Marking a Path

One of my favorite principles is cultivated naivety, which I define in a tutorial I prepared for new employees a couple years ago as:

The principle that it is better to be ignorant than to make hasty assumptions. It is an empirical stance: the presumption that novel evidence provides the luxury of learning through experience.

In simpler terms, just cover your ears and say "nah nah, I'm not listening" whenever you hear or read that something is impossible, or that a particular path is the standard by which all others must be tested. Each entrepreneur follows a unique path. At times there may be similarities, but I see them as more incidental than necessary. I am convinced that to truly excel one (whether a company or individual) needs to mark their own path.

I wrote a couple months ago about reaching a point in my life as entrepreneur where I wanted to reach out for more support from others, and was considering bringing on a CEO or hiring an individual or team to lead business development. Years ago, I described myself as an accidental entrepreneur. In the interim, I've come to embrace that aspect of myself, and to realize that entrepreneurship is not a detour in my life, but a direction. That said, as I've pointed out elsewhere, there are no typical entrepreneurs.

My path has led from academia and cross-disciplinary research that fell between the cracks of academic departments, to starting and leading an R&D based business. It has been said that nothing focuses a mind like a crisis. Our crisis as an R&D business was having multiple proposals over the past couple years go unfunded. We remain committed to the projects, but without funding, it's rather difficult to pursue them, and frustrating to be held back from work that we believe is worthwhile.

Perhaps, I thought, we need a quick product, a fast break, something to sell tomorrow, then we'll be expanding our sources of revenues, hedging the lean times when R&D funding is not forthcoming, and providing a fount from which to continue the efforts. In the past couple months, I've reached in that direction, but haven't found that path any easier or more direct than the one I've followed since founding the company four years ago.

We are unapologetically involved in early-stage research, and are content with the challenge of bridging basic with applied research. Lately I've returned to a view that that perhaps may remain our true home. Finding and building that niche, connecting the needs of users with translational research, and delivering solutions to the market with the technologies we develop, is the task we face.

Disconnect

What bothers me about investing these days is the disconnect between a company's inherent worth--its capacity to address market needs and customer desires, translating those solutions into real profits for the company while delivering benefits for its customers--and the value of its shares.

NFLX, source E*Trade Financial

Let's take Netflix for example. Netflix was founded in 1997, as an online version of a traditional DVD rental and sales outlet.* In 1999 they lighted upon a brilliant scheme: offer DVDs through the mail by subscription for a flat monthly fee. By early 2000, they dropped the per item model entirely. Brilliant!

In 2002, the company went public. Already in 2000, CEO and founder Reed Hastings saw the future of Netflix as "owning a transition stage as rental converts to video-on-demand." Clearly, ahead of his time, the streaming model was in mind. To put that in perspective, YouTube was not founded until 2005.

Towards the end of the first decade of the 21st Century, Netflix was on a tear to increase its share of streaming as a percentage of its business. By 2011, the decision was made to make the shift. Sure, there were some missteps in designing and executing the shift, and in anticipating and responding to customer confusion and resistance to the shift.

But here's my take: the model is sound. The DVD through mail model was innovative in terms of distribution and convenience. The streaming model is liminal (in part because the infrastructure to handle the huge amounts of bandwidth required is still fragile as ISPs seek a profitable path forward) but clearly the future. A future that Netflix foresaw.

But the share price of Netflix stock is volatile beyond reason. In the middle of 2011, around the time of upheavals regarding separation of DVDs from streaming, the share peaked at around $300, dropping below $70 before the end of the year. Then back up, and now, today, shares fell off a cliff, off by 10-15% from yesterday!

NFLX falls off a cliff 4/24/2012, source E*Trade Financial

Sure, even at today's pricing, Netflix trades at a PE ratio north of 30. And the news that came out yesterday is that Netflix exceeded analysts estimates. While revenues grew by 21 percent, it lost 8 cents per share as opposed to the 27 cents per share analysts expected. The point I make is that stock prices, and the wild swings of over-selling and over-buying, are out of line with a company's core, which is delivering market solutions, and making a profit on sales that exceed costs.

A business leader should remain focused on this: how do I develop and deliver products and services to the market that benefit my customers and make a profit for my company, employees, and owners? But the stock market distorts these values. It certainly gives this entrepreneur pause in considering whether going public is an exit strategy to aspire towards.

