Gloating, Part 1

I’m not an investment analyst and don’t usually recommend stocks, but a month ago it seemed pretty obvious that Apple was being severely undervalued by the equity markets. So I posted a short article saying its price was absurd and that it was a clear “buy.”

What’s happened since then? Shares of Apple (AAPL) closed today at $386.90, up ~23% from the June 20th close of $315.32. In other words, in one month Apple created over $60 billion of shareholder value (measured by change in market cap). Not too shabby.

Their earnings report yesterday (which blew away the analyst consensus by 33%) had a lot of interesting data on their rocketing sales by product and region, but the most important thing about their share price growth over the past month is that there hasn’t been any single major driver, like a huge product announcement (its recent patent wins were about as close as it came). Instead, Apple’s just been consistently executing on a great strategy.

Of course, a month is nothing in this game – we’ll check back again in 6, 12, and 24. But remember that performance is a lagging indicator of a successful strategy, which is why smart amateurs that understand Apple tend to out-predict the Wall Street pros. A good example is John Gruber of Daring Fireball, who picked up on a strategic shift when Apple announced the iPad a year and a half ago:

There was a meta-message in today’s Apple event, not about the iPad in particular, but rather about Apple as a whole … [T]his is Apple’s way of asserting that they’re taking over the penthouse suite as the strongest and best company in the whole ones-and-zeroes racket.

Some people have asked me why I write so much about Apple. This is a company that was almost dead 15 years ago, but is now in the running to becoming the most valuable company in the world. Strategy and innovation is how they did it.

Why Apple Had to Choose

Fifteen years ago, in perhaps the most important article on business strategy ever written, Michael Porter wrote that “the essence of strategy is choosing what not to do.” He drew a critical distinction: many decisions lead to unambiguous improvement, but real strategy – the key to lasting competitive advantage – requires trade-offs: choosing to focus on doing A well, even if that requires you to sacrifice B. Porter’s idea is neither complex nor new, but it’s still hard-learned.

Apple recently released a completely redesigned version of its advanced video-editing software, Final Cut Pro X. Amateur movie-makers such as the New York Times’ David Pogue praised its ease of use, but the reaction among professional video editors was scathing. Missing features and other changes were slammed. With regard to the negative feedback he got following his review, Pogue said he’d “never encountered anything quite like this.” The pro crowd was so incensed with what was termed Apple’s “failure,” “worst launch,” and “biggest mistake in years” that speculation quickly turned to what Apple could have been thinking. Some suspected that it intentionally stripped away critical features to “dumb down” its product and appeal to the much larger amateur editing market – a theory that only angered the pros further. Pogue himself emphatically argued that Apple didn’t intentionally turn its back on the professional market – instead, Apple just “blew it.”

Pogue is wrong. As Sachin Agarwal (founder of Posterous and a former Final Cut Pro product designer at Apple) put it, they knew the Final Cut Pro X redesign would be controversial. He described the rationale for their decision bluntly: “Apple doesn’t care about the pro space.” Nor does it compete on features – it “doesn’t play that game.” Instead, Apple took a professional-grade product down-market by making it simpler, cheaper, and more intuitive – and to do this, they changed and eliminated functionality.

What’s funny is that this has always been Apple’s strategy. While IBM made faster and more powerful PCs for the technical elite in the 1980s, the Macintosh had less RAM but introduced a mouse and graphical interface that any user could understand. More recently, many critics thought the iPad would be dead on arrival because of the features it lacked, but a few, such as John Gruber, understood that Apple was making a conscious trade-off - ignoring the feature-seekers and tinkerers in order to create the world’s most intuitive computer, cheap and capable enough for the mass market.

Did Apple have to choose? If it tried to design software or devices for both laymen and the elite technical segment, it would be forced to make a thousand subtle sacrifices to pull off the straddle – on features, UI, price, marketing, etc. In the end, it might still have made great products, but not as good as those it has now.

The risks of failing to choose are all too apparent when you consider some of the biggest disasters in the high-tech industry recently. There are eerie parallels between last week’s anonymous Research in Motion open letter to the CEOs (“instead of chasing feature parity … [t]here is a serious need to consolidate our focus…. Strategy is often in the things you decide not to do”) and Yahoo’s infamous 2006 leaked “peanut butter” memo (“We want to do everything and be everything – to everyone…. The result: a thin layer of investment spread across everything we do and thus we focus on nothing in particular…. We need to boldly and definitively declare what we are and what we are not”).

