Notes on Disruptive Innovation: Intellectual History and Future Paths

My notes on HBS Working Paper 17-057 (PDF) titled Disruptive Innovation: Intellectual History and Future Paths by Christensen C., Altman E., McDonald R., and Palmer J. It complements my previous blog posts like Business Theory of Disruptive Innovation, Jobs To Be Done: Business Raison d’Etre, and Managing the Six Phases of Transient Competitive Advantage

3 principal components of disruptive innovation:

  1. The pace of technological progress outstrips growth in market demand for higher-performing technologies, causing incumbents to overserve the market and, as a result, creating a gap in lower market
  2. There is a strategically important distinction between different types of innovation
    • Sustaining innovations: improve product along existing dimensions of performance (make a good product great)
    • Disruptive innovations: usually cheaper but better at other dimensions (create a new product)
  3. Established profit models constrain investment in new innovations because they are typically less profitable

Anomalies uncovered in further research

  1. At first, the idea is that incumbents don’t invest in disruptive innovation. But that’s not true: investment ranges from little to freely flowing
    • Opportunity framing vs. threat framing: threat framing usually leads to greater resource allocation
    • However, despite investments, inertial forces prevented from adoption
  2. A small subset of incumbent leaders successfully dealt with disruptive innovations
    • autonomous business unit separate from parent company free to enact own business mode
  3. Different types of disruptive innovation:
    • Low-end disruptions: enter the low-end of the market, solidify market share and position in the value network, then move up-market
    • New-market disruptions: compete against non-consumptions
  4. For disruption to occur, industries must be structured so that producing higher-performing products and services results in higher profitability for firms, giving them an incentive to go upmarket.
  5. Specific industries have an “extendable core” that allows firms to produce at first simple products at low cost, but eventually can make more sophisticated things at lower cost

Causal Pathway for Disruptive Innovation theory

  1. Insidious resource allocation process within the organization that favors “sure” investments
  2. Customers ultimately provide the firm with the resources it needs to survive
    • Sustaining innovation serves and is valued by existing customers
  3. As performance improves, there is a more significant overlap between different market segments
    • Disrupters invade contested up-market to increase economies of scale
    • Incumbents retreat to uncontested up-market to protect profitability

Research with Intel on investment in disruptive innovation.

Predictions:

  • If the innovation was sustaining and Intel was an incumbent in the target market, the venture would succeed.
  • If the innovation was sustaining and Intel was an entrant in the target market, the venture would fail.
  • If the innovation was disruptive and an autonomous business unit was formed to pursue it, the venture would succeed.
  • If the innovation was disruptive and an integrated business unit was formed to pursue it, the venture would fail.

Using business plans to classify the ventures and survival to proxy performance, the theory correctly predicted the outcomes of 45 of the 48 businesses (94 percent accuracy rate) (Raynor, 2011)

Refining Performance Trajectories

  • The variance in the speed of disruption across different industries
  • The variance in speed of disruption within the same industry over time

Responding to Disruptive Innovation

Incumbent Response Strategies

  • Separate organizational unit tasked with developing or commercializing the new innovation
  • Aggressively invest in existing capabilities to extend current performance improvement trajectories to slow or delay the onset of disruption
  • Boldly retreat by proactively repositioning to profitable new niches
  • Organizational ambidexterity to manage conflicts arising from pursuing different types of innovations simultaneously
  • Redefine the organization’s identity to convince customers to value their products not on functional dimensions but on characteristics like nostalgia, authenticity, etc
  • Partner with or license startup technology once it advances beyond a certain threshold or acquire it altogether
  • High brand status can help incumbents re-emerge after experiencing a decline due to disruption

Hybrid offerings

  • Combine the new technology with the existing one to ensure a smoother transition
  • Improve existing technology while learning the uncertain technology
  • The performance difference between using new technology to enhance existing products and deliver to an existing customer base (sustaining) versus using hybrid technology to target new customers or applications (disruptive)
  • Hybrid may be of particular use to enter a market to support both legacy and new use
  • Business model hybrids?

Platform Businesses

Modularity

  • Platform businesses are built around modular architectures; the primary competitive advantage is interaction with one another and building upon the others’ products
  • Platform and network-based business strategies are emerging more rapidly, especially in IT- and cloud-enabled business models
  • When products are not yet good enough to satisfy customer performance requirements, firms rely on highly internally interdependent and integrated product architectures to maximize performance. Firms cannot afford to adopt modular architectures because standard interfaces compromise performance
  • When performance is satisfied, the basis of competition shifts to other product dimensions such as convenience, customization, price, and flexibility
  • When the shift to less integrated happens, modular architectures enable simpler and more efficient interfaces between products. Disruptive entrant incorporating modularity strategy can be highly effective

Disruption through incumbent transitions to platform business

  • When in an industry’s lifecycle, it’s effective for the incumbent to transition to modular/platform
    • If differentiation is performance-based, platform business is sub-optimal
    • If the industry over-serves and competition basis shifts to convenience, the platform may prove viable

Disruption through complementor ecosystem and network effect

  • A strong link between the management of complementor ecosystems for disruptive innovation
  • The competitive success of platform strategy hinges on the ability to create and harness network effects
  • A pricing strategy can disrupt the incumbent. E.g., offer free products to gain adoption
  • To build network effects, a firm may adopt strategies that rely on revenue sharing or royalties rather than sales revenues
  • Coopetition as a form of defense against disruption

Financial Metrics

  • Disruption is not a technology problem; it is a business model problem (and tightly related to the profit model)
  • Two problems with Profit Model
    • A measure of success -> drives investment decisions, especially when compensation is tied to financial success
    • Shows short-term success -> drives investment decisions, avoiding the long-term return perspective
  • New startups without defined profit formula as a success metric gauge success in different ways
  • The use of financial metrics may unconsciously create bias against disruptive innovations
    • Implications of marginal cost thinking and sunk cost fallacy
    • Valuation metrics don’t work if you underestimate the true benefits of innovation
    • Ratio-based metrics = manage by metrics (balance sheet management)

Updates to My Blog Post

I have updated my blog post titled “Managing the Six Phases of Transient Competitive Advantage” to include the Management Priority in each of the six phases:

Phase 1: The management is focused on its vision and aims to deeply understand the job to be done.

Phase 2: The management is focused on its vision and aims to find the right customers for its new product or service.

Phase 3: The management is focused on the operations as it aims to establish the right business and profit model to repeatedly deliver to the customer needs.

Phase 4: The management is focused on the operations as it aims to maximize the market opportunity.

Phase 5: The management is focused on finance as it aims to maximize the profit & loss statement.

Phase 6: The management is focused on finance as it aims to maximize the balance sheet statement.

Managing the Six Phases of Transient Competitive Advantage

The traditional goal of corporate strategy is to obtain a sustainable competitive advantage. However, this paradigm is outdated in the fast-moving globalized world we live in today. Instead, firms should consider their business models flowing from one transient competitive advantage into another.

What is a sustained competitive advantage?

A sustained competitive advantage includes everything that allows a firm to meet its customers’ needs better than competitors or substitutes. It consists of any attributes of the product sold, or service offered that the customer values highly, the perceived value of your brand, the business operating and profit model, etc.

By definition, a sustained competitive advantage is sufficiently strong, unique, and inimitable. That allows the firm to indefinitely fend off competitors vying for the same customers, discourage new entrants from entering the market, and prevent customers from considering any available substitutes.

The sustained competitive advantage is often described as an economic moat, similar to the deep and wide trench around a castle. In this parallel, the castle is your business, and the size of your moat determines how well your firm can protect its business.

In the past, firms would search for this sustained competitive advantage by deeply analyzing a target market, its customers, and the existing supply chain. Once a potential competitive advantage was uncovered, the firm would go to market and do everything possible to turn the advantage into a sustained advantage.

What is a transient competitive advantage?

In a globalized world, barriers to entry have lowered significantly. So, your position in the market with a competitive advantage is exposed to many more players than before. A threat can now be mounted from any country, not just known players in your vicinity.

Furthermore, the rapid increase in information flow and the digital world also exposes these potential disruptive threats to investment markets. Capital has increased visibility on attractive opportunities and can deploy resources to go after them if necessary.

The transitive competitive advantage distinguishes itself in that it is, by definition, not indefinite but limited in time. This significantly affects how a firm should approach ensuring its long-term success.

With a traditional sustained competitive advantage, the assumption is that a competitive advantage can be sustained indefinitely. So, the firm is primarily concerned with reinvesting in the economic moat around its castle to protect its business. The best firms can dig the deepest and largest trenches and, therefore, can protect their business indefinitely.

With a transient competitive advantage, the assumption is that no competitive edge can sustain forever. Therefore, the firm is no longer focused on protecting the existing economic moat at all costs but on the continuous transformation process.

The focus on transformation shifts the firm’s priority from protecting the economic moat to managing the rise and demise of competitive advantages.

How should a transient competitive advantage be managed?

We outline six distinct phases of the transient competitive advantage paradigm. We differentiate the phases from the perspective of McGrath’s “Transient Waves,Damodaran’s “Corporate Lifecycle,Christensen’s “Innovation Cycle,” and Ulrich’s “MOE Organization.”

Phase 1 – Launch of Disruptive Start-Up Team

The first phase of the transient advantage wave begins with identifying a new business opportunity and the decision to mobilize resources to capture it.

In this phase, the team is small. It operates like a start-up, focusing on developing a product that gets a well-defined job done better than anything else currently available. The identified opportunity can take many shapes, including:

  • Addressing a market need for which demand far exceeds supply
  • Low-end disruption in a market where an existing product or service overserves a significant portion of the customers, and therefore there is an opportunity to better serve the customer with a lower-cost business model.
  • New market disruption addresses under-served customers with a more suited product or service offering.

The management is focused on its vision and aims to deeply understand the job to be done.

The team leader is a visionary who can tell a compelling and plausible business story with potential upside for huge profits. The leader must connect the dots between the business opportunity, how the product addresses this opportunity, and what business model can capture the value created. The strength of the story will draw employees and investors to the vision.

The visionary is surrounded by RD innovators and out-of-the-box thinkers who are comfortable with experimentation and iteration and have a fundamental belief in the positive outcome of the project. The RD innovator’s priority is to turn the business idea into a feasible prototype that can be brought to market.

At this point in the business lifecycle, the revenue growth is non-existent, the operational cash flow is negative, and the reinvestment needs are high. Since the business is not generating any surplus cash, there can be no dividends returned to the shareholder. Also, there is no money to pay interest on the debt. Therefore, financing should be done exclusively with equity.

Phase 2 – Ramp Up of Disruptive Young Growth Team

The second phase of the transient advantage wave takes the working prototype to market. It aims to scale the business by turning the business opportunity into a revenue stream.

In this phase, the team remains small. Still, it adds market-oriented capabilities such as marketing and sales and operational-oriented capabilities such as supply chain management.

The management is focused on its vision and aims to find the right customers for its new product or service.

The team leader is a pragmatist (not a purist) who stays consistent in words and action with the business story that launched the business. The leader’s primary focus is to ensure the team remains focused on developing a disruptive product that “gets the job done” and finds customers who “need to get that job done.” At the same time, make the compromises required to ensure market viability.

A common mistake is that the business team pivots too quickly away from the business idea to address the initial customers’ needs. Especially when the team is part of an already established organization with an existing customer base. Another common mistake is to see the narrow, pure vision as the only yardstick of success which may prevent the business from taking off in the first place. The business leader must manage the friction between the “pure vision” original team members (developers) and “pragmatic” new team members (marketing, sales, supply chain).

At this point in the business lifecycle, revenue grows exponentially, starting from a low base. While the (re)investment rate remains high, the business should aim to achieve at least the operational breakeven point. Since profitability remains near zero, there is still no surplus cash to return to shareholders or money to pay interest on the debt. Therefore, financing should still be done exclusively with equity.

Phase 3 – Exploitation of Sustained High Growth Team

The third phase of the transient advantage wave aims to scale up and expand the business operations to capture profits by exploiting the fast-growing business

In this phase, the business is considered more than viable and success hinges on the team’s ability to turn revenue into profitability. The team shifts the focus from entrepreneurship and innovation to business management, operational excellence, and sustained RD development. In addition, the organizational focus shifts from focusing on the product alignment with the initial business idea to expanding the offering into a portfolio developed to address the growing or changing customer needs.

The management is focused on the operations as it aims to establish the right business and profit model to repeatedly deliver to the customer needs.

The team leader is a builder who can deliver the financial numbers in alignment with the original business story. They accomplish that by setting up a scalable organization with the capacity to build business processes that allow repeated success in the market.

The organization grows rapidly in size and capabilities, including but not limited to a variety of operational, finance, and human resource management. This is often associated with severe growing pains and a challenge to maintain a thriving company culture.

At this point in the business lifecycle, revenue growth remains high while operational costs are growing slower due to the benefits of scale. As a result, the business profitability is growing and should have a low but growing operating cash flow. The (re)investment needs remain high; therefore, there is still no surplus cash available for the shareholder. Since there is a positive cash flow, there’s room for small debt financing as long as it doesn’t waste the money needed for reinvestment. So, equity financing is still the primary choice.

