Separating Fads From Long-Term Success

May 10, 2004

By SANDY DAKOFSKY

We all know not to invest our businesses in a fad, right? So how come James D. Robinson, the former chief executive officer of American Express, once had his unclothed caricature adorning the cover of Institutional Investor magazine? Its article, "The Emperor Has No Clothes," berated his creating a "financial supermarket," which was a fad at the time. If someone so highly qualified could not avoid this fad, what chance do the rest of us have?

Some would argue Robinson was not all that wrong. Just look at the trend of consolidation in financial services. Others would argue that at the very least, his timing was off, or it took the repeal of Glass-Stegall to facilitate the trend.

"Fads" have powerful allure

Recent examples such as the Internet and wireless show that fads have powerful allure: hype, activity, capital and, most important, high valuations in the form of high publicly traded stock prices and high exit multiples for owners of nonpublic companies (i.e., they can sell for a lot of money). To have a successful concept in Wall Street terms there has to be (a) a "big" idea that is technologically feasible and can be brought to market, (b) market acceptance with enormous long-term growth potential and (c) Wall Street interest.

Fads usually have one or more of the above gone awry. While they may have good technologies and/or concepts underlying them, fads or market "bubbles" usually have (c) but have failings in either (a), (b) or both. When they don't pan out, stock prices and exit multiples collapse and very few, if any, yield big payoffs.

Let's explore this briefly with a look at some "success" stories.

All That Glitters Are Lasers

As the Cold War and defense spending wound down, United Technologies (UTC) decided to exit a laser business. Five engineers in the division bought it for the value of its liabilities and started LASER. They rapidly built a business that grew at 55 percent a year for five years and was sold to the largest laser manufacturer in the world for eight times earnings.

Did LASER see something that UTC did not? UTC had a different perspective for two reasons.

First, like others in the defense industry, it was exiting defense segments in anticipation of the post-Cold War era.

Second, LASER's business size was under UTC's radar.

LASER looked beyond this trend in a shrinking market. What did LASER do to build value despite the long-term trend in defense?

Recognized the long-term potential of nondefense applications.
Looked beyond applications in an up-and-coming (bubblelike) telecommunications market.
Developed a two-tiered business model of research for clients and commercial applications.
Used its research to help them identify viable commercial applications. These new applications led to jumps in sales.
Found mainstream applications such as marking, coding, engraving and materials processing.

VIPlace tried to capitalize on the rising stock prices of its Internet counterparts. It offered a unique concept - a high-level posting service for executives and companies with jobs to offer, along with an array of support services. It did well in terms of growth up to a point and made money, which its Internet counterparts did not do.

Then as it thought about obtaining capital to become bigger, it struggled because at the time several stumbling blocks appeared:

It could not articulate how it would grow. Investors expect a compelling business plan with minimized risks (e.g., technology and execution) before investing.
It was blinded by the allure of Internet company valuations and never questioned their reasonableness.
It downplayed the importance investors place on growth and size of itself and its market. Fad or not, investors look for significant growth, which for them is upside. In fads, however, the growth is unrealistic.
It expected a higher valuation relative to Internet counterparts simply because it was profitable and the others were not.

Although no decision was reached, this is a success story of sorts as this indecision was their saving grace. They have a real business and remain in business despite what has happened to many Internet counterparts who sold out to a larger Internet company (for stock) or to raise venture capital at a high valuation, but sank when stock prices collapsed.

What you can do

The best way to create value for yourself is to marry your long-term objectives with meaningful long-term trends. This builds a business on solid bedrock as opposed to the quicksand on which a fad is built. The key is threading your way toward the solid bedrock.

Some questions may help.

What is the meaningful long-term trend and likely value?
Does the underlying concept have a real economic advantage?
Are demand and supply there now?
How many marketplace changes are required to achieve the high growth investors typically look for?
What is the likelihood of achieving that growth?

What should you do if your company's industry is experiencing a fad? That depends on your objectives. If they are short-term, sell out for cash. If they are more long-term, you could run the business as usual and eventually the fad owners will be out of business. Alternatively, you could raise capital assuming you have a non-fad purpose in mind, or you could buy these companies when they fail at cheap prices, assuming you think there is long-term value.

Sandy Dakofsky is a managing director at Carter Morse & Co., an investment banking firm in Southport.