A couple of days ago, a thoughtful reader (thanks, Omar) pointed me to the text of a terrific speech, “A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business,” that was given in 1994 by Charles Munger, Warren Buffet’s second-in-command at Berkshire Hathaway. Munger offers a bracingly clear-headed and plain-spoken lesson on how to think strategically about business and competition. He has great insights into the tricky balance between specialization, scope and scale that seem particularly relevant today, when, as Om Malik recently wrote, “everybody is in everybody’s business.”
But my favorite moment comes when Munger explains why investing in great new technology often leads to economic pain, if not ruin:
The great lesson in microeconomics is to discriminate between when technology is going to help you and when it’s going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles – which are a real commodity product. And one day, the people came to Warren and said, “They’ve invented a new loom that we think will do twice as much work as our old ones.”
And Warren said, “Gee, I hope this doesn’t work because if it does, I’m going to close the mill.” And he meant it.
What was he thinking? He was thinking, “It’s a lousy business. We’re earning substandard returns and keeping it open just to be nice to the elderly workers. But we’re not going to put huge amounts of new capital into a lousy business.”
And he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.
That’s such an obvious concept – that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.
Keep that in mind the next time your company’s considering a big investment in information technology. You know you’re going to pay the bill, but who’s going to end up reaping the rewards?
Does this apply to buying technology that can save you money?
Sure. If your competitors adopt the same or similar technology, the savings get competed away, ending up in customers’ pockets in the form of lower prices.
There is one major difference here though than most businesses. Buffet could afford to close the business and walk away – most people cannot. So they are stuck in a situation where – if they invest, they make nothing off it, but if they don’t they lose tons of business to the competition that did invest.
The next paragraph in the article explains exactly what I am referring to :
“Conversely, if you own the only newspaper in Oshkosh and they were to invent more efficient ways of composing the whole newspaper, then when you got rid of the old technology and got new fancy computers and so forth, all of the savings would come right through to the bottom line.”
– IF you own the ONLY newspaper ….
I think many of us close enough to how technology gets used realize it brings more incremental gains than strategic ones. Unless the shift it creates is disruptive to the basic economics of a market. In markets that are basically shrinking or commoditizing faster than they are growing, IT can’t make much of a difference. In growing markets, incremental gains help gain market share, and so IT does matter. ;)
“…all go to the benefit of the buyers …” what’s wrong with that? Southwest airlines has been profitable for 35 years with predictable, low pricing. Wal-Mart was biggest company is world with low prices. Intel/Dell have done pretty well. Buffett’s thinking will destroy many US businesses. If we do not think about our consumers, the Chinese will constantly undesell us. Our biggest asset is automation and technology applied well.
Yes, but if I’m spending $100k on something and I have the opportunity to save half that with technology, why wouldn’t I? I’m still going to be paying less. Even if my competitor also achieves the same savings.
Ordaj: You’re assuming the technology is free, which it’s not.
But, anyway, you may have no choice but to invest if your competitors are buying it and it does reduce costs/improve productivity. You have to invest to maintain competitive parity, even if you never earn a return on the investment.
This is called margin flight – the inevitable movement of impatient capital towards higher returns, caused by disruptive innovations. The solution lies in either adopting the new technology, or moving to a different part of the value chain. (See, for instance, Christensen, C. M., M. Raynor, et al. (2001). “Skate to Where the Money Will Be.” Harvard Business Review (November): 73-81.)
The difficulty of that kind of thinking is that it does not allow you to make decisions that temporarily lowers your profitability, or, even worse, make investments that will permanently lower it. Instead, you run the business by optimizing quarters. This is not something that Warren Buffett is known to do.
Nice little paradox.
I see this more as the IT as an arms race argument.
These are just my personal experience and honest opinions – not a trolling session.
The majority of IT projects would seem to be CODB (cost of doing business) and therefore a competitive necessity (as opposed to advantage). They are “strategic” in much the same way that a modern transport system is “strategic” to a postal service and hence should be cost focused / commodity or utility based – “cheap as chips”.
One of the issues with the adoption of technology that has become pervasive in your industry and is little more than a CODB, is that the technology will often have a dubious long term correlation with profit. As per Buffet’s example above any cost reductions are general across the market (assuming a competitive market), and will most likely be passed onto the consumer. In isolation an attractive ROCE can be shown, but in totality for the business it rarely appears.
Take a fictitious “new ACME XRP” product that will reduce labour costs by 50% making a saving of $X per unit compared to the current process. In all likelihood by the time your ACME XRP is in place – your competitors have either or are implementing their own XRP. The cost base for the market has or will be reducing, the selling price follows. Yes, you saved $X per unit – margins didn’t increase though, or if they did it was temporary effect.
Of course this is better than not installing an XRP system and finding yourself in a market with competitors who have a lower cost base for the same level of service.”new ACME loom” product was on the market. At some point the Mill would need to adopt the ACME loom over it’s own loom product – ideally taking as much value from the CA phase without losing too much in the transitional phase through either over investment in a home grown system or the cost of transition to the industry standard.
In this case, the new ACME loom is on the market and it looks likely to be CODB in this field – chances are one or more of your competitors has been using this for some time and been doing very well. You don’t have the choice of whether you wish to invest or not, you have to – if you wish to stay competitive in this field.
When the salesman comes knocking, and tells you how they can customise the ACME loom to your individual business need to give you that extra edge – don’t. Cheap as chips is the name of the game in CODB – it’s a playing field, adapt your business.
Unless you can establish new markets or increase share, or find other CAs, then each technological advancement in CODB will require capital and ultimately depress margins further in a truly competitive market.
The end options would always appear to be either cash out, go for as much of a monopoly as legally possible and hope your product doesn’t become consumer producible, change market or get used to vanishing margins.
This is not an argument against investment, quite the opposite. If Warren’s group were also investing in R&D for loom technology (which they might have been), they might have created the loom, extracted a good deal of profit from the CA stage it created and then licensed the loom onto others (making more) or transition fairly early to ACME loom when it appeared.
Such investment, needs to be treated as a venture capital exercise – something which I would argue that large companies with large IT groups should do.
However, this is an argument against investing heavily in CODB type products and understanding that the route from CA to CODB is well trodden and IT systems are no exception. Many of these products need to be implementation cost focused as they bring no real value or advantage other than being a necessity to compete.
In my view, the same is true with looms as with other technology.
It’s an experience call – and I agree with Warren wholeheartedly on this one.
Nick,
You wrote
”
Keep that in mind the next time your company’s considering a big investment in information technology. You know you’re going to pay the bill, but who’s going to end up reaping the
rewards? ”
Returns from IT Projects are of 4 types – Brand, Knowledge, Money and Time. More at http://www.kaytek.co.in/erp/itprjroi.htm.
Thanks for allowing me to share my thoughts on your forum.