Phase 4 – Exploitation of Sustained Mature Growth Platform

The fourth phase of the transient advantage wave focuses on leveraging a solidified position in the market and associated profitability to transform the business team into a business platform.

In this phase, the business has a double focus: internal and external. The external focus remains entirely on addressing the customer needs by continuously updating and refining the portfolio offering with new and better products. Since the customer knows and trusts your business and products, their willingness to pay is at its highest point. The internal focus is new to the business team. It addresses the need to find appropriate purposes for the increasing cash surplus generated from operations by transforming into a business platform.

Due to the double needs, two leaders are now required: a platform leader and a business leader.

The management is focused on the operations as it aims to maximize the market opportunity.

The business leader is an opportunist who keeps the business story in check with the numbers and quickly captures any new opportunities that extend from the existing business and may include M&A. Furthermore, the business leader aids the transformation from a business team focused on generating profits to a business platform that can support different business teams with capabilities and financing.

The platform leader focuses on repurposing the surplus cash to establish a business platform to fund new waves of transient advantage.

The organization continues to grow in size and diversity in capabilities. By now, the business should have several idiosyncratic internal processes that are inimitable competitive advantages. “The way we work” is a crucial differentiating feature within the broader market. The unique, idiosyncratic qualities are fundamental to the transformation from a business team into a business platform

At this point in the business cycle, revenue growth is slowing but still above the market average. However, thanks to a finetuned operating engine, profitability and operating cash flow are high and growing. At the same time, the reinvestment needs are less. Thus, there is a surplus of cash. The cash surplus can be used to transform the business team into a business platform or return to the shareholder. In the case of the former, the business platform can invest surplus cash in beginning a new wave of transient advantage. Debt financing is generally cheaper than equity financing, and there’s more than sufficient cash to pay interest on debt, so business operations should be financed primarily by debt.

Phase 5 – Reconfiguration of Efficient Mature Stable Platform

In the fifth phase of the transient advantage wave, the business platform reconfigures the organization to allocate internal resources where they are most needed.

In this phase, the business is no longer growing. Furthermore, there is increasing tough competition trying to steal your market share. Thus, it is important to reconfigure the organization to make resources available for new business opportunities. The platform and business leaders continue to manage the internal and external focus, respectively.

The management is focused on finance as it aims to maximize the profit & loss statement.

The platform leader focuses on absorbing the idiosyncratic capabilities and repurposing the surplus cash to establish a business platform that will fund new waves of transient advantage.

The business leader is a defender who adjusts the business story to reflect the mature nature of the business. They shift focus from finding new markets to defending existing market share, which is necessary to ensure further profits are extracted from the business and transferred to the platform.

The organization shifts its focus from sustaining development to efficiency optimizations where the same is done with increasingly fewer resources. The organization reduces headcount and outsources capabilities that are not essential to the business’s survival. The RD developer is replaced with an RD optimizer focusing on reducing product costs.

An essential part of reconfiguration is to ensure that, while resource allocation is dynamic, the organizational platform structure and support provide a stable environment for people to thrive. If people fear that reconfiguration equates to job insecurity, there may be significant organizational resistance to free up resources.

At this point in the business cycle, revenues are stable but not growing beyond the market average. Due to increased competition, profitability is under pressure. It requires the organization to become more efficient to ensure positive operational cashflows. At the same time, (re)investment needs are low, so there’s surplus cash that should, in its entirety, either be returned to the shareholder or reinvested via the business platform. There is no need to risk equity to finance the continued operation of the business, so debt financing is preferred.

Phase 6 – Disengagement from Efficient Declining Assets

The sixth and final phase of the transient advantage wave focuses on healthy disengagement from the business by either liquidating or absorbing the assets into the platform.

In this phase, the business has run its course and is no longer of value to the shareholders or the business platform. Healthy disengagement is as vital as continuous innovation.

The management is focused on finance as it aims to maximize the balance sheet statement.

The platform leader focuses on absorbing the remaining valuable assets and capabilities and repurposing the surplus cash to fund new waves of transient advantage.

The business leader is a liquidator who dismantles the business and sells the assets of no further use to the business platform. They can maximize the cash received for the sold-off assets by ensuring timely disposal. They can avoid bad press and, if possible, reduce the business operations so that the platform is well-compensated to maintain legacy support.

The organization is dismantled with only critical roles remaining if there’s a need to maintain legacy support. People transfer within the business platform into new positions. In the end, the business is discontinued entirely.

At this point in the business cycle, revenue continues to decline until the business is discontinued. Due to the reducing revenues and increased competition, profitability declines faster than revenue. Thus, there is a declining operating cash flow. There are no reinvestment needs, and as assets are converted into cash, there’s a negative reinvestment rate. The surplus cash is either transferred to the business platform or returned to the shareholder. Any outstanding debt is retired in an orderly manner.

Table1: Six Phases of Transient Competitive Advantage

 Phase 1Phase 2Phase 3Phase 4Phase 5Phase 6
McGrath's “Transient Wave”LaunchRamp UpExploitExploitReconfigureDisengage
Damodaran's “Corporate Lifecycle”StartupYoung GrowthHigh GrowthMature GrowthMature StableDecline
Christensen's “Innovation Cycle”DisruptiveDisruptiveSustainingSustainingEfficiencyEfficiency
Ulrich's “MOE Organization”TeamTeamTeamPlatformPlatformAssets
Business LeaderVisionaryPragmatistBuilderOpportunistDefenderLiquidator
Business CapabilitiesEntrepreneur
RD Innovator
+ Marketing
+ Sales
+ Supply chain
- Entrepreneur
- RD innovator
+ business manager
+ RD developer
+ Op manager
+ Finance manager
+ M&A - RD developer
+ RD optimizer
- Marketing
- Sales
- Supply chain
- RD Optimizer
Business PriorityBusiness ideaCreate revenue streamAchieve profitabilityMaximize profitabilityDefend market positionScale down business
Management FocusVision: Understand the job to be done
Vision: Find the right customers
Operation: Build the business operations
Operation: Maximize the market opportunityFinance: Manage the P&LFinance: Manage the balance sheet
Product focusDevelop productScale productExpand portfolioMaintain portfolioReduce portfolioLiquidate assets
KPI PriorityProductProductCustomerCustomerPlatform Platform
Revenue growthNoneExponential from a low baseHighAbove market but slowingStagnating to market averageDeclining
Operating cash flowNegative BreakevenLow but growingHigh and still growingHigh but stagnatingDeclining
Reinvestment needsHighHighHighAverageLowNegative
ProfitabilityNegativeBreakevenGrowingHigh and growingHigh Declining
DividendNoneNoneNoneSmallHighShrinking
FinancingEquityEquityEquity and low debtEquity but mostly debtDebtRetiring debt

Xi Jinping’s 10 Concentric Circles of Core Strategic Interest

globe in close up

In this blog post, you can find a summary (with additional notes) of Xi Jinping’s 10 Concentric Circles of Core Strategic Interest as outlined by the Honorable Kevin Rudd in his book The Avoidable War which is likely the most important book I’ll read this year.

It takes courage to not only provide, in great detail and in a respectful manner, careful context to the current mindset of Chinese political leadership but to do so with neither the cynical view of the inevitability of Thucydides’ Trap nor the naive view that things will simply find a way to work themselves out for the best.

I’m not in the position to argue the merits of the proposed Managed Strategic Competition framework, but I certainly subscribe to its aspirations and long-term goals. The book’s an excellent read for anyone who thinks understanding China’s goals is relevant to their business today and in the future.

I don’t claim any ideas or insights provided in this blog as my own. I’m merely providing the summary and notes for those looking for a primer. If you want more context on this topic, please go buy the book.

#1 – Centrality of Xi Jinping & CCP

The underlying axiom of Xi Jinping’s leadership is as follows: to ensure a prosperous future for the Chinese people, the Chinese Communist Party (CCP) must remain in power indefinitely, and Xi Jinping is the only person capable of leading the CCP.

The axiom predicates on Marxist-Leninist ideology that proposes the establishment of a socialist dictatorship by the people as a prelude to achieving communism, as opposed to the (capitalist) dictatorship of the elite.

To understand the CCP and Xi, you must accept they are True Believers of the ideology, just like the Soviet leadership was under Stalin.

Sidenote on Stalin, to quote biographer Stephen Kotkin: “But from the secret archives, what we’ve learned is that behind closed doors when these guys didn’t expect anyone to overhear, they talked like Communists: of class warfare, kulaks, global imperialism, finance capital. It was not just about personal power, careerism, and control. They were, to a great degree, true believers. There was a deep intellectual and emotional commitment to Marxism. This applies in spades to Stalin.” https://www.pushkinhouse.org/blog/interview-with-stephen-kotkin

Once you accept that the ideology is fundamental to Xi and the CCP’s worldview, you can frame the CCP’s existential struggle to remain in power. From this perspective, it’s only natural to understand that the party is haunted by the 1991 fall of the Soviet Communist Party. China is now one of only four remaining communist countries next to Cuba, Laos, and Vietnam. And, by far, the most significant power.

The obsession with the fall of the Soviet Communist Party and viewing it as a great tragedy also aligns with Xi’s friend Vladimir Putin’s perspective on the matter. It seems like something Xi and Putin can intellectually and perhaps emotionally bond over.

It also deserves to be mentioned that the CCP has deeply studied what caused the fall of the Soviet Communist Party. Long story short, the fall is attributed to weak men unable to stop the forces that brought down the party. The CCP has vowed this will not happen to China, which naturally requires strong men to lead the country.

That isn’t to say there have never been discussions inside China about whether it should transform into a multi-plural social democracy. Discussion took place since Deng Xiaoping was in power. However, after decade-long consideration, in 2001, the CCP concluded that there should be only 1 party and that a single-party system was fundamental to the long-term survival of China. Note that the CCP came to this conclusion long before Xi Jinping rose to power.

Under Xi, however, there’s been a transition to a more forceful ideological nationalism. The Chinese system used to be described softly as “Socialism with Chinese Characteristics.” However, Xi frames the system as part of “China’s historical greatness, across its dynastic history, always lay in strong, authoritarian, hierarchical Confucian governments.”

On a personal level, Xi Jinping aspires to secure his leadership position and legacy to the level of at least Mao Tse-tung but definitely surpassing Deng Xiaoping.

This is already the case with Xi Jinping’s speeches and writings, formerly adopted by the CCP as Xi Jinping Thought, similar to Mao Tse-tung Thought and exceeding Deng Xiaoping Theory.

The CCP identifies Five Poisons as the five main perceived threats to the stability of CCP rule as follows:

  • Uyghur supporters of the East Turkestan independence movement
  • Tibetan supporters of the Tibetan independence movement
  • Adherents of the Falun Gong
  • Members of the Chinese democracy movement (including Hong Kong)
  • Advocates for the Taiwan independence movement

They are a thread because (1) they provide an alternative vision of China, and (2) they operate inside and outside China.

A short word on the United States: Xi and the CCP see the United States as the only force capable of stopping China’s inevitable rise to global superpower. This preoccupation with the United States as the primary blocking object standing between China today and China’s future permeates throughout Xi’s strategic and tactical analysis ranging from reunification with Taiwan to transforming into a self-sufficient domestic economy.