Contrast these with Steve Jobs’ philosophy on strategy, repeated endlessly over the years: “People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully … We’re always thinking about new markets we could enter, but it’s only by saying no that you can concentrate on the things that are really important.”

RIM’s share value is down ~33% over the last month. Yahoo’s is down ~60% over the last five years. By contrast, since Jobs returned to Apple, its share value is up almost 10,000%.

Michael Porter might say that the Final Cut Pro X debacle is exactly why Apple is the most successful company in the world.

What Should I Watch? The Evolution of Recommendation

One of the great promises of the Digital Age is a better way to figure out the answer to the question above. People love great writing, artwork, film, and music, but no one is going to experience, in their lifetime, more than a fraction of all the content in existence. That’s why we try hard to find the stuff we’ll probably enjoy.

But that’s always been really difficult – as the saying goes, you can’t judge a book by its cover. Even if you could, no one wants to waste time searching through every title ever written to find the ones they’ll like. So for ages we’ve relied on poor solutions for discovery of new content (not to mention food, fashion, software, etc.). The three main ways we’ve done this are:

Curation: Experts decide what the best content is, and we listen to them. That’s why everyone read To Kill A Mockingbird in high school, and why movie critics put out Top 10 lists. Of course, there’s much to be said for being exposed to high culture and different viewpoints, whether we want to be or not. But the nature of art is subjectivity – everyone has different interpretations and tastes, so I might not like the experts’ picks. And who decides who’s an expert anyways – have you ever bought a book from the Staff Favorites rack at a bookstore?

Popularity: TV channels, radio stations, movie theaters, and bookstores offer an array of the most popular content, and we pick from the available options. Pretty simple – they modify their offering based on what sells, and everyone wins, right? But again, there’s no personalization here, and we don’t all have statistically average tastes. Worse, picking based on popularity creates a feedback loop that might misrepresent reality (did anyone actually like Rebecca Black’s Friday video?).

Word of Mouth: The old standby. Our friends and family probably have a better idea of what we’ll like than anyone else, and we’re more inclined to trust them (I’ll read anything my dad or my buddy Tom sends me). But unfortunately their experiences probably overlap significantly with ours (as Mark Granovetter pointed out decades ago), so while you might get fewer false positives (bad recs), you’ll also have more false negatives (missed content). It’s also tedious to poll your friends every time you’re looking for a movie to watch.

Enter the recommendation engine. Of course, in the Digital Age of plentiful data, a lot of companies can get more mileage out of the same basic methods listed above – for instance, the New York Times can now easily measure and display its most popular articles. But technology can also do a much better job of helping us discover new content when our tastes take us beyond the Top Ten (this has also created a revolutionary paradigm for content sellers, which Chris Anderson of Wired termed the Long Tail). Although I’m not an expert in the field, it seems like there are at least three entirely new ways to use consumer data to recommend new content:

Intrinsic algorithms use the actual attributes of the content and combine them with individual user feedback. The best example of this is probably online radio Pandora, which uses the Music Genome Project’s 400 attributes to tag every song in its database. If you say you like a song, it cues up more songs with similar traits (e.g., beat, vocal pitch, etc.). While this approach is widely praised for helping discover good music, it’s probably harder to apply to other types of content. There are also certain things we love about great art (like a metaphor in a song’s lyrics) that can’t be reduced to digitized attributes.

Preference algorithms rely on both our own and others’ ratings. Amazon was a pioneer in using its massive scoring database to shift from just popularity-based discovery (“X is highly rated”) to adding a preference-based algorithm, too (“you liked X, and most people who like X also like Y, so we recommend Y”). But while the logic is simple, the algorithms get incredibly complex. The gold standard is Netflix, whose Cinematch recommendation engine is so critical to their success they offered a $1 million prize to researchers that could improve it by 10%. But this approach has limits too, many of which have been described by Eli Pariser (example: preference algorithms tend to be risk-averse, so restaurant recommendation engines keep sending people to decent, inoffensive places like Chipotle).

Social algorithms – right now, social networks’ role in recommendation is just word of mouth on steroids, but their use for discovery is only just beginning. You could talk about Game of Thrones (or “like” it) on Facebook today, and your friends may be intrigued. But far more powerful would be an automatically generated recommendation if a significant percentage of your closest ties liked or mentioned something.

So which approach is best? The more interesting question is how these approaches can be combined to produce exponentially better discovery. That’s why Facebook’s announcement last week that Reed Hastings, Netflix’s founder and CEO, was joining its board was exciting. Sure, it may signal Facebook’s preparations for an IPO, or its future addition of streaming video, but it might also pave the way for Netflix to integrate a social element into its recommendations. What if curation and/or intrinsic factors were added too? Google might also be well positioned to offer a killer recommendation engine in the future if Google+ takes off. And at the very least, a better recommendation system could help Amazon win the retail war against Walmart – or vice versa.

