Revisiting the growth fetish (kind of a relief to be agreeing with Felix Salmon again)

Salmon has an excellent post, based in part on an equally good John Kay post, about the trouble people have with the idea of healthy contraction in business.

Here's Salmon:

I can understand where Mims is coming from. HP is a technology company, and under the unspoken rules of the US stock market, all public companies, and especially all technology companies, should constantly be growing as fast as possible. It’s the inexorable mathematics of discounting: if a company can deliver consistent growth which is faster than the prevailing discount rate used to calculate net present value, then its stock price should, by rights, be infinite. Consequently, given that infinite upside, it’s worth risking quite a lot to achieve growth.

But the facts are pretty plain: (a) HP is very good at producing excellent products in the shrinking markets which make up most of its business right now; (b) HP has in recent years shown no particular ability to produce excellent products in other markets; (c) Meg Whitman is not by nature a visionary innovator. Given those facts, it makes perfect sense for HP to run its existing businesses as efficiently and as profitably as it can, and to extract as much value out of them as possible, in the knowledge that all companies are mortal. In fact, it makes more sense to do that than it does to follow the Tim Armstrong playbook, where AOL’s CEO decided to take his enviable dial-up revenue stream and invest it in doomed content plays like Patch.

Here's Kay providing some historical context:

The marketing guru Theodore Levitt elaborated this theme in an article half a century ago. Levitt denounced marketing myopia. There was always, he suggested, a future for a company; the key was to look for a creative answer to the question: “What business are we in?” Manufacturers of buggy whips might still be around as carmakers if they had only understood that they were not simply encouraging faster horses; they were transport companies.

Much of Levitt’s analysis was devoted to urging oil companies to recognise that they were really in the energy business. Some of these companies found his arguments persuasive.

Yet 50 years later, few of their diversifications into other forms of power have worked out – their flirtation with coal in the 1970s and 1980s was particularly unsuccessful – and the traditional oil majors still make most of their money out of oil.

Levitt did not recognise that competitive advantage, rather than a fertile imagination, is the key to success. The whip manufacturers had neither production capabilities nor marketing channels relevant to the automobile industry. The skillset needed to manage coal mines is very different from that required to run an integrated oil company.

Recent history has provided a textbook illustration of the limitations of the Levitt hypothesis – the disastrous remodelling of JC Penney’s dowdy stores by Ron Johnson, brilliant designer of Apple’s retail chain. The outlets of both JC Penney and Apple are shops but the age group and disposable incomes of their customers – and their reasons for visiting the stores – were entirely different: JC Penney and Apple were not really in the same business.

Along with ddulites, the growth fetish has been a hobbyhorse here at West Coast Stat Views since before we were West Coast Stat Views.

Think of it this way, if we ignore all those questions about stakeholders and the larger impact of a company, you can boil the value of a business down to a single scalar: just take the profits over the lifetime of a company and apply an appropriate discount function (not trivial but certainly doable). The goal of a company's management is to maximize this number and the goal of the market is to assign a price to the company that accurately reflects that number.

The first part of the hypothesis is that there are different possible growth curves associated with a business and, ignoring the unlikely possibility of a tie, there is a particular curve that optimizes profits for a particular business. In other words, some companies are better off growing rapidly; some are better off with slow or deferred growth; some are better off simply staying at the same level; and some are better off being allowed to slowly contract.

We also managed to tie a similar take on JCP to another favorite hobbyhorse, fitness landscapes.