The distrust of the United States is rooted in the complex history of post-Qing China and the CCP’s rise to power. Below is a timeline with the most relevant events:

  • 1882: US Chinese Exclusion Act prohibits all immigration of Chinese laborers for 10 years. It was the only law ever implemented to prevent all members of a specific ethnic or national group from immigrating to the United States.
  • 1911: Xinhai Revolution against the Qing emperor under the lead of Sun Yat-sen, then studying and raising funds in the United States
  • 1912: the founding of the Republic of China by Sun Yat-sen’s KMT
  • 1917: United States enters World War I and calls upon China to join and send troops to the front. China agreed with the understanding that the German territories in the Chinese province of Shandong would be returned to China after the war was won
  • 1921: the founding of the Communist Party of China (CCP)
  • 1921: “big three” reject all of China’s demands at Versailles to appease Japan, leaving China disillusioned to the core
  • 1922: The United States fails to support Sun Yat-sen’s newly formed government, even though it is modeled after American democracy, against the local warlords. This forces Sun Yat-sen to call upon Moscow for strategic support.
  • 1923: Soviets help establish friendly relations between KMT and CCP to defeat the warlords and unify China
  • 1925: Sun Yat-sen, the founder of the Republic of China, dies and is succeeded by Chiang Kai-shek
  • 1928: the reunification of China following the defeat of the last of the warlords during the Northern Expedition
  • 1929: KMT and CCP are preparing for civil war; with KMT looking to the United States and CCP looking to the Soviet Union as respective allies
  • 1931-1937: United States assistance fell short of KMT military and financial needs against the Japanese invasion and communist insurgency. In the end, the United States withdrew support for KMT, fearing direct conflict with Japan. This resulted in enormous losses of Chinese lives fighting against the Japanese.
  • 1946: US fails to clarify to what extent it would help the KMT against the CCP in the civil war. It stops military and financial support for the KMT and misguidedly aims to reconcile nationalists and communists. Meanwhile, the Soviet Union continues its military support for CCP.
  • 1946: US fails to sufficient distance itself from the KMT to make CCP (Mao) believe it is a reliable ally; therefore, Mao concludes the Soviet Union is the only reliable ally
  • 1949: Founding of the People’s Republic of China (mainland) and retreat of the KMT and its Republic of China to Taiwan
  • 1949-1960: further deterioration of China-US relationship
  • 1971: Nixon and Kissinger’s “Opening to China” + Zhou Enlai’s “Ping-pong diplomacy” was positively received by Mao Tse-tung. Positive reception predicates on
    • Deterioration in Sino-Soviet relationships post-Stalin, creating a threat on China’s northern border
    • Economic implosions of the Great Leap Forward and Cultural Revolution
    • DOES NOT predicate on CCP’s reappraisal of western values or ideals, but pure pragmatic survival
  • 1972: Shanghai Communique representing the United States’ first diplomatic negotiations with PRC since its 1949 founding
  • 1979: formal diplomatic normalization
  • 1979: US Taiwan Relations Act
  • 1989: US sanctions following Tiananmen Square are only temporary
  • 1989: Final agreement on the Sino-Soviet border after 300 years of dispute revitalizes the Sino-Soviet relationship
  • 1991: Fall of the Soviet Union; CCP politically and ideologically horrified about the implosion of Soviet communism, however, sees upside that this eliminates Soviet long-term threat to national security. This eliminates a key strategic rationale for the Sino-US relationship since 1970.
  • 1996: China launches missiles into waters around Taiwan to discourage democratic elections prompting the US to respond by showing political and military support
  • 1997: Asian Financial Crisis prompts Chinese thinking to reappraise the benefits of the laissez-faire, free-market, anti-state approach by the IMF
  • 1998: Chiang Mai Initiative was proposed by China as an alternative to the American-led IMF when stabilizing measures are needed
  • 1999: US-guided missiles strike the Chinese embassy in Belgrade during Balkan War. The US claims accident: China claims deliberate attack
  • 2001: China admission to the World Trade Organization, opening up global markets
  • 2001-20xx: US “war on terror” post-9/11 helps China to position itself on the international platform as a reasonable counterweight against Western aggression
  • 2008: Financial crisis originating in the United States is to China:
    • (1) proof of the weakness of the capitalist system
    • (2) proof that the weak American system can cause damage around the world
    • (3) opportunity to position itself as the engine of global economic recovery

#2 – Maintaining and Securing National Unity

Suppose we accept the CCP’s core belief that they must remain in power to ensure the long-term survival of China. In that case, it is logical to accept that anything that would challenge this power represents an existential threat to the CCP and the Chinese people.

Taiwan

This alternative is no better exemplified by Taiwan because it represents a parallel, successful, functioning, democratic version of the Chinese society built by the CCP post-civil war. Furthermore, Taiwan has also proven it is possible to transition from a single-party authoritarian state to a multi-party democratic state with minimal bloodshed. Therefore, Taiwan is not only an alternative vision of China but also a blueprint for democratic transition.

China’s approach to Taiwan has been under the motto “One Country, Two Systems,” which is also used for Hong Kong and Macau. The underlying idea is that the countries would naturally transform into a single system through economic entanglement over time.

However, this is a historic miscalculation that not only China but also the West made. The West expected that the economic integration of China with the world economy would lead to a natural transformation into a modern liberal Western democracy. Similarly, China hoped that the economic integration with Taiwan would lead to a natural transformation into a One China.

The expectation that economic integration leads to political assimilation is also present in today’s Europe Union, which is under constant stress (as evident during the 2014 Financial Crisis).

Of course, neither happened.

If anything, the economic fruits borne from the increased economic interaction are always seen as evidence that the system in place is, in fact, successful. So, China believes it has proof that the Chinese system works, and Taiwan believes it has proof the Taiwanese system works.

In addition to the false idea that economic integration automatically leads to cultural and political assimilation, there’s also the aspect of national identity developing over time. Taiwanese people born and raised in the 1950s and 1960s may still feel strongly connected to the Chinese identity through family ties. However, this is much less so for Taiwanese born in the 1980s and 1990s, as they have much less personal experience with the mainland Chinese identity.

In other words, the feeling of national unity isn’t present because there’s no shared national identity. Hong Kongers feel Hong Kongese, and Taiwanese feel Taiwanese.

This directly threatens the CCP’s need to maintain and secure national unity and resulted in the 2019 actions in Hong Kong. The protests and China’s response popped the bubble of any Taiwanese believing in the “One Country, Two Systems” mantra.

From China’s perspective, that leaves only a few options available to force the reunification with Taiwan: political isolation, economic debilitation, or military coercion.

Political isolation is an ongoing process with China systematically peeling away Taiwan’s international partners with the promise of economic benefits.

Economical debilitation is an ongoing process, both direct and indirect. A direct approach is exemplified by China’s ban on its citizens traveling to Taiwan as individual tourists in 2019. Indirectly, China can use its position within international institutions to prevent or slow Taiwan’s international trade growth.

Military coercion is not currently on the table but is inscribed in China’s anti-secession law as a means of last resort in case all possibilities for a peaceful reunification are completely exhausted. https://www.mfa.gov.cn/ce/ceus/eng/zt/999999999/t187406.htm

Tibet, Xinjiang, Inner Mongolia, Hong Kong, & Macau

Taiwan’s situation is unique, to say the least. In addition to the specific historical setting, it’s the only region separate from the mainland by sea. That distinguishes it from the situations in Tibet, Xinjiang, Inner Mongolia, Hong Kong, & Macau, which are connected to the mainland.

Xi and the CCP have identified three evil forces threatening national unity: splitism, extremism, and terrorism. It utilizes these three forces to justify its actions in any of these regions.

The observation that a slow, gradualist approach to reunify Taiwan and Mainland China has failed, combined with the emergence of a solid national identity in Hong Kong and Taiwan, has made China take more active steps in ensuring national unity.

In 2019, when Hong Kong protestors took to the streets against a draft extradition law, the Hong Kong government, backed by China, forcibly struck down the protests. It eventually enacted the Hong Kong National Security Law. This effectively ended the “50 years period of one country, two systems” principle, which China had agreed to as the condition for the peaceful handover of Hong Kong from the United Kingdom.

Similarly, in Tibet, Xinjiang, and Inner Mongolia, the Chinese government has acted with increased aggression to impose a unified Chinese national identity and culture upon the local population. The CCP considers the regions potential sources of “three evil forces” threatening national unity: splitism, extremism, and terrorism. It utilizes these three forces to justify its actions in any of these regions.

Xi is indifferent to the solid and sustained international reaction against Chinese actions in or against Taiwan, Hong Kong, Tiber, Inner Mongolia, and Xinjiang. He believes that the national security imperative of “complete security” is more important than any foreign policy or reputational cost to the regime.

Furthermore, Xi is encouraged by the fact that the rest of the world is, to various extent, dependent on the Chinese economy. Thus, he believes international political reactions are primarily symbolic, largely superficial, and entirely temporary. This understanding is supported by the fleeting nature of the political and economic sanctions following the 1989 Tiananmen. It was re-reconfirmed by the reaction to the 2019 Hong Kong crackdown.

#3 – Growing the Chinese Economy

Xi’s understanding of modern economic theory is allegedly relatively limited. While he is primarily driven by Marxist-Leninist ideology, Xi understands that ensuring economic prosperity is fundamental to political legitimacy and national unity.

The relationship between an authoritarian regime and its people is often described as an unspoken, unwritten social contract. In this social contract, the people accept giving up their freedoms in favor of economic growth and higher living standards. However, as Stephen Kotkin points out about Putin’s Russia, “There is no contract. The regime doesn’t provide the economic growth, and it doesn’t say, Oh, you know, we’re in violation of our promise. We promised economic growth in exchange for freedom, so we’re going to resign now because we didn’t fulfill the contract.” https://www.newyorker.com/news/q-and-a/stephen-kotkin-putin-russia-ukraine-stalin

It’s crucial to frame the economic discussion within the context of Xi’s first core strategic interest of staying in power. Therefore, economic prosperity is merely a practical tool to secure national unity; unity is a prerequisite for ensuring CCP remains in power. While Xi recognizes economic prosperity is a powerful and primarily peaceful tool, economic prosperity is not the only tool available to safeguard national unity.

Furthermore, Xi also believes for China to defend itself, it must build power that isn’t reliant on external partners, systems, manufacturing, or technology.

Xi has identified Five Major Challenges when it comes to the economy:

  1. How to maintain economic growth to provide employment and support rising living standards while …
  2. … maintaining the optimal balance between state and market without ceding party political control to entrepreneurs
  3. How to better distribute the benefits of economic growth, so economic inequality is reduced
  4. How to impose carbon constraints to deal with environmental challenges without harming economic growth
  5. How to manage the external economic pressures from the United States on trade, investment, and technology

Under Xi Jinping, China’s political economy has undergone four transitions. I will briefly cover the first three and provide more detail with the fourth.

Pre-Xi: “Reform and Opening-Up”

The Pre-Xi economic strategy was designed under Deng Xiaoping and focused on rapid GDP growth to join the developed world as quickly as possible. The model turned China into the world’s manufacturing powerhouse as it focused on labor-intensive, low-wage manufacturing for export. It was characterized by high levels of state investment and a significant role for state-owned enterprises (SOEs). Any environmental impact resulting from the rapid economic growth was largely ignored.

2013-2015: “Adopting The Decision.”

Following the appointment of Xi Jinping as the General Secretary of the Chinese Communist Party in 2012, the first phase of Xi’s economic transition began with the adoption of “The Decision.” The Decision was a set of sixty decisions related to specific economic reform.

A key decision was to let the market forces play a decisive role in the economy. This follows the economic success resulting from engaging with an open, international free market during the previous three decades,. Furthermore, the party would encourage rapid expansion of private enterprise in the services, financial, and technology sectors as the new engine of economic growth. Of course, SOEs still played a significant role in ensuring Party control over the economy. Lastly, the party would uphold new principles of environmental sustainability.

2015-2016: “Deleveraging.”

The Great Deleveraging was sparked by the 2015 Chinese Financial Crisis, caused by the proliferation of private margin-lending to invest in speculative assets. Xi interpreted the cause and effect of the crisis as ideological confirmation that reckless expansion of capital is harmful to society as a whole.

Among the many measures taken to stabilize the equity markets include a general halting of 2013 market reforms favoring a more market-oriented economy and imposing tighter capital controls.

2019-2020: “Return to 2013.”

Halfway through 2018, it was clear that economic growth was slowing significantly. The reason was two-fold.

First, the actions taken during and after the 2015 Chinese Financial Crisis made it more difficult for the private sector to acquire the capital and business confidence needed to expand domestically and globally. By 2018, the private sector was responsible for 90% of job growth, 80% of urban development, 70% of technological innovation, and 50% of the country’s taxation. The US-China Trade War and tariffs also played a role.

Xi offered a multilayered response to the 2018 economic growth challenges.

  1. First, the new “Institutional Economic Reform” represents a partial return to the 2013 blueprint.
  2. Second, reiterating the centrality and importance of private enterprise as China’s principal economic growth engine
  3. Third, the internationalization of specific industries allows for foreign competition to enter the market with the goal of improving the domestic effectiveness of the credit-allocation system for private enterprise
  4. Fourth, internationalization of trade, investment, and IP standards to resolve the ongoing US-China trade war
  5. Fifth, Financial stimulus to artificially prop up the economic growth

2020-now: “New Development Concept.”

The 2018 US-China Trade War profoundly affected Xi. It confirmed his personal bias and fear that external US power could undermine China’s growth strategy. This experience has sharpened Xi’s pre-existing economic worldview in a more ideological, conservative, and nationalist direction.

The New Development Concept is Xi’s economic strategy with which he aims to guide China through an increasingly dangerous world. It is meant to “ensure our survival” through “foreseeable and unforeseeable storms.” Xi understands that national power relies on economic as well as military power.

The ideological root of this economic strategy goes back to 2017 when Xi announced the Principal Contradiction facing the Communist Party had changed. “Principal Contradiction” is a key theoretical term in old-school Marxist dialectical materialism. Xi’s use of it illustrates once more that he’s a True Believer in communism.

Since 1981, the principal contradiction the party had identified and worked to resolve was “the ever-growing material and cultural needs of the people versus backward social production.” It was resolved with the central task to generate rapid GDP growth by reform and opening up.

In 2017, Xi identified the new principal contradiction: “the ever-growing people’s need for a better life versus unbalanced and inadequate development.” It is to be solved with a more balanced, better-quality development across regions and sectors.

The New Development Concept is rooted in Xi’s fondness for the real economy of physical goods and assets over Xi’s disgust for the fictitious economy of speculation and financialization. This is another ideological Marxist perspective that considers that the fictitious economy produces noting of material value while extracting wealth from the middle-to-low-income class.