Going further, recommendation engines have been mostly add-ons for content sellers so far (stand-alone recommendation platforms haven’t been widely adopted), but imagine how powerful a universal recommendation engine across all types of content (and other choices we make) could be. Again, there are legitimate concerns about a world of excessively personalized discovery, as Pariser argues in The Filter Bubble - ideally, we’d always be quite conscious of recommendation and decide when to switch it on and off. But at the very least, I bet we’d watch a lot less bad TV.

As always, your feedback is welcome.

It’s the Brand, Stupid

There’s a lot of discussion going on about whether – and why – consumers will choose to buy tablets (mostly running Android) other than the iPad, and, to a lesser extent, smartphones (mostly running Android) other than the iPhone. As usual, pundits and analysts predict that Apple’s dominance must inevitably erode, while John Gruber (@daringfireball) and a few others argue that they’re wrong. Gruber calls the debate “perhaps, the most polarizing topic of punditry in tech today.”

The pundits’ argument is based on sensible Econ and Strategy 101: Apple is making a killing now, but that’s because it was first out of the gate with these products, and without some kind of protective moat, all good things must pass, right? Apple doesn’t seem to have an insurmountable barrier or killer app (like iTunes with the iPod). Therefore, the fast followers will catch up on Apple’s hardware capabilities and apps, and price-compete their way to share. The only question is how long it will take.

One big counterargument, of course, is that Apple has core competencies that not only got it out of the gates first, but enable it to run faster too – particularly in innovation and design. By the time Samsung caught up to the iPad, the iPad 2 was already around the next corner.

In the tablet market, Gruber, John Paczkowski and others make a second argument too – that catching up to Apple isn’t good enough. To really win, a competitor like Samsung, RIM, or Dell has to provide a good answer to the question “why should somebody buy this instead of an iPad?” But this only hints at the much bigger moat Apple’s built around itself: its brand.

Many techies see a brand as an elaborate marketing ploy companies use to appeal to the emotional part of consumers’ minds, and a lagging indicator of success. In other words, you can fool consumers for a while, but your brand will stay strong only if the products are; either way, a brand doesn’t itself create lasting success.

This misapprehends what a brand really is: a promise in the mind of consumers. Unlike, say, five years ago, today most of the extremely high value of Apple’s brand doesn’t come from its ads, its fanboys, or even its retail stores. It comes from average consumers’ experiences.

Imagine a non-techie thinking about buying a new smartphone or a portable computer. Even if she’s never been in an Apple store, there’s a decent chance she got an iPod Nano as a present at one point. More importantly, she almost certainly knows many people who have bought an iMac, iPod, iPhone, MacBook, or iPad over the past decade, in various versions and combinations.

What impression of Apple has this given her? Almost certainly, it’s been overwhelmingly positive, because Apple hasn’t launched a crummy new product in a long time – and that includes both new-category (iPad 1) and next-gen (iPhone 3GS) devices. And here’s the key – when it comes to sales, it’s OK to have a bunch of misses, so long as you have a few big hits. But with a brand, misses hurt. People hate wasting money, and they know they’re taking a risk when they buy a major new piece of technology, same as when they go to a pricey new restaurant. If people talk about how a product kind of sucks, that won’t just hurt sales of that product – it hurts sales of the next one too. The opposite is also true.

Four or five years ago, even if you heard great things about Apple products, it was still acceptable to brush them off – sure, the iPod was cool, but I’m not sure about this new phone. But now, in consumers’ minds, Apple has been batting pretty close to a thousand for a decade. And that’s its best asset – the fact that you can’t sneeze without hitting five people who’ll tell you they love their iPad, will never switch from their iPhone, or that their Macbook “just works” – and zero who say otherwise. In other words, it’s the brand. We’ve been surrounded by great Apple experiences for so long now, we’ve been trained what to expect – if Apple announced it was coming out with a washer/dryer, we’d laugh, but we’d also immediately form some positive expectations about how it would look and function.

