Sometimes, The Best Business Decision Is To Change Businesses

When you use fundamental analysis to estimate the value of a stock, you have to make a lot of projections.

How quickly will the sales grow? Will profit margins expand or contract? What will the company's capital structure look like, and where will interest rates go? Where will tax rates be in the future?

If the projections you put into your valuation model are off, then the value you calculate will be off. Analysts call this phenomenon "garbage in, garbage out."

To demonstrate how difficult this exercise is, let's try projecting the sales for A1 Widgets Corporation, a hypothetical company that's the worldwide leader in selling indestructible widgets. Based on A1's order book, sales for widgets will grow for exactly five years. In the fifth year, everyone in the world who will ever need a widget will have one. From there, there will be no more demand for widgets, and the widget factories will close.

What will A1's sales look like after the fifth year?

If you said $0, then you'd be wrong.

Because A1's owners and management had the foresight to quietly gain a foothold in the emerging cloud infrastructure and AI technology businesses. As a result, the company will soon see more sales and growth than ever before. Earnings will eclipse what they made selling widgets. And the stock price will explode.

No, this was not a trick question.

There are countless examples of companies expanding into or outright pivoting to businesses that no one could've foreseen.

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Buying a stock is about more than investing in a company's product 🤔

Having a great product to sell isn't enough to have a business that'll generate a great return for shareholders for many years to come.

You also must have stellar management with a killer instinct for allocating capital.

Not only does management have to figure out how to sell the company's core product for growth and profitability, but they also have to be able to read the tea leaves and recognize when the tides of business are turning. Maybe the market for the product is saturated. Maybe the product is becoming obsolete. Maybe customer preferences are shifting with technological developments. Maybe there are other significant opportunities to pursue, and the company has both the finances and expertise to capitalize on them.

Most companies continually make subtle adjustments that often go largely unnoticed. Some completely overhaul their business.

Take Berkshire Hathaway, which was a textile company when Warren Buffett took over it in 1965. Not long after, Berkshire became an insurance company that also sold candy. Today, it's a diversified conglomerate selling everything from energy to airplane parts to underwear. And it has a massive stock portfolio generating market-beating returns. (I discussed Berkshire's culture of change in a recent appearance on Yahoo Finance.)

Another famous example of a company that's undergone a total transformation is Netflix. The company defined change when it introduced DVD rentals by mail while many consumers were still walking the aisles of brick-and-mortar video stores. While it dominated the mail-based rental business, management quickly shifted its efforts and aggressively invested in streaming services and original content. In 2023, Netflix mailed its last DVD. The stock currently trades at an all-time high, with the company valued at over $500 billion.

Last week, I was on Yahoo Finance's "Stocks in Translation" podcast with Jared Blikre and Sydnee Fried. (Catch it on Yahoo Finance, Apple Podcasts, Spotify, or YouTube!) Jared brought up Apple, which generated $96 billion in sales from services.

Here's what I said about Apple during our discussion:

If we were having a conversation about valuations 25 years ago when Apple was only making desktop computers, [you would ask] how many computers can they sell before you hit a ceiling? And so if you’re only thinking about investing in a company that only makes computers, then yeah, it might not make sense to pay a premium on the stock that you’re buying. But if you can be a little bit more imaginative, and if you understand that this is a company that understands change and tweaks its business model as the world changes, and as it reaches a saturation point, then you can begin to imagine a path where a company can continue grow earnings like Apple has and turn into a multi-trillion dollar company.

Apple's Mac computers account for less than a tenth of the company's sales. Meanwhile, phones, a category they didn't get into until 2007, account for about half of sales. Services account for about a quarter of sales.

It's even harder than you think 🫠

Acknowledging that your best product has matured and may be on a path to obsolescence is a tough pill to swallow. That said, once you've come to this realization, the hard part is likely just beginning.

Those leading the change will inevitably be met with resistance, not just outside the company, but also inside the company, where many employees won't be ready to let go of the old way of doing things.

Even assuming you have the full buy-in of the company, who knows if you're pivoting in the right direction? You very well could be trading one failing business for another that's doomed to go sideways.

Of course, even the most successful companies have made many bets that have gone bad. The difference between companies that can and can't move past these failures is great risk management and the confidence of shareholders.

But if you fail enough times, you'll eventually lose the faith of the shareholders.

No one ever said any of this was easy.

How investors can play this 💸

Every publicly traded company is doing everything it can to make sure earnings will grow, perhaps in a way that leads to market-beating returns in the company's stock price.

But many disappoint.

Unfortunately, there isn't a surefire way to identify winners consistently enough that you can build a portfolio that outperforms the market.

One of the reasons for this is that over time, it's a minority of stocks with massive returns driving the market's performance.

So, how can investors play this?

Historically, one of the best moves has been to buy broadly diversified index funds like those tracking the S&P 500. While the diversification may limit your upside, it also makes it almost certain that you'll have exposure to the big winners, including the companies that successfully pivot their businesses in ways that create massive amounts of shareholder value.

A quick personal note…

The evolution of many companies isn't too dissimilar from the ups and downs many of us face in our lives.

As I recently shared with Joe Fahmy on his podcast, my entry to writing about markets was anything but planned and orderly. And over the span of my career, I experienced at least six major pay cuts, including one big one that occurred after I got laid off.

Few of us are lucky enough to live a life where everything goes up and to the right in a smooth, straight line.

But most of us are on a non-linear path, whether by choice or because of forces outside our control.

The good news is that just because things don't go as planned doesn't mean we're doomed to spiral. Read enough biographies (and business case studies), and you'll eventually see that the most impressive people (and companies) were the ones who had to overcome many challenges by making big, unplanned changes.

Just a thought.

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