The new economic strategy also serves Xi’s core priorities of protecting China and the CCP against external or internal opposing forces. The New Development Concept rests on three main pillars forces that can be summarized as follows:

  • Common prosperity: prioritize security, political stability, and economic equality over rapid individual wealth accumulation
  • Dual circulation: prioritize societal cohesion over economic efficiency
  • Self-sufficiency: prioritize national self-sufficiency over the benefits of open international exchange

Prioritize national security, political stability, and economic equality over rapid individual wealth accumulation.

This opposes directly Deng Xiaoping’s economic strategy of rapid GDP growth, which allowed “some people and some regions to become prosperous first, for the purpose of achieving common prosperity faster.” Deng’s strategy is best captured with his slogan, “to get rich is glorious.”

Xi Jinping realizes that private wealth accumulation may lead to alternative sources of power than the party. Preventing wealthy individuals from becoming too powerful suppresses rising internal, opposing forces from materializing. This is best illustrated with the broad crackdown on technology firms exemplified by the public humiliation of Jack Ma..

Xi no longer cares what the billionaire class thinks is the best direction for China. He no longer cares if they lose money as he pursues his core national strategic priorities.

Prioritize social cohesion over economic efficiency

This force aligns with the priority of the second core strategic interest of national unity over the third core strategic interest of growing the economy.

Xi Jinping realizes it’s not safe to rely solely on the expectation of continuous economic growth as glue to hold the nation together. Likely, the experiences of the 2015 Chinese Financial Crisis, the 2018 Trade War, the 2018 Economic Growth Slump, the paradox of a communist society with great income inequality, and the increasing dissatisfaction of the Chinese youth with the economic injustices have led Xi to conclude that a more robust, unified social cohesion is required to hold the nation together in case the economic growth falters (as this would be a sign of the CCP breaking the unwritten, unspoken social contract).

The refocus on social cohesion and shared culture falls under “Common Prosperity.” It has materialized in different ways, from the crackdown on video games and entertainment celebrity worship to the plans for cultivating masculinity in schoolboys. Furthermore, there’s an ongoing discouragement on exposing Chinese youth to international culture, including banning foreign teaching materials. Xi Jinping wants the Chinese youth to show nationalistic virility and become patriotic, productive citizens. He utilizes a mix of paternalistic, Confucian, and Leninist morality.

The Common Prosperity goal is positioned as completing Deng Xiaoping’s economic strategy of “first some get rich as a shortcut to achieving common prosperity.” Xi, therefore, places himself above Deng Xiaoping, as he aims to achieve what Deng couldn’t.

While Xi no longer cares about the billionaires, he does understand that private enterprise is not only a key driver for the economic growth engine but also an important source of wealth distribution

  • Primary: market wages
  • Secondary: state spending
  • Tertiary: (forced) philanthropy

Prioritize national self-sufficiency over the benefits of open international exchange

The desire to ensure national self-sufficiency mirrors Mao Tse-tung’s obsession to eliminate all vulnerabilities to any pressure from the outside world. The desire to achieve self-sufficiency goes hand in hand with the vision of a dual-circulation economy.

The dual-circulation strategy is a conscious reversal of Deng Xiaoping’s “great international circulation.” It aims to increase economic growth mainly by (1) meeting consumption demand from the growing domestic middle-class (internal circulation) and (2) transitioning the global economic engagement from labor-intensive, low-wage manufacturing for export to high-value imports and exports (external circulation).

The desire for self-sufficiency and the transition away from low-wage manufacturing is best exemplified by the Made in China 2025 national strategic plan.

Where China cannot be self-sufficient in the short term, Xi aims to diversify its economic engagements to minimize the power of a single trade partner. That primarily means economic decoupling from the United States. The economic decoupling debate centers around five main topics: trade, investment, technology, capital, and currency.

Trade

  • China aims to be less reliant on export for GDP growth and shift focus to domestic consumption
  • China aims to reduce the relative importance of the US for export while staying the most important import partner for the US. It will diversify its export to European Union, Japan, Korea, Indonesia, Southeast Asia, and Belt-and-Road Initiative countries.
  • China has signed Regional Comprehensive Economic Partnership (RCEP) and is an applicant to the Comprehensive Progressive Trans-Pacific Partnership (CPTPP)

Foreign Direct Investment

  • China aims to further reduce reliance on US FDI, even though FDI as a whole is still relatively small in China. For example, by increasing FDI with European Union through the China-Europe Comprehensive Agreement on Investment (CECAI)
  • China accepts (temporary) market reforms and the entrance of international competition in specific industries where it sees a need

Technology

  • China missed out on the first three industrial revolutions (fossil fuel, electricity, digital) and aims to be the first mover of the fourth revolution (artificial intelligence)
  • Made in China 2025 + New Generation Artificial Intelligence Development Plan
  • Key battlegrounds: data for algorithm development, advanced semiconductor manufacturing, and commercial application

Capital Markets

  • US and China capital markets are too intertwined to suggest east decoupling
  • China is still eager to have access to the large US capital market, whereas the US is taken active steps to prevent China from access

Currency

  • Maintain the managed float of the Renminbi as a tool to help achieve economic goals
  • Limited role of the Renminbi as global currency due to refusal to open the country’s capital account and free float. While the RMB is part of the IMF SDR basket, only 2% of global reserves are currently held in RMB
  • China aims to have a first-mover advantage in the digital space with the international digital RMB, becoming the preferred reserve currency in the developing world (as opposed to the US Dollar). The ultimate goal is that the international RMB is the basis of geo-financial and geopolitical power to protect China from external pressures

#4 – Environmental Sustainability

Everyone’s aware of the high environmental cost of China’s rapid economic growth in the past third-five years. So are the Chinese. Over the past decade, there’s been an increasing demand from the Chinese to have a clean environment as part of the unwritten, unspoken social contract between the Chinese Communist Party and the Chinese people.

Three overarching core strategic interests of the CCP drive the necessity to focus more intensely on environmental issues.

  1. The ability to which the party can provide a clean and sustainable environment for the people adds or subtracts to the political legitimacy of the ideology
  2. A rising global focus on climate change can put China in a vulnerable position; thus, it’s in the party’s interest to safeguard the country from any political or economic impact of climate change
  3. The party can legitimately position China as a global citizen or even global leader if its success with its Green Belt-and-Road Initiative after the abandonment of coal diplomacy in 2021

The party realizes environmental devastation threatens the future of China’s economic development and, ultimately, national security.

Furthermore, the party realizes that the absence of the United States at the forefront of the climate change debate provides two opportunities. One, it puts China in a favorable negotiation position vis-à-vis the United States. Two, it helps demonstrate China’s capability for global leadership.

#5 – Modernizing the Military

Military power is fundamental to ensuring domestic security and projecting global power. Under Xi, China aims to become a “peer competitor of the United States in all areas. This shall guarantee that:

  1. The perceived historical failure of the Red Army to step in against the anti-communist revolution in the Soviet Union will not be repeated in China
  2. China cannot be forced by the United States in any arena or dispute
  3. China can use its ability to provide security through its military power as leverage with third-party nations, similar to the United States

Under Xi, the military has undergone a distinct modernization. China now sees informationized warfare as the fundamental condition for the successful prosecution of modern warfare.

Under Xi, the original time plan for achieving a “world-class” military has been brought forward from the original 2035 target to 2027. Bringing forward the date may hint toward an early military attack on Taiwan or may just be a way for Xi to encourage military leaders to show more decisive leadership.

The term “world-class” is defined explicitly in Chinese strategic literature as one that can compete effectively with any world-class adversary overall, possessing a strength and deterrent capacity to match them. It implies the military should have transregional and transcontinental force delivery capabilities.

A critical part of addressing the challenge of informationized warfare is the establishment of the PLA Strategic Support Force (PLASSF). The PLASSF is a regional command structure for strategic support which integrates all of China’s space, cyber, reconnaissance, and electric warfare capabilities.

Under Xi, the ground force (PLA) has been reduced in size and budget. It has three priorities: supporting an amphibious assault on Taiwan, dealing with threats in China’s western theatre (i.e., India), and dealing with domestic and foreign terrorist threats.

Contrary to the ground forces, the PLA Navy (PLAN) has significantly increased in size and budget. That’s only logical considering China sees the next major threat coming from the sea rather than land. This includes conflicts in the East China Sea, South China Sea, Taiwan, and access to the Pacific.

The PLA Air Force (PLAAF) has also increased in size and number, primarily to support its naval activities.

Xi also created a new PLA Rocket Force (PLARF), which integrates China’s nuclear and rocket capabilities. Its goal is to become the fourth force on equal footing with the ground, air, and naval forces.

Under Xi, China’s nuclear policy has shifted from “minimum deterrence” (to avoid Soviet blackmail) to rapid expansion (in case of scalation with the US). Its operational policy has also shifted from “no first use,” meaning to launch a nuclear weapon after surviving a nuclear attack, to “launch on warning,” meaning to launch a nuclear weapon as soon as a likely nuclear attack is detected.

Additionally, China does not clearly understand the United States’ redlines concerning nuclear warfare. Also, considering its limited nuclear arsenal, China is uninterested in discussing arms control with the US and Russia.

China’s defense operations are centered in the Central Cyberspace Administration Commission (CCAC). Its forces are split across three main agencies: PLA, Ministry of State Security (MSS), and Ministry of Public Security (MPS). The PLA focuses on military network warfare. The MSS focuses on gathering any type of military or civilian information. The MPS focuses exclusively on domestic affairs.

China’s military space program falls under the direct control of the Central Military Commission (CMC), and its operations are directed by the PLASSF.

The current evaluation of the overall US-China military balance is that China is closing the capabilities gap faster than anticipated. China is stronger closer to its shores, and strength declines as proximity to the mainland increases. However, this may change in the near future.

In simulated war games, the US is losing a battle over Taiwan in multiple scenarios. That gives China increased confidence should it see military intervention as necessary. The balance is unclear in the East China Sea against Japan and the US. Therefore, China will likely pursue a less aggressive road in the short term. In the South China Sea, where the US has no treaty obligations other than the Philippines, the balance clearly favors China, hence its continued aggression.

China also has the advantage that its form of central, authoritarian government can marshal the complete economic resources more easily.

China’s primary challenge to continued military modernization is budgetary. The military budget is already 10% of the overall budget. Thus further increasing is difficult. Furthermore, China’s budget is heavily reliant on proceeds from a continued fast-growing economy which is under pressure after a shift away from private enterprise.

Additionally, China may have awakened the American bear from long strategic hibernation with its recent actions.

Lastly, due to the limited recent real-world battle experience, it remains unclear whether the Chinese military is capable of fighting and winning wars.

#6 – Managing Neighboring States

China’s core strategic interest today is to reduce and eventually eliminate any significant threats along its border. Its strategic approach has been influenced by a careful study of the history of America’s Monroe Doctrine and its “spheres of influence” concept. Since the late 1980s, China has looked to modernize its policies toward its neighbors, prioritizing economic growth and culminating in the 2003 Good Neighbor Policy.

The Great Wall of China represents a historical recognition that defense along the border is fundamental for national security. However, while the Great Wall protected China from land invasions, it did not prevent the series of sea invasions from bringing the century of humiliation. This historical awareness is reflected in China’s military transformation under Xi.

China also has the modern understanding that national security is not just a matter of military preparedness but also requires political and economic diplomacy. China aims to develop and maintain positive and accommodating relationships where possible and compliant relationships if necessary.

A brief overview of China’s current relationship with its neighbors:

Russia is a “useful strategic asset” as China sees itself as the superior force but presents itself and treats Russia as its equal. The main driving force of the relationship is the personal relationship between Xi and Putin. Being on good terms with Russia is essential for China as it provides security on its Northern border, allowing it to focus on its Western and Southern borders.

India is a “problematic neighbor” as the border disputes remain a fundamental source of ongoing struggles. While bilateral relations improved during the Trump administration as countries were looking to hedge against the demise of the US, recently, US-India relations have improved again. While initially hesitant, now with more conviction, India is also a member of the Quad. The Quad is a strategic security dialogue between Australia, India, Japan, and the United States to counterbalance Chinese security domination in the Indo-Pacific region.

Japan is a “problematic strategic neighbor” as it’s a US-allied force in the East China Sea and is increasingly strongly aligned with democratic Taiwan. There is also an ever-present historical backdrop of the Japanese atrocities in China during the Second World War. During the Trump era, Japan sought to normalize relations, notably regarding managing the North Korea threat, but China misplayed its hand. Now relations are again deteriorating due to China’s diplomatic errors.

North Korea is an “all-weather ally” because it is a neighbor that will always be there. China has supported North Korea despite Xi and Kim’s difficult relationship. The Trump admin’s actions toward North Korea gave China a surprising opportunity to position itself on the international stage as a global leader.

South Korea is a “historic good neighbor” because of its shared cultural heritage and similarities. China believes this shared heritage will, over time, bring South Korea back within its direct sphere of influence. There’s a generational change in South Korea that feels less emotionally connected with the West post-Korean civil war. The pull of China’s economy, the growing anti-Japanese sentiment, and the recognition that China does not support armed reunification of the Korean peninsula have pushed South Korea in the direction of China.