That’s why it’s getting harder to defend buying anything but an Apple product: simply because you can be confident you’ll like it. Tech mavens might always be willing to adopt the “best” product, but most consumers are more wary. If Samsung, RIM, Dell, or anyone else today announced a tablet that had 13 good reasons why everyone should buy it instead of an iPad, tomorrow most people would still buy iPads, because the one reason that really matters to the average Joe is risk. Technology is complicated and often disappointing, but Apple’s brand credibly promises people that they’ll love the next thing they buy that has a little bitten apple on it. Other tech brands can’t do that without sounding like the Boy Who Cried Wolf. And one great product won’t close the credibility gap – they’ll need a decade of great products, with almost no misses. The kind of trust Apple’s built up creates incredible momentum. That’s why the “tablet market” is Apple’s to lose.

Apple’s Absurdly Low P/E Ratio

Fortune has a short post by @philiped today that calculates Apple’s PEG ratio (price / earnings / earnings growth, a favorite measure of Peter Lynch) to be below 1.0, and far below companies such as Dell, Amazon, and Cisco, implying that it’s undervalued (same for Google and IBM).

In other words, Apple’s profit growth is explosive, but as I write this, its P/E is still in the mid-teens (currently 15.0). Google’s is 18.8. The S&P 500 overall is 22.6. Amazon’s is 81.3.

This means either the market is expecting Apple’s growth to slow dramatically, or it believes Apple’s future earnings to be highly risky – or both. Whatever the case, Apple’s stock is down 10% in the past four months.

This is absurd. Would anyone in his right mind actually bet against Apple’s earnings growth right now, given the sales it’s posting for iPads, iPhones, and iMacs? If this is a Steve Jobs story, it’s hugely overblown.

Prediction: Apple will continue to outperform the S&P and tech peers like Amazon over the next 6, 12, and 24 months. I’m putting reminders to check back into my calendar.

Buy now.

Dissatisfaction Is the Mother of Innovation

My friend Dave is a great guy, but terrible to go to restaurants with. Invariably, he ends up peppering the server with endless questions, trying to order things not on the menu, and complaining about the food once it’s served.

People like Dave may be hard to dine with, but they can be great for innovation. That’s because they’re continually dissatisfied with what’s available, looking instead for an ideal experience. The best innovators utilize several techniques to understand consumer dissatisfaction – and then use that understanding to drive innovative ideas.

Listen to problems, not solutions

Recently, many have cited Henry Ford (who famously quipped, “If I had asked people what they wanted, they would have said faster horses”) and Steve Jobs (“You can’t just ask customers what they want and then try to give that to them”) to make the case that listening to customer feedback is pointless. But as Ted Levitt, Tony Ulwick, and others have argued, while customers are notoriously bad at coming up with solutions to their own problems, their actual difficulties and complaints – the problems themselves – are a goldmine for observant researchers. That’s why management gurus like Clay Christensen and Gary Hamel have advocated listening not only to your core (and presumably satisfied) customers, but to those on the fringe – the unhappy non-users and complainers. And the louder they whine, the better.

Map out dissatisfaction

To better understand consumer dissatisfaction, author and consultant Adrian Slywotzky has advocated creating a “hassle map” – laying out the entire customer experience with a product or service to pinpoint where customers become frustrated by wasted time and effort. Far too many companies focus solely on adding exciting features to the product itself; great innovators instead often aim to eliminate irritating aspects of the experience. For example, Apple’s most successful products have often reduced hassle in the customer experience as much as they’ve added new capabilities. Through Visual Voicemail, the iPhone improved the bothersome process of navigating phone messages. The iPad greatly reduced both lengthy computer start-up time and the painful need to frequently recharge (through its hugely extended battery life). Most recently, the iCloud service aims to eliminate the irritating need to sync Apple devices using cords. Contrast these improvements with those of other PC-makers in recent years, who focused on adding security features, hundreds of gigs of storage, cameras, etc.

Imagine the ideal

P&G’s consumer researchers have been known to put on “futurist exhibits” to help spur innovative product concepts. After extensive consumer observation and discussion, researchers mock up nonworking but clever products in answer to the question: “How might consumers solve this problem in 50 years?” For example, rather than using an imperfect product that P&G offers today, perhaps the consumer of the future will simply swallow a pill annually to prevent hair from going gray, press a button to have house walls suck away dirt, or drink a tasty beverage to automatically clean his or her teeth. While these Jetson-like inventions may seem far-fetched, the brilliance of the “in the future” conceit is that it allows P&G innovators to forget today’s technical limitations and instead imagine what a perfectly simple and effective solution could look like. Who doesn’t like to imagine a frustration-free future?

Through these and other methods, companies can use consumer dissatisfaction to drive better innovation. A twist on the old maxim is appropriate: Don’t let today’s ‘good enough’ be the enemy of ‘better yet…’ And if you learn to love customer dissatisfaction, you may even be able to put up with a whiner like Dave.