Full disclosure: I currently own no shares in Netflix (NFLX). At the end of 2011 I made two purchases of shares at $67.25 & $67.89 respectively. All these shares were sold in February 2012 at $129.75. I am a customer of Netflix, formerly subscribing to the DVD mailing subscription, then DVD and streaming, currently streaming only.

* Much of the history of Netflix is gleaned from http://www.fundinguniverse.com/company-histories/Netflix-Inc-company-History.html & http://en.wikipedia.org/wiki/Netflix.

Shares Per Earning?

In the heyday of gargantuan Urban Assault Vehicles, before petroleum topped $100 per barrel, the joke was that fuel efficiency could be measured in gallons per mile not miles per gallon. I have written on this blog critically about established companies that refuse or decline to pay a dividend to their shareholders. Recently, Apple (AAPL) decided to reinstate dividends after a 17 year absence, in an effort to draw down some of its reported $100 billion stockpile of cash, and incidentally to reward shareholders. Their announced quarterly dividend of $2.65 translates to an annual dividend yield of about 1.85% at today's stock price.

I've mentioned how the Price-Earnings ratio (PE) is often used as a rough measure of valuation, with a 15/1 PE ratio being a traditional conservative target. Apple currently trades at a fairly reasonable PE of 16. I've also noted the recent increase in dividends by financial institutions, to yields around 2.5%.

E*Trade's website is currently touting high-yielding stocks, with the highest yield (by AT&T) at 5.7%. Wow I thought. What's their PE ratio? As it turns out, their annual dividend of $1.76 is significantly higher than their earnings per share of $0.61 (trailing 12 mo. earnings for those curious). And their PE ratio is a not so appealing 47.

That means, AT&T is currently paying out dramatically more to shareholders in dividends than the company is earning. The shares trade for about what they did a year ago, having come up from a trough in the fall. What is their strategy here? Their quarterly dividends have been above $0.40/share since 2008, and have slowly increased from the $0.20s to the $0.30s, and into the $0.40s over the past decade.

Clearly they have a treasure chest of cash ($23 billion to be accurate), else they couldn't sustain such a dividend through thick and thin. The yield at least in part explains the share price. But how sustainable is this approach? With 5.9 billion shares outstanding, they're spending more than $10 billion per year in dividends, or about $6.75 billion per year more than they are earning. Three to four years then it would seem, unless they increase their market share.

*Full disclosure: I personally own neither Apple nor AT&T stocks, and have no immediate plans to purchase either.

Innovator as Sculptor

I don't mean the plastic arts per se. Erwin Schrödinger said:

The task is ... not so much to see what no one has yet seen; but to think what nobody has yet thought, about that which everybody sees.

There is talk that innovators create disruptive technologies. Iron oxide may sizzle and flare, but it quickly burns out. A flash in the pan may momentarily disturb, but not likely disrupt. Disruption follows transformative innovation, not simply novelty or difference.

Not all that glitters today will be the light bulb, telephone, or computer of tomorrow. What most we can learn from nineteenth and twentieth century inventors is their commitment--the unrelenting drive to define new problems and solve them often before the world had even awakened to the possibility of their existence.

It is common to see a setback as a sign of defeat, to read an obstacle or hurdle as an impasse. The process of deconstruction may be easy if the focus is simply on identifying the flaws in what has come before. We can all complain with little effort or engagement about the failings of one technology, process, or another, like clicking thumbs-up or down on a website.

But this is not innovation. Destruction is simple. Innovation requires the emergence of something new out of what was before, or even what didn't appear to be; it is sculpture in its most essential form: to envision and realize potential out of raw substance.

There is a long, deep view required for true innovation. It is a willingness and ability to see beyond the amorphousness of yesterday to the form of tomorrow. It is not simply seeing in a child's eyes the glimmer of accomplishments to come; it is imagining that child in the raw soup of chemistry and cells from which they may someday emerge.

In practical terms, it is creating a vision of tomorrow, based in sound ideas, backed by knowledge and evidence, but challenged on every side and at every turn. The difficulty is not the envisioning, but holding fast to that vision, through the fog of quotidian existence. It is the patience of the planter, who sets an apple tree for their grandchildren to climb, along with the forethought and perseverance to align the tree and property today with what will be in fifty years.