Laos is a “Chinese satrapy.”

Cambodia is a “Chinese satrapy.”

Thailand is a “soon-to-be-former US ally” as its relationship with the United States has deteriorated after the 2014 US sanctions following the military takeover of Bangkok.

Myanmar is a “continued good neighbor” as China practices a pragmatic diplomatic approach with the changing government. The 2021 military coup was an annoying setback to the relationship after China had invested significantly in building the relationship with Aung San Suu Kyi.

Vietnam is an “open play neighbor” as it’s hedging its geostrategic bets against either China or US security risks. The relationship between Vietnam and China will always be against the historical backdrop of the border war of 1979.

Malaysia is a “good neighbor” with which China has normalized relations after a series of controversial Belt-and-Road Initiative projects

Singapore is an “open play neighbor” as it is a military partner of the United States. But after a formal reset of diplomatic relations in 2018, it is more sensitive to Chinese interests.

The Philippines is an “open play neighbor” despite being a formal US treaty ally. The Philippines is constantly re-aligning and re-positioning itself towards China and the United States to both benefits economically from China and maintain its historic security ties with the United States.

Indonesia is a “crucial neighbor” as it’s the main strategic battleground between the United States, China, Japan, and Australia for strategic influence and access to the South China Sea. The Indonesian government prioritizes economic development for its large, growing, tech-savvy population over military security support, which plays in the hands of China. China sees a great opportunity in closer collaboration with Indonesia and even offered it a seat in the BRICS grouping.

Xi identifies three mega-trends that are moving Southeast Asia steadily in the direction of China:

  1. The size and proximity of China’s economic footprint in the region provide an excellent incentive for SEA countries to, at the very least, maintain positive diplomatic relations with China.
  2. China’s strategic shift in the South China Sea from aggressively pursuing its sovereignty claims to prioritizing diplomacy based on joint economic development has alleviated some sources of hostility from SEA countries.
  3. Post-Obama, the United States has been largely missing militarily, politically, and economically from the region. Especially after it abandoned the Trans-Pacific Partnership (TPP) free trade agreement.

#7 – Securing China’s Maritime Periphery in East Asia & West Pacific

Whereas China considers the continental periphery “problematic,” it sees the maritime periphery as outright “hostile.” This view is, of course, rooted in the experience of the past 180 years where China remained exposed to Western aggression from the United Kingdom and France during the Opium Wars, Japan between 1895 and 1945, and the United States preventing China from taking back Taiwan.

China sees the region as strategically aligned against China; therefore, its primary objective is to fracture US alliances. America, without its alliances, would be considerably weaker. China claims these military alliances are a relic of the Cold War.

A militarily-politically weakened United States would yield sufficient doubt in American commanders about the possibility of winning an outright war against China. In China’s eyes, this doubt would cause the United States to simply not enter a war, even if provoked. Not over Taiwan, not over territorial claims in the East China Sea, not over territorial claims in the South China Sea. This fits nicely into Sun Tzu’s expression, “The supreme art of war is to subdue the enemy without fighting.”

Eventually, China aims to displace the United States as the dominant force in the Asia-Pacific region and push back US forces beyond the second island chain.

China uses two main tools to achieve this objective.

  1. Grow its military force such that, if needed, it can overwhelm the United States and their allies
  2. Leverage the economic appeal of the Chinese domestic market to build diplomatic relationships that undermine American leverage

One response from the West is the Quad. The Quad is a strategic security dialogue between Australia, India, Japan, and the United States that aims to counterbalance Chinese security domination in the Indo-Pacific region.

The Quad’s mantra is “to advance a free and open Indo-Pacific. Its spirit is “to strive for a region that is free, open, inclusive, healthy, anchored by democratic values, and unconstrained by coercion.”

There’s also a Quad+ which includes South Korea.

Despite a rocky start in the mid-2000s, due to changing strategic circumstances in the region, the Quad has revived since 2017. Since 2017, the Quad has evolved from an informal framework of cooperation to discuss regional security to, possibly, a future institutionalized security framework.

China’s response to the Quad has changed several times from initially marginalizing the forum as nothing more than a “headline-grabbing idea” to a “small clique aiming to start a new Cold War” warranting full-scale political attack.

Most recently, China has again pivoted on the Quad topic away from efforts to attack its members (“kill one to warn one hundred”). China now focuses on deepening strategic interactions with ASIAN countries through RCEP and CPTPP trade agreements. Essentially, the strategic aim is for China to “go bigger” than the Quad to preserve its regional influence.

A brief overview of China’s current relationship with its South Pacific neighbors:

Australia is a “pro-American neighbor,” which China sees as a middle-rank trade and investment partner. China is primarily targeting Australia to dislodge the Quad and reduce the US influence. However, it is met with significant pushback. This eventually resulted in a currently very strained relationship.

New Zealand is “America’s soft underbelly” in the Pacific as in the 1980s, it severed its post-war alliance with US and Australia. New Zealand was China’s first free trade partner in the developed world. However, New Zealand has deep historical and cultural ties with Australia. It has somewhat reluctantly joined the cause to oppose China’s punitive actions against Australia. Nevertheless, New Zealand is looking to increase defensive cooperation with China stating China is now firmly part of the international rules-based order.

Pacific Islands are “strategically important partners” for multiple reasons. First, the microstates historically have been politically aligned with Taiwan. Breaking the alliance weakens Taiwan’s international diplomatic status. Second, the microstates control a vast area of mineral and energy reserves that China wants to access. Third, it also has significant-sized fisheries, which China wants to tap into to feed its seafood-hungry population. Fourth, it provides China with a place to develop intelligence, security, and communications facilities to monitor activity in the Pacific.

The Pacific Islands have, historically, always relied on Australia as a proxy of the United States for support. However, Australia’s recent disregard for climate change action has put a strain on the relationship. Climate change is an existential threat for the Pacific Islands as rising sea levels could submerge the nations. China sees excellent alignment with its domestic environmental and climate change challenges and is looking to leverage this political opportunity. Additionally, China always leverages the economic angle as it does in all its diplomatic relations.

#8 – Securing China’s Western Continental Periphery

Beyond Asia, Xi’s priority is to project strategic, diplomatic, and economic power across Eurasia and the Indian Ocean to reach the Middle East, Africa, and Europe. China has used several institutional tools, including the Shanghai Cooperation Organization (SCO), the Conference on Interaction and Confidence-Building Measures in Asia (CICA), and of course, most recently, the Belt-and-Road Initiative (BRI).

The BRI consists of a trans-Eurasian Silk Road Economic Belt and a Maritime Silk Road across the Indian Ocean, through the Red Sea, to the Mediterranean. The BRI aims to accomplish a couple of goals:

  • Enhancing economic exchange with Europe and the Middle East
  • Securing a more benign strategic environment
  • Weening off American strategic influence
  • Stabilizing Islamic central and South Asia
  • Build up new markets to mitigate any potential future economic threats from the United States

The United States has recently pushed the Build Back Better World (B3W) as an alternative to BRI. However, for many countries in the developing world, BRI provides a better option. That’s because B3W typically targets higher standards, greater governance, value-driven, and sustainable projects. On the other hand, BRI has fewer demands on good governance or financial returns and is typically the only infrastructure funding program available.

It’s almost as if China’s employing the theory of disruptive innovation to geopolitics by providing a lower-cost alternative for access to capital.

The other side of this coin is that many BRI projects are not great investments from a financial perspective, causing several major projects to default. This has put the future prospects for BRI under question domestically. It may jeopardize future projects should a slowing domestic economy put further financial constraints on China’s budget. That said, within the Chinese framework, the “current leader cannot be wrong,” meaning moderating investments is the only likely course of action.

While BRI is an important economic framework, it does not represent the majority, let alone the totality of Chinese efforts.

BRI Central Asia

In Central Asia, security is the highest priority for China, given it may be a source of extremist support for the Muslim Uyghur. China’s leading BRI partner is Kazakhstan

Central Asia is an important new market for Chinese construction and infrastructure companies as the domestic demand slows.

China carefully balances the BRI framework against the Russian Eurasian Economic Union (EEU). Fortunately, it has developed a great sense of diplomatic touch and accommodates Russia’s sensibilities in the region. Furthermore, Russia and China have a shared concern over the long-term Islamization of the wider region.

BRI South Asia

Pakistan is China’s all-weather leading BRI partner in South Asia. It has a great interest in preventing the country from becoming a failed state following the economic decline and political instability. Furthermore, it is also concerned about further Islamizing Pakistani politics and preventing it from becoming a breeding ground for radical Islamist groups supporting the Uyghur population.

The China-Pakistan Economic Corridor (CPEC) is the main economic development plan, with the Port of Gwadar as the endpoint. Via CPEC, China aims to assist Pakistan in building energy, road, port, industrial, and telecommunications networks to support the rest of the BRI network. The Port of Gwadar is available to China on a 40-year lease. It will serve dual use of commercial and military purposes.

China’s main concern is that the region is notoriously unstable. So far, the Pakistani government has not been able to sufficiently guarantee the safety of CPEC investments.

Afghanistan is an even more problematic situation for China. After the chaotic US retreat, China is left by itself to help stabilize the country. However, China has a long-standing policy of non-interference. That implies respecting the sovereignty of any government and prioritizing cooperation regardless of ideology or politics. However, it is a national security concern to not have Afghanistan become a home base for Xinjiang separatists.

Therefore, it is uncertain how far its political and military engagements should go with the sovereign governments and Russia to ensure regional security and stability.

BRI Indian Ocean

The Indian Ocean is of primary national security concern, given that 80% of China’s oil imports pass through the Strait of Hormuz and the Strait of Malacca. To ensure security, the PLA has developed China’s “string of pearls, ” a series of ports across the Indian Ocean to support the long-term projection of Chinese naval power. These pearls are located in Bangladesh, Cambodia, Djibouti, Myanmar, Pakistan, and Sri Lanka.

With this approach, China is emulating the US playbook of rolling out a global network of port facilities and airfields capable of supporting a blue-water navy.

So far, partners have been very accommodating to China’s needs.

BRI Middle East

China is challenging and supplanting the United States as the region’s most important external power. However, China has no interest in replacing the United States as the principal external power.

Its principal concern is to secure its long-term energy supply. To do this, it has set up major joint venture investments across the region. Fortunately, the Gulf states are aware that business with the United States is declining due to domestic fracking. Therefore, China is becoming a more important buyer. It has also invested significantly in the high-technology industry (e.g., Israel) and the financial sector (participating in wealth funds)

As usual, China leverages its economic power to build and strengthen diplomatic relationships. But China’s non-interference foreign policy has also proven exceptionally successful in this challenging region. It has built friendly relationships across the region by constantly trying to distance itself from regional disputes and not taking sides.

Xi has successfully outflanked the United States in the Middle East at virtually every turn:

  • It has leveraged its economic strength and buyer power to secure better deals for its future energy needs
  • It has leveraged its economic strength and supplier power by providing access to Chinese goods, including military equipment
  • It has leveraged the region’s need to balance the reduction of US exports
  • It has leveraged the US’s poor handling of regional conflicts in the past decades
  • It has leveraged its non-interference foreign policy to make friends with states who are enemies (“the friend of my enemy is also my friend”)

The question remains whether China can continue its non-position-taking policy when binary choices have to be made in the future.

#9 – Increasing Chinese leverage across Europe, Africa, Latin America, and the Arctic

China’s global strategy is to increase its economic, foreign, and security policy influence across all regions. That includes Europe, Africa, and Latin America, considered important markets for Chinese goods, especially to mitigate reduced access to the American market.

Furthermore, China is always looking to secure a long-term supply of commodities and sources of foreign direct investment and capital flows.

Lastly, with its strong relations across the developing world, China can pull unprecedented political and diplomatic leverage in international institutions like the United Nations.

Europe

China has long looked at Europe through the pragmatic lens of win-win economic opportunity and engagement. This has only accelerated after the US-China trade war of 2017.

China recognizes that Europe constitutes a region with an extensive range of diverse cultures, each with a strong urge to maintain its own diversity. It has tried to leverage these differences with a divide et impera approach focused on smaller states. It aims to leverage the smaller states’ disproportional power in EU and NATO institutions to fracture unity on core questions. Examples are Hungary and Greece, but also China’s 16+1 summit mechanism.

A primary concern for China is that it sees Europe as the last remaining defender of global human rights norms. This is deeply problematic for China because it challenges the CCP’s domestic and international political legitimacy. If China could neutralize Europe’s unity on human rights, it would be a victory.

China also aims to reduce or extinguish Western confidence in the Western liberal-democratic tradition. That has been a long-term objective of the party, given it would provide a definitive answer to whether liberal democracy is the inevitable political destination for all humankind.

Europe has long sought to develop a cooperative relationship with China, culminating in the near agreement on the EU-China Comprehensive Agreement on Investment (CAI). However, this was put on hold in 2021. Europe’s concern with China is primarily:

  • China’s domestic market is still largely closed to European business, despite China’s access to European markets
  • China’s foreign direct investment into Europe is still minimal
  • China’s state-driven approach to the acquisition of technology presents national security concerns
  • The distinct difference in citizen privacy laws and their enforcement
  • National security concerns related to 5G technology 
  • China’s close collaboration with Russia and its positioning as a global security provider

Currently, there are three groups within Europe concerning the discussion on the geopolitical future of Europe.

