It’s tempting to invest in areas that promise certain returns for a given investment. Unfortunately, by the time an opportunity has become so well understood that anyone could pursue it, it is well on the way to commoditization. To find big payoffs, you must be willing to explore high uncertainty bets.
“The viability of a company depends on its ability to innovate.”
You might well have heard it from me, but this quote is actually from Bansi Nagii and Geoff Tuff (then partners at the Monitor Group) authors of a great 2012 Harvard Business Review article “Managing Your Innovation Portfolio.” In that article, they tell the same stories I tell, of companies dimly recognizing that just adding a twist here or a tweak there to their line of offerings is eventually going to lead them to a dull, less-and-less profitable slide into decline and irrelevance.
Let’s understand why that is.
Just as we do at Valize, they recommend looking at investments in new capabilities across a spectrum of uncertainty (we do the analysis using software). They call this the “innovation ambition matrix.”
Closest to the day-to-day business are investments in what they call the “core.” As you might expect, these are mostly things one is doing to keep today’s business humming along. These are critically important, of course – get those wrong and you won’t have the resources to do much else.
Next are investments in what they call adjacencies. At Valize, we call those new platforms. We both agree that, as they say, “an adjacent innovation involves leveraging something the company does well into a new space. Procter & Gamble’s Swiffer is a case in point…it used a novel technology to take the solution to a new customer set and generate new revenue streams.” We would use examples like Adobe’s amazing transition to cloud-based services and Amazon’s highly successful venture into enterprise software as well.
Finally, we have what they call potentially transformational initiatives (we call these options for the future). As they say, “these are designed to create new offers – if not whole new businesses – to serve new markets and customer needs. These are the innovations that, when successful, make headlines … also called breakthrough, disruptive or game-changing.”
An observation they make, with which we heartily agree, is that “few organizations think about the best level of innovation to target, and fewer still manage to achieve it.”
The right way to allocate, and the surprising relationship with returns
Nagji and Tuff then did a study to see whether paying attention to your innovation portfolio has performance effects. What they found was that, indeed, it does. They correlated the allocation of resources across the elements of the portfolio with share price. The data revealed a pattern: Companies that allocated 70% of their innovation activity to core initiatives, 20% to adjacent ones and 10% to transformational ones outperformed their peers, typically realizing a P/E premium of 10% to 20%. As they note, “our subsequent conversations with buy-side analysts revealed that this allocation is attractive to capital markets because of what it implies about the balance between short-term predictable growth and longer-term bets.” That all seems sensible.
Here’s where it gets interesting. In a further study, the authors sought to understand what proportion of bottom-line gains companies enjoyed because of their innovation efforts. How much from core, adjacent and transformational initiatives, in other words. What they found was that the return ratio is roughly the inverse of the ideal allocation. Let’s stress this:
Core innovation efforts typically contribute 10% of the long-term, cumulative return on innovation investment; adjacent initiatives contribute 20%; and transformational efforts contribute 70%.
In other words, the biggest bang for the buck from innovation comes from investing in the transformational bucket.
Managing transformational potential – a caveat
To Nagaji and Tuff’s analysis, we would add one major caveat. Yes, the biggest returns lie in the transformational space. But only if these are managed using the logic of real options. A real option is a small investment that you make that buys you the right to make a future choice, when more information is available.
Managing options is different than managing the core. What you are looking for with an option is the smallest and fastest investments you can make to learn whether there is a huge upside that you might capture. If things don’t look good, you simply stop making such further investments. Sure, you might lose money on a few of them, but the huge returns possible to high quality options allows you to write the poor quality ones off without even looking back. It’s a numbers game, as Alberto Savoia so often points out.
This is how venture capitalists invest. The best of them, anyway (not the ones who were punch-drunk with the excessive amounts of capital floating around the system in recent years).
The classic trade-off was that you’d invest in many more ventures than you had any right to expect would succeed. Of 10, say, you’d have 6 that would fail outright, a couple that would become the ‘living dead’ (not terrible failures, but not big exits) and one or if you were super-lucky, two, that achieved substantial exits, returning far more than the cost of the capital that went into the bundle of ventures.
So yes, the transformational space is where the big returns are to be made. But only if you manage them as options on a transformational outcome, not as tweaks to an existing process you understand well. For more on the distinction, have a look at this great article by Geoffrey Moore.
And if you don’t invest in transformation? The commodization monster awaits
In 2003, just as the tech economy was recovering from the dot.com crash and the early winners of the initial digital implosion were starting to demonstrate viable business models, Nick Carr, writing in the Harvard Business Review, argued that inevitably, the marvels of IT which were generating hefty profit margins would be subject to the forces of commoditization, eventually ending up with all the charm and profitability of a public utility.
Just as happened to the railroads and electric companies before them, Carr suggested that the explosion of investment in digital assets would eventually lead to a per-unit decline in the value of those assets.
This isn’t limited to high tech. As far back as 1823, economists such as David Ricardo and Karl Marx articulated the Law of Diminishing Returns, asserting that the profits for a given unit of a product will eventually be reduced to the incremental cost of production for that additional unit. From the perspective of corporate innovation, what that means is that the more you invest in an existing and well-understood business, the less return you will get for each unit of investment. This is because of limits in the upper amount of addressable demand, competitors entering to grab what demand there is for themselves, increasing investment in fixed costs, and so on.
To escape commoditization, investment in innovation is essential. Leaders know this. And yet, as I discussed in a recent article, they still allow themselves to get distracted by the seeming certainty of making investments in the core business.
The implications seem obvious, at least to those of us who’ve spent our careers in the areas of strategy and innovation. Manage your portfolio of investments across ranges of uncertainty. Make sure you aren’t putting all your resources – people, assets and budget – into the core. Figure out the processes you need to navigate the pressures of keeping today’s business humming along even as it prepares for inevitable obsolescence or transformation.
We’ve worked with many organizations who get this right. Never perfectly, never without conflict, never without stress, but better than those who simply ignore reality.
And of course, to the most innovative among us, uncertainty means opportunity.
Implement discovery driven growth in your organization
When everyone around you is frozen in the headlights, this is a great time to make low-risk but determined moves into future spaces. We can provide a blueprint. Reach out to firstname.lastname@example.org to learn more.