated across many fabs, again resulting in lower costs per chip.

  Early movers in lithography advances. Each generation of semiconductors moves to smaller-scale features. This enables significant manufacturing and product efficiencies. By virtue of its higher demand forecasts, Intel is able to justify moving a fab to the smaller etch widths sooner, further enhancing their per-chip cost advantage at any given moment.

  Network Economies. Consumers don’t buy just chips; they don’t even buy just PCs. When buying a personal computer, what they’re really purchasing is this: the ability to do certain tasks which are enabled by applications running on PCs, meaning software and hardware go hand in glove; they are complements. In the early years of consumer PC sales, because of the memory and speed limitations of chips, operating systems and some applications had to be programmed specifically for the processor. In particular, the program that launched the IBM PC, the spreadsheet Lotus 123, was written specially for the Intel processor, as was the operating system MS-DOS that was provided by Microsoft. This meant that when other PC makers came on line, they had to utilize IBM clones, or else they would have no programs. This meant that they used Intel, or Intel-compatible, chips. Network Economies were in force.

  Switching Costs. If you owned a PC and were considering a switch to something else, the same chip-specific programming would stop you from moving to a non-Intel machine. Otherwise, all the hours of toil you had put into your current programs would be unusable.

  In time, OS and application software became abstracted from the chip level, largely eviscerating any Network Economies, but by that point Intel had achieved a huge scale advantage. My former partner Bill Mitchell put it well:

  “The one-sentence story of Intel is a single design win, then a decade and a half of very high Switching Costs, then Scale Economies.”109

  How exactly did Intel get there for each of their sources of Power?

  Scale Economies. To establish this advantage, Intel seized the required market share lead by the end of the explosive growth stage of the PC market. Once growth settles down, the stakes are well known, and the volume leader can and will use their cost advantage to fend off competitors.

  Network Economies. The importance of the takeoff stage is even more pronounced with Network Economies. Network Economies are often characterized by a tipping point: once the leader has achieved an edge in installed base, most users will find it to their benefit to choose that leader. For application software developers, the choice of attractive microcomputer platforms was winnowed to only two choices with sufficient scale: Apple and PCs. Lacking in competitive applications, other platforms were doomed.

  Switching Costs. Even for Switching Costs, takeoff is the critical stage: first off, Switching Costs are a source of Power for those who get to the customer first, and a wealth of customer relationships are established in the takeoff; secondly, in the takeoff period, customers are often struggling to find any supplier, so the price competition that will eventually arbitrage out the value of switching costs for new customers has yet to occur.

  The Power Progression: Takeoff

  So there we have it: all of Intel’s sources of Power were rooted in the takeoff period. Again, takeoff is the stage when differential customer acquisition can take place at favorable terms, which is why it presents
such ideal Power opportunities. There is such a high degree of flux that the normal lags in the arbitraging process are material to the outcome: resolving uncertainty, transparency, product tuning, building capacity, establishing channels, effective marketing and so on. For Intel, Operation Crush made a crucial difference to Power. In a mature business, it would have simply been part of the to-and-fro of arbitrage.

  What cut-off point in the growth rate marks the end of this takeoff period? It depends on the degree of flux and uncertainty, but based on my experience, 30–40% per year seems a workable choice. By this measure, for the PC market, takeoff probably started in 1975 with the 8080 and continued through 1983.

  Figure 9.2: Annual Growth of Microcomputer Shipments (units)110

  *three-year moving average

  Armed with this understanding, you can see that Intel made it in just under the wire. They made a decisive break from the peloton of competitors at a crucial time. If the PC market had forged ahead for another year or two without them, the window of opportunity would surely have closed—no breakaway would have been possible. Intel would have captured some sales, but their prospects for Power would have dimmed as the opportunity for Scale Economies quickly receded. Put into context, if another company had won the IBM contract, Intel as we know it today would not exist.

  This sort of situation breeds a common form of false positive. Often in the explosive growth stage, companies will exhibit quite attractive financials. The future looks bright. Long-term success seems assured. Unfortunately, if a company has not established Power, competitive arbitrage will catch up as soon as growth slows; fundamentals will assert themselves, and the favorable early returns will prove fleeting. As a strategist and value investor, I cringe every time a CEO or CFO says they are pleased by the entrance into their market of a well-heeled competitor, insisting it “validates the market.” In 1981, at the introduction of the IBM PC, Apple had the temerity to run a large ad in the Wall Street Journal: “Welcome, IBM. Seriously.” They did not understand the nature of Power attainment in the takeoff stage: you and your competitor are in a race for relative scale, and there can only be one winner.