The first group wants Europe to focus on strategic autonomy, staying neutral in the US-China struggle for global domination, and maximizing Europe’s economic opportunities.

The second group sees a crystal-clear division between the Western liberal democracies and China. It proposes aligning Europe with the United States and other Western nations against authoritarian states like Russia and China.

The third group sees nothing wrong with China’s conduct and suggests we can learn something from them. It proposes Europe should develop closer relationships with the future global superpower.

Latin America

There’s not a long history between China and Latin America, primarily due to the implication of America’s Monroe doctrine. However, since 2001 China has increased its visits to Latin America, which has only accelerated during Trump’s administration.

China’s regional interests include further diplomatic isolation of Taiwan (Panama, Honduras) and, of course, its economic interest. China sees Latin America as another excellent market for Chinese exports and a trading partner to secure a long-term supply of raw materials like oil, iron, ore, copper, and soya beans.

Xi has faced significant internal and external criticism for its support of Venezuela. The domestic criticism is that Venezuela has defaulted on a substantial quantity of loans which puts the sustainability of China’s loan strategy into question. External criticism is that many regional governments see Venezuela’s instability as a potential cause of mass immigration across the continent. However, Xi has pointed out that Venezuala is the “all-weather ally” in Latin America.

China has displayed a remarkable ability to balance the long-term strategy against short-term headwinds. A prime example is how they dealt with Brazil’s Bolsonaro. Bolsonaro directly attacked China during his 2018 presential election campaign, stating, “China is not buying from Brazil, China is buying Brazil.” Yet one year later, during a state visit to Beijing, he exclaimed the two economies were “born to walk together.”

Generally, the region has been accommodating Chinese diplomacy despite America’s warning of China as the “new imperial power.” Latin America seemingly welcomes China as a counterweight against the United States as it provides more leverage against the former sole superpower.

Africa

Africa has a long history of supporting China, rooted in Mao Tze-tung and Zhou Enlai’s leading role in the Non-Alignment Movement. African countries have never really been part of the American sphere of influence as they were mostly (negatively) influenced by the European colonial and post-colonial powers. Similar to Latin America, China provides African nations with the leverage it never previously had to stand up against European forces.

China’s economic interest in Africa is vast and deep. First, it sees Africa as a long-term energy and raw materials supplier. Second, it considers a growing billion-strong consumer market for Chinese goods in Africa.

Chinese political interest in Africa is rooted in the presence of African nations in international institutions like the United Nations. Via its diplomatic ties, Africa typically provides China a reliable block of votes in any multilateral forum whenever Chinese interests are at stake.

China’s ideological interests in Africa are to showcase its development model as superior to the West by proving the model also works in a non-Chinese setting. Xi Jinping has declared to “welcome Africa abord the express train of China’s development.” Ultimately, succeeding in China supports the global ideological ambition of delegitimizing liberal-democratic capitalism.

China’s investment interests focus on creating a win-win outcome that delivers tangible economic benefits to both parties. FDI typically comes with a lot fewer requirements than Western investment. Western investment generally has additional requirements that include the promotion of open democracy and free market mechanisms. It also requires ensurances to deliver on the promise. Even with the higher barrier to access, Western investment projects are often criticized for ineffective, strings-attached, and unpredictable investment. Despite the fewer requirements, China’s FDI still falls significantly behind that of individual European states. Furthermore, only 5% of China’s aid is from “non-loan” investments. That causes some to worry about potential debt-trap diplomacy.

China’s security interests primarily protect the Chinese citizens and investments in the region. However, China has set up a China-Africa peace and Security Initiative to broaden the security collaboration. Generally, African nations don’t seem to mind the increased presence of the Chinese military.

Arctic

In 2013 China became a permanent observer of the Arctic Council. Xi declared China to be a “polar great power.” China’s primary strategic interest in the arctic appears to be two-fold. First, tapping into the energy and mineral reserves that will be unlocked by global warming. Second, the emergence of a new maritime shipping route connecting the Atlantic and Pacific oceans. For this purpose, China has invested resources into jointly developing with Russia the Arctic Silk Road

Antarctica

China’s ambitions in Antarctica are primarily scientific activities for now. However, it appears China is also looking at exploitation sometime in the future. This is currently not allowed under the Antarctic Treaty.

#10 – Rewriting the Global Rules-based Order

Post World War 2, the United States and its allies constructed a liberal international rules-based order, including establishing the institutions required to manage it. Below is a brief list:

1944 Bretton Woods Conference

  • IMF = International Monetary Fund
  • WB = World Bank
  • GATT = General Agreement on Tariffs and Trade (later WTO)
  • WTO = World Trade Organization

China was present at the Bretton Woods conference but represented by the Nationalists under Chang-Kai Shek and not the communists. Russia was also present but refused the ratify the agreements stating they were mere “branches of Wall Street” and opposed the communist ideology.

1945 San Francisco Conference

  • UN = United Nations

China and Russia were present as inaugural members of the United Nations, with both having a permanent seat in the UN Security Council.

1948

  • UDHR = Universal Declaration of Human Rights
  • NATO = North Atlantic Treaty Organization

China, under the CCP, had always claimed it wasn’t included when the rules-based order was set up. Until recently, it was not in the position to challenge these rules, but now it is. China prefers the rules-based order versus the alternative, which is chaos (e.g., revolution). Before 2014, China showed little interest in playing a more significant role in international affairs. This is symbolized by Deng Xiaoping’s expression, “Hide your strength, bide your time, never take the lead.”

Since 2014, Xi Jinping has declared a new era of Chinese multilateral activism and has said China should “strive for achievement.” Under Xi, China has three approaches to challenging the existing liberal rules-based order.

First, grow support in the developing world to secure changes to existing norms and values that are inconsistent or offensive to Chinese interests and values.

Second, increase the influence within the existing institutions by increasing funding and installing Chinese or China-friendly candidates in senior leadership positions.

Third, create its own network of new multilateral institutions outside the framework of the existing institutions. This already started before Xi with the Chang-Mai Initiative (CMI) and Asian Monetary Fund (AMF) and has accelerated with, for example, the Belt-and-Road Initiative (BRI), Silk Road Fund (SRF), New Development Bank (NDB), Asian Infrastructure Investment Bank (AIIB), Shanghai Cooperation Organization (SCO), and Conference on Interaction and Confidence-Building Measures in Asia (CICA).

Xi has been helped tremendously in all three approaches by the systematic American withdrawal under the Trump administration.

Another angle to changing the global rules-based order is one of international standard-setting and regulatory frameworks. We are familiar with the topic of 5G telecom, where China aims to set the new international standard for telecommunication by directly supporting its national champion Huawei. Other examples include replacing the TCP/IP communications network architecture with New IP. But technology is not the only sector where China aims to lead the world toward new, China-friendly standards.

Generally, China has three approaches to imposing its standards for international regulator frameworks.

  1. If possible, simply have the superior proposal
  2. If possible, have a dominant global market share within the target segment such that your framework becomes the de facto standard
  3. If needed, leverage diplomatic ties to enforce the adoption of your proposal (even if it’s not equivalent to the Western proposal)

Xi is not entirely clear on what a new order should look like but has clarified that China will not simply replicate the current US-led order. Furthermore, there is no “grand blueprint.” Instead, Xi’s process of establishing a new global order follows the typically Chinese iterative trial-and-error process.

However, it is crucial to remember that Xi is fundamentally a True Believer in Marxism. When Xi declares China is in the process of building a “community of common destiny for all mankind,” it’s important to frame this within the Marxist-Leninist worldview, which sees state socialism as a superior governing mechanism to liberal-democratic capitalism.

Practically, China will continue to work on transforming the existing global governance system and offering Chinese Wisdom as an alternative perspective.

A Corsair Valuation (NASDAQ:CRSR) – Post-IPO Update

In this blog post I take a shot at valuing Corsair (NASDAQ:CSRS) using a discounted cash flow valuation method. The calculation suggest an equity value ranging from US$1.62 to US$2.76B.

corsair logo

The Corsair Touch

Corsair Gaming Inc. is an American computer gaming components, peripherals, and systems company founded in 1994 as Corsair Microsystems by Andy Paul, John Beekley, and Don Lieberman. While originally selling processor cache and later system memory modules, soon Corsair started gravitating towards the DIY computer enthusiast market segment.

Over the past two decades Corsair has significantly diversified its product portfolio. Starting with flash memory and power supplies in 2006, Corsair is now a market leader in a wide range of product categories including computer chassis, gaming peripherals, cooling solutions, and streaming gear.

What enables Corsair to become so successful is what I’ll call the “Corsair Touch”. The Corsair Touch describes how Corsair enters a product category and finds a way to become successful. The Corsair Touch consists of a couple of key ingredients.

  1. Hire or develop experts who are technically proficient and deeply involved with the enthusiast community. The experts have a finger on the pulse when it comes to market trends. Not only can they anticipate new market trends, they also know how to integrate the new trends in future products. Corsair is rarely first to move with a new trend, but more often than not they make the right move.
  2. Enter any new market with a high-end product to win over the enthusiasts and establish a credible brand reputation. Then expand with more affordable offerings to gain market share. However, always stay clear of the low-end price-sensitive segment.
  3. Outsource most if not all manufacturing to lower-cost OEMs in Asia and avoid investing in fixed assets.
  4. Finally, leverage the world-class worldwide distribution and sales engine to push the products to the market

On August 21st, 2020, Corsair Gaming, Inc. filed its IPO prospectus with the SEC aiming to go public on the Nasdaq exchange under the symbol CRSR.

Gathering Information

There are four major value drivers to consider:

  1. Revenue, growth, and duration of growth
  2. Profitability and efficient use of assets
  3. Reinvestment in existing and growth assets
  4. Risk.

We can use the following documents to gather information about Corsair’s value drivers from 2005 to 2020:

corsair financial data

For reference I also collected data from publicly listed peers Logitech, Turtle Beach and Razer using the data service provider Finbox.

corsair comparables data

You can download the excel sheet here: https://hanweiconsulting.com/wp-content/uploads/2020/09/fcffsimpleginzu-corsair-v1.1.xlsx.

Revenue Growth

As mentioned in the opening paragraphs, Corsair has diversified its product portfolio away from the highly commoditized and volatile DRAM memory market. The company has successfully expanded into a wide range of computer components, accessories, and peripherals. You can see this expansion illustrated in a picture included in the IPO prospectus.

Between 2005 and 2010 Corsair is a nimble growth company focused on driving revenue through expanding the product portfolio and riding the organic growth of the PC DIY market. Between 2010 and 2015, the PC DIY market slows down, and Corsair identifies PC gaming as a market segment with above industry growth potential and more favorable margins.

After an unsuccessful IPO in 2010 and 2012, Corsair turns to Francisco Partners and obtains a $75 million strategic investment in the company. The investment is used to execute the growth strategy outlined in the 2010/2012 IPO prospectus:

  1. Achieve Leading Market Position in Each Product Family
  2. Increase Sales of Gaming Peripherals
  3. Leverage Our Scalable Operating and Business Model
  4. Build on Our Existing Infrastructure to Address Growing Opportunities in the Asia Pacific Region
  5. Selectively Pursue Complementary Acquisitions

In 4 years, Corsair doubled its revenue and becomes a $1 billion dollar company. Considering Corsair’s current position, it’s safe to say they absolutely succeeded in each of their strategic goals.

In 2017, Francisco Partners sold its stake in Corsair to EagleTree Capital. From the Press Release we note that the post-acquisition EagleTree aims to “[…] maintain the company’s focus on innovative products, to expand into new markets, and to pursue selective transactions”. This aligns with the growth strategy outlined in the 2020 IPO prospectus:

  1. Advance as the global leader in high-performance gaming and streaming gear.
  2. Continue to develop innovative, market-leading gaming and streaming gear.
  3. Expand into new gear and services that grow our market opportunity.
  4. Leverage our software platforms to sell more gear to existing customers.
  5. Strengthen relationships with end-users by increasing direct-to-consumer sales.
  6. Continue to grow market share globally.
  7. Selectively pursue complementary acquisitions.

The 7 strategies outlined boil down to 2 standard growth strategies: (1) organic growth through horizontal diversification, and (2) inorganic growth through M&A.

Profitability

Corsair operates a global, scalable, nimble business model utilizing the “Corsair Touch” to respond quickly to new market trends and demands. The facility in Taiwan assembles, tests, packages, and supplies the DRAM, liquid cooling products and pre-built gaming systems. All other Corsair products are produced at third-party, outsourced, factories located in China, Taiwan, and South-East Asia.

The outsourcing operations strategy allows Corsair to leverage the intense competition between suppliers and choose the best quality and best price. This helps maximize customer willingness to pay (increases price) and helps reduce cost, which combined allows Corsair to capture more value.

The DRAM business is still a significant part of Corsair’s overall business and has a big impact on profitability. DRAM is highly commoditized and operating profits are determined by volatility in market demand and supply, as well as timing of purchase. The gaming peripherals typically have a much higher gross margin in the range of 35-40% or higher.

Since 2007, Corsair has steadily increased gross margin by diversifying into higher-margin product categories. That said, Corsair’s gross margin of 24.2% is still well below industry peers Logitech and Turtle Beach’s 35% and higher gross margin. The same can be said about the operating margin. While positive, unlike its industry rival Razer, the operating margin fluctuates between 2% and 6%. This is also below industry peers Logitech and Turtle Beach. Expressed as a percentage of revenue, both Product Development (RD) and SG&A expenses are below the industry peers.

Reinvestment

Looking at the 2018 and 2019 cash flow statements, Corsair has every scent of an early growth company. The cash flow from operations is relatively low compared to the vast amount of cash for investment financed by debt. However, the picture changes if we factor out the recent three acquisitions of Elgato (2018, $46.6 million), Origin PC (2019, $13.8 million) and SCUF Gaming (2019, $136 million). In the 18 months spanning 2019 and the first half of 2020, Corsair spent $126+$10 million in cash on the three aforementioned companies representing 90% of all investment activities. This paints the picture of a company that is primarily looking at acquisitions to fuel future growth rather than reinvesting in existing assets in place.

This can be good or bad news.

It is good news if management believes the current assets in place and operations are well-tuned and ready to provide significant profits as they scale up further. In this case the existing core business becomes the cash cow to fuel the M&A inorganic growth. This offers a well-balanced short-term and long-term perspective for the company.

It is bad news if management believes the current assets in place have no future and the only growth can come from bringing outside products and people to guarantee the future of the company.

Risk

I use weighted average cost of capital (“WACC”) calculation to determine the risk. WACC has the following components: equity and debt.

Cost of Equity

To determine the cost of equity we use the following inputs:

  • Long-term Riskfree rate: US 10Y bond yield = 0.69% (Sept 10, from tradingeconomics.com)
  • Unlevered beta: 1.35 (Sept 10, from Damodaran‘s latest Valuation Spreadsheet)
  • Equity risk premium: 6.4275% (Sept 10, calculated using Damodaran‘s latest Valuation Spreadsheet and Corsair’s revenue per region)

Cost of Debt

To determine the cost of debt we use the following inputs:

  • Long-term Riskfree rate: US 10Y bond yield = 0.69% (Sept 10, from tradingeconomics.com)
  • Interest Coverage Ratio: 2.05, which results in an estimated synthetic rating of B2/B and associated estimated company default spread of 8.25% (Sept 10, from Damodaran‘s latest Valuation Spreadsheet)
  • Average maturity: 4 years (90% of debt is due in 2024)
  • Tax rate: 25% (United States corporate tax rate)

WACC

(in thousands)EquityDebt + Operating LeasesCapital
Market Value (*)$549,610$481,449$1,031,060
Weight in Cost of Capital54.32%46.69%100%
Cost of component14.95%6.71%11.10%
(*) market value of equity is determined by the total purchase price consideration of Eagletree’s acquisition of Corsair detailed on Page 72 in the IPO

The cost of capital is relatively high because the high debt-to-equity (increases relevered beta) and low interest coverage rate (lowers synthetic rating). The easiest way to improve the WACC is to use the proceeds of the IPO to lower the debt. This will not only provide additional free cash flow (less interested to be paid) but also increase debt capacity at more favorable interest rates.

The additional debt capacity can then be used as a source of finance for future acquisitions.

Initial Corsair Valuation

Using Damodaran’s model for DCF valuation, an initial Corsair valuation could look like this.

Revenue growth: 15% 2-5Y CAGR. High growth in the coming 5 years driven by continued aggressive expansion of the product portfolio both organically (new product launches in existing categories) and inorganic (acquire market leading companies).

Profitability: 15% EBIT in Year 10: leverage the lean business model to sell more of the same products with minimum overhead, focus on diversifying the portfolio with high-margin computer peripherals, and drive margin with aggressive direct-to-customer business.

Reinvestment: 2.00x Sales-to-Capital in Year 10: continue the focus of reinvestment on growth assets rather than fixed assets, acquire the right companies to be #1 or #2 player in each entered product category or segment, continue the “Corsair Touch”.

Risk: 5.92% WACC in Year 10: similar to that of mature companies (riskfree rate + 4.5%)

Value of Equity ~ US $3.58B

Valuation Caveats

The initial valuation paints a positive picture of Corsair’s future, its projected cash flows and its value. In this section I want to add more personal side notes to this Corsair valuation and hopefully add perspective.

Revenue Growth

The revenue growth as projected in the Corsair valuation depends on the continued success in the existing product categories and the outstanding success of future product categories and acquisitions. The success essentially depends on the future success of the “Corsair Touch”.

For the “Corsair Touch” to be successful Corsair needs to continue to attract and retain industry experts, and those experts must continue to create value that Corsair customers are willing to pay a premium for. This value not only depends on Corsair but also on the rate of innovation of the OEMs and suppliers who produce the Corsair products. Since Corsair does little own manufacturing it needs a strong and integrated value chain. If the rate of innovation drops significantly and Corsair is no longer able to create products that customers are willing to pay a premium for, it risks being dragged into a price war with lower cost companies.

Additionally, a key strength of the “Corsair Touch” is the global, scalable, nimble business model. For this strength to help fuel growth, Corsair must be able to identify the product categories that have high synergy with the business model. The 2018 Elgato acquisition is a perfect example of this.

Elgato is a market leader in streaming equipment for PC gaming, had a limited high-margin product portfolio of mainstream plug and play equipment, and is operating in a hot and rapidly growing market. The combination “PC”, high-margin”, “plug and play”, “limited portfolio”, and “high growth” is a perfect fit for the “Corsair Touch” model and I have no doubts it will be a success.

Potential targets similar like Elgato could be:

  • Thrustmaster, leader in joysticks, game controllers and steering wheels
  • Hercules, leader in PC-DJ equipment and software
  • Fanatec, leader in sim racing hardware and equipment

SCUF Gaming is a different story as they produce highly customizable game controllers targeted at console gamers. While the high (gross) margin is a plus point, it remains to be seen how the “Corsair Touch” can be levered with these products. After all, Corsair is more known as a “PC Gaming” company and not as a general ‘Gaming” company like their competitor Razor. Also, the “Corsair Touch” does not really cater well to customized products.

Perhaps SCUF Gaming is a way for Corsair to establish itself as more than just a PC Gaming company and expand the product portfolio to all types of gaming. Including PC, console, handheld, mobile, and cloud gaming. That would certainly open up a lot of new avenues for expanding the product portfolio.

Profitability

The profitability case hinges on two main factors. One, leverage the “Corsair Touch” and charge a premium in high-margin product categories. Two, increase the direct-to-customer sales.

I already discussed the first point at length in the previous sections.

In July 2020 Corsair hired Kenji Gjovig as VP eCommerce. Coming from Albertsons Companies he joined to lead the direct to customer ecommerce business. It will be a tough job. As reported in the 2020 IPO prospectus, sales to Amazon accounted for 26.8% of net revenue for the six months ended June 30, 2020, increasing from 17.7% in 2017.

The big picture challenge for Corsair is that a lot of their business and products are “amazonable”. The online etailers that survive are those who can carve out a niche or offer a product/service that are “unamazonable”. Corsair must find a way how it can attract customers who are used to the ease of simply adding a Corsair product in their one-click Amazon check out. This can be done, but will not be easy and will not be cheap. An easy way out would be to offer lower prices through the online store, but not only does that impact the profitability, it also impacts the brand value. Offering exclusive products or customized products is another option, but that is incompatible with the “Corsair Touch” business model. High expenditure on advertising and marketing to lure people to the ecommerce platform is expensive and will eat into your margin. Offering better or more personal service compared to Amazon may seem easy to on paper but very quickly becomes expensive. Especially for a company selling worldwide.

Reinvestment

The reinvestment is targeted mostly at M&A. A key challenge with M&A is that for attractive businesses there are usually multiple bidders and multiple bidders often result in a Winner’s Curse. The Winner’s Curse is a tendency for the winning bid in an auction to exceed the intrinsic value of an item. Similarly, many companies who do M&A end up overpaying for acquisitions.

Overpaying for an acquisition basically means you have overestimated the value (value transfer and value creation) of the acquisition. Reasons for this can be overestimating the synergies (“dreams”), underestimating the cost of capital (minimizing the risk premium), exaggerating the residual growth rate in the calculation of the terminal value, and using multiples of “comparables” which are not really similar or simply inflated.

M&A is really difficult and Corsair will need not only a clear acquisition strategy, a strong negotiation strategy (“BATNA, be able to walk away”), but most importantly key people who can identify potential targets and accurately evaluate the value it can create for the business after acquisition.

It is difficult to judge whether Corsair management is doing things right from outside. However, we can look at the transactions detailed in the 2020 IPO prospectus. Specifically, we can look at the goodwill mentioned. Goodwill is the price paid for future cash flow and is calculated as the acquisition price minus the book value of the assets.

  • Elgato (2018): $23.133 million net assets, $23.487 million goodwill
  • Origin PC (2019): $1.499 million net assets, $12.270 million goodwill
  • SCUF Gaming (2019): $63.670 million net assets, $72.642 million goodwill

The obvious standout here is SCUF Gaming as Corsair paid more in goodwill than net assets. In 2019 SCUF Gaming reported net sales of $68.3 million, gross profit of $26.5 million and operating loss of $2 million.

Terminal Value

The terminal value captures the value of a business beyond the forecasted cashflow period. The terminal value often comprises a large portion of the total value of the business. My model uses the perpetuity method which assumes a business will continue to generate cashflows at a constant rate forever.

The obvious caveat is of course that we do not know if Corsair will continue to generate revenues beyond year 10. Perhaps with the rise of cloud gaming or other technologies we soon will not need any of the products Corsair is selling.

My assumption is that Corsair will continue to shift its product portfolio towards new categories and markets and hence I am okay using the perpetuity method in this Corsair valuation.

Corsair Valuation: Sensitivity Analysis

Last step of the Corsair valuation is to do perform a simple sensitivity analysis. In the past I used Crystal Ball to perform my sensitivity analysis but recently I have switched to the ModelRisk excel plugin.

Inputs:

  • CAGR 2-5Y: lognormal distribution (mu=10%, sigma=5%)
  • Profitability: triangle distribution (min=5%, mode=12.5%, max=20%)
  • Sales to Capital ratio: triangle distribution (min=1.5, mode=2.0, max=2.5)

Outputs:

  • Mean value of equity ~ $2.29B
  • 25% percentile: $1.62B
  • 50% percentile: $2.15B
  • 75% percentile: $2.76B

Corsair Valuation: Post-IPO Update

On September 23, 2020, Corsair Gaming was listed on the Nasdaq raising $238 million by offering 14 million shares at $17. The share price dropped on opening day by over 16% to $14.24.

I updated my valuation work sheet with the additional data such as outstanding shares and re-ran the simulation. You can find the information below:

Worksheet download: https://hanweiconsulting.com/wp-content/uploads/2020/09/fcffsimpleginzu-corsair-v1.2.xlsx

Simulation:

As of Sept 24, 2020, Corsair sits around the 15% percentile.

Disclaimer: For all intents and purposes, the content and information below is for entertainment purposes only and should not be considered investment advice.

Markets Aren’t Crashing? (S&P 500 Valuation)

Why aren’t markets around the world crashing to historical lows amidst the global pandemic? In this blog post I take a closer look at the factors driving market valuation and discuss whether the markets are delusional or rational.

On February 19, the S&P 500 index reached a new all-time high of 3386.15. One month later, on March 23, the same index stood 34% lower at 2237.40. All gains since January 2017 wiped out due to the COVID-19 induced fear and uncertainty. Today, April 29, the S&P 500 sits around 2800, still down from it’s peak right before the crisis but far from the market crash everyone seems to be talking about.

The question on some people’s minds seems to be: when will the market eventually crash? Other people claim the earnings headwind is already priced in. Using the DCF method, I value the S&P 500 index and look at the data to try and make sense of this question. I cover three main inputs to value the S&P 500:

  • Equity risk premium: is the implied equity risk premium unusually low or high?
  • Earnings forecast: is the expected growth in future cash flows reasonable?
  • Payout ratio: are the expected returns reasonable?
Valuing the S&P 500 market index
Valuing the S&P 500 market index

Implied Equity Risk Premium

The equity risk premium is the price of risk in equity markets. It can be understood as the premium investors demand for investing in an equity asset. The riskier an asset, the higher the associated risk premium will be.

Although no asset is truly risk free, we could argue that government bonds from first world countries like United States or Germany are risk free in practice because their governments will never default. Similarly, you’ll find that the risk premium for well-established firms in mature markets will be lower than the premium for startups in developing markets.

In valuation and corporate finance, the equity risk premium is an essential input for calculating the cost of equity and cost of capital. Traditional methods employ a backwards looking historical equity risk premium. In modern valuation we prefer to use a forward-looking implied equity risk premium.

The implied risk premium is estimated using current market data such as market capitalization and risk-free rate, and most recently available company earnings reports. In this blog post I outline how to perform the calculation using tools provided by the online data service Finbox.

Historical Perspective

Since my first blog post on how to use Finbox to estimate the implied equity risk premium, I’ve been tracking the implied equity risk premium of a variety of major indices. Below you can find the updated visualization.

As you see in the chart above, the implied equity risk premium for the S&P 500 decreased from near 8% at the end of March to 5.5% at the end of April. I discussed a variety of elements influencing the equity risk premium calculation in times of crisis in a follow-up blog post earlier this month. If you’re interested, I would definitely recommend going through that blog post.

According to Damodaran’s research, historically the equity risk premium for the S&P 500 averages around 4.5%. This is substantially lower than today’s 5.5% to 6.0%. If we consider only the years since the 2007-2008 financial crisis, the historical risk premium hovers around 5% to 6%. Today’s risk premium falls within this range perfectly.

Future Cash Flows

An crucial input to value the S&P 500 is the expected future growth of cash flows. There are a variety of methods to determine this input. You can rely your own expertise to estimate the growth every year. Of course, you can also rely on the forecasts of the managers of the firms you’re tracking. You can also ask analysts to provide estimates. You can use a top-down approach and estimate the growth for the index as a whole, or a bottom-up approach by estimating the growth of each company in the index to derive the overall growth of the index.

In my blog post titled Finbox Implied Equity Risk Premium Follow-Up I outline a particular method of estimating the growth of future cash flows using Finbox. There are two key inputs:

  1. For each company in the index, the expected growth in net income in the first year
  2. For each company in the index, the expected compound annual growth rate of net income for the next five years

The growth estimates are provided by industry analysts and aggregated by Finbox. In the charts below you can find the estimates over time.

index 1y net income growth tracker finbox
index 5y cagr tracker finbox

As you can see, the analyst estimates are slower to adjust to the crisis than the market. One would hope that is the case! The market can be irrational and emotional, but we need analysts to help us make sense of the situation and provide careful, well-founded and rational insight.

Since about a week or so, we see that the analysts have started putting a figure to the impact of the virus. Estimates for Western markets range from near -20% (Europe and UK) to -10% (United States). For China and Japan, the situation is slightly different, and in particular the Chinese situation is an interesting topic (which I will cover in a future blog post).

The bottom-up analyst outlook for the next 5 years remains relatively stable for all markets. The forecast slightly more favorable for the US and European companies and hovers around 4-5% CAGR.

Sustainable Payout Ratio

The last input we need for our discounted cash flow model is the expected return of the excess cash flows generated by the firm to the shareholders. This topic addresses the dividend decision in corporate finance. Simply put, it poses the question whether the excess returns will be reinvested in the firm or returned to the shareholders.

In theory, a company aims to maximize shareholder wealth. If the company has interesting and highly profitable projects lined up, then reinvesting excess returns into those projects is preferred. However, if the company has no interesting projects then the company should return the cash to the shareholders such that the shareholders can invest it in other companies that may have interesting projects.

There are two ways companies can return cash to the shareholder: dividends and buybacks. Each method has its advantages and disadvantages, and it’s up to the management of the company to determine what’s best for their situation. Collectively, we can capture the returns to the shareholders as a Payout Ratio. The payout ratio for the S&P 500 currently sits around 88%. That means for every $100 in net earnings, S&P 500 firms return $88 to the shareholders.

In this discounted cash flow model, we employ a sustainable payout ratio based on the stable growth rate after year 5 and the trailing twelve months return on equity.

We can argue at length whether it is reasonable to assume companies will eventually return to the shareholder every dollar they can’t reinvest (and whether the cash that gets reinvested actually creates value for the shareholder), but what we all assume is that the payout ratio is a decision made by the company management. The management is accountable to the shareholders, and this dynamic ensures the payout ratio will be reasonable considering the company’s performance. If the payout ratio would be impacted by external forces, e.g. government mandating a maximum payout ratio of 70%, then the value of the index would drop very rapidly.

Bringing It All Together

Let’s bring together the different inputs.

  • At 5.5%, the implied equity risk premium for the S&P 500 is higher than the historical equity risk premium for US equity markets, but sits right in the middle if we consider the risk premium since 2008.
  • At -9.52% for the next year, the Finbox aggregated analyst earnings forecasts for the S&P 500 firms are quite downbeat. This reflects a major impact of the coronavirus on supply and demand.
  • The sustainable payout ratio assumes companies will return excess returns to shareholders if management does not have interesting projects to invest in

Based on the findings above, it certainly looks like investors are making a reasonable attempt at valuing the market. The equity risk premium implies investors don’t find stocks any riskier than they were pre-crisis. The earnings forecasts that drive the discounted cash flow model are not implying a straight up catastrophe, but are definitely downbeat. Lastly, the payout ratio implies investors expect firms will return cash to the shareholders reasonably.

Of course, the above is merely my opinion. Perhaps you find equity risk greatly underestimated, or find the analyst forecast too positive considering the circumstances, or expect payouts to substantially change in the coming years. In the table below I’ve added a couple of scenarios to value the S&P 500 with different assumptions.

Equity
Risk Premium
Y1 Growth
Forecast
5Y CAGR
Forecast
Sustainable
Payout Ratio
S&P 500
Valuation
5.41%-9.52%4.64%95.89%2863.32
7%-9.52%4.64%95.89%2190.51
5.41%-20%4.64%95.89%2834.18
5.41%-9.52%1.00%95.89%2439.10
5.41%-9.52%4.64%75.00%2285.78
Alternating assumptions that drive different S&P 500 valuation

Also, you can use the excel document below to experiment yourself. It contains the latest data on April 29, 2020, as provided by Finbox API. Simply adjust the assumptions on the last sheet and see how the intrinsic value estimate changes.

(PS: the answer to the question whether markets today are delusional or rational is of course that they are both and neither at the same time *wink*)

Finbox Implied Equity Risk Premium Follow-Up

In this post, I want to follow up on the method to estimate the implied equity risk premium using the Finbox API function with an updated methodology, comparison with other market indices, and briefly discussing Damodaran’s numbers.

If you haven’t read my previous posts on the topic, feel free to check them out first:

  • Implied Equity Risk Premium Estimate Using Finbox (link)
  • S&P 500 Intrinsic Valuation Using Finbox (link)

Updated Methodology: Incorporating Net Income Growth Forecast

A key input for computing the implied equity risk premium is the earnings growth forecast for the next five years. The earnings growth serves as a base to estimate the potential dividends and buybacks firms can employ to return value to the shareholder in the coming years. The next five year growth is not a number you can find in a whitepaper or datasheet; it’s called a forecast for a reason.

In my previous article I proposed using Finbox’ Net Income Forecast CAGR 5Y (ni_proj_cagr_5y) as input for the earnings growth. The net income forecast is based on a bottom up estimate of growth for each of the S&P 500 firms. In total Finbox reports 6,283 estimates (April 4, 2020).

Finbox also offers a Net Income Growth Forecast (ni_proj_growth) metric which provides a forecast for the earnings growth in the next year. Incorporating this data in the model helps fine-tune the Year 1 growth. When discounting a series of cash flows, getting the “early money” right is important.

I kept the Year 5 earnings estimate consistent as to not dismiss the 5Y CAGR forecast input. For years 2 through 4, I split the difference between year 1 and 5 equally. The resulting calculation looks as follows:

Implied equity risk premium calculation on April 4, 2020
Implied equity risk premium calculation on April 4, 2020

The difference between the old methodology and new methodology is not that big: 6.64% (old) versus 6.61% (new).

Using Alternative Indices: STOXX 50, FTSE 250, CSI 100, S&P 100, Russell 1000

A question that comes up all the time when discussing the implied equity risk premium is: Why use the S&P 500 to calculate the risk premium? Why not any other index? What makes the S&P 500 so special that we can use it as the foundation to calculate the cost of equity in finance?

Implied equity risk premium tracker using the old methodology
Implied equity risk premium tracker using the old methodology

As Damodaran puts it in the 2020 edition of his paper on the equity risk premium: “Given its long history and wide following, the S&P 500 is a logical index to use to try out the implied equity risk premium measure”. In the section titled “Extensions of Implied Equity Risk Premium” (p110), Damodaran further expands on the topic of computing the equity risk premiums.

Out of curiosity, I used the same method on a couple of other well-known market indices. Below you can find the implied equity risk premiums as calculated on April 4, 2020.

  • CSI 100 (CN): 8.78% (RMB 21T total market cap)
  • FTSE 250 (UK): 8.81% (GBP 289B total market cap)
  • S&P 100 (US): 6.73% (USD 15.32T total market cap)
  • S&P 500 (US): 6.61% (USD 22.69T total market cap)
  • STOXX 50 (EU): 8.41% (EUR 2.35T total market cap)
  • Russell 1000 (US): 6.29% (USD 25.28T total market cap)

We can note two things.

First, the difference between the US stock market indices (S&P 100, S&P 500, Russell 1000) is not that large: 6.29% to 6.73% in favor of the larger market index. This can be explained by assuming the forward-looking estimate of the equity risk premium for small cap firms is -0.32% and for the large cap firms 0.12%.

Second, the difference between the US stock market indices and other indices is quite large (>2%).

This can potentially be explained by difference in risk-taking culture as “many companies and individuals in Europe have a cultural suspicion of risk-taking, entrepreneurialism and ‘Anglo-Saxon’ capital markets. Simply put, if you’re more risk averse you will demand a higher premium for investing in a more risky asset.

A second possible explanation is selection bias. Collectively, US companies are global leaders operating in a relatively free and open market with strong access to capital. The premium investors demand for a stake in a US company operating in this business environment is simply lower than for the same stake in any other market.

A third way to look at the difference is to consider that the markets may be overpriced (if the implied premium is too low) or underpriced (if the implied premium is too high). One could argue that the US and European equity market should be of equivalent risk, and therefore conclude that the European equity is underpriced (and may present an interesting investment opportunity).

Equity Risk Premium: Damodaran Versus Finbox API

Every month Damodaran updates the Implied Equity Risk Premium on his personal website. The Implied ERP on April 1, 2020, is 6.02%. Why are his numbers lower than the implied equity risk premium as computed using the Finbox API?

Damodaran's monthly implied equity risk premium update
Damodaran’s monthly implied equity risk premium update

Before we get into the number crunching, let’s state the obvious and say that these are extraordinary times of economic uncertainty due to (1) the global coronavirus pandemic and (2) associated economics of stoppage, (3) the credit & funding market dislocations, and (4) the oil price wars.

Historically, the US equity risk premium averages around 4.5% (source: Damodaran’s Implied ERP (annual) from 1960 to Current) with peaks over 7% only occurring a handful of times in March 2009 (7.68%), April 2009 (7.01%), October 2011 (7.64%), January 2012 (7.32%), February 2012 (7.04%), and June 2012 (7.28%) (Source: Damodaran’s Implied ERP by month for previous months). The increased risk premiums were marked by market crashes: the financial crisis of 2007-08 and the European sovereign debt crisis of 2010.

Damodaran historical implied premium for US equity market between 1960 and 2019
Historical implied premium for US equity market between 1960 and 2019 (source: Damodaran)

Returning to the number crunching, a key difference between the two methods is the choice of inputs.

InputDamodaranFinbox API
Cash flowDividend + buybacksDividend + buybacks – stock issuances
GrowthTop down forecastBottom up forecast
Payout RatioSustainableSustainable
Difference in inputs to compute implied equity risk premium

In particular, the growth forecast is different. Damodaran’s analyst-acquired bottom-up estimate is 6.42% whereas the top-down estimate is 3.18%. Bottom-up estimates tend to over-estimate the growth as analysts focus in on specific firms and may not fully take into account the macro-environment. Sadly, there are no top-down estimates available through the Finbox API so the bottom-up forecast (weighted by net income) is the only option we have.

Also, the timing of the computation plays a role. Between March 12, 2020, and April 4, 2020, we tracked the implied equity risk premium using the old methodology resulting in an average of 6.75%, with minimum of 6.29% and maximum of 7.49%. Damodaran’s 6.52% falls within the range we’re seeing using Finbox.

Lastly, one of the limitations of the implied equity risk premium during a crisis is that while the index level and risk free rate are current, the earnings and cash flow numbers are stale. The trailing twelve months earnings will eventually come down as firms release their Q1 and Q2 reports. The index level has already “priced in” lower earnings whereas our model may not.

One way to work around this problem is to make the earnings growth forecast as current as possible. While Finbox updates the metric at least once a day for the most recent changes in analyst forecasts, they are still dependent on timely analyst forecasts.

Another workaround is by manual intervention and overriding the Finbox input with your own estimate of earnings growth. Matching Damodaran’s inputs (dividends + buybacks as cash flow choice, Year 1 earnings growth of -30%, 5Y CAGR of 1.47%, Adjusted expected cash payout of 87.86%) yields a lower, covid-adjusted implied equity risk premium of 5.54%.

Covid-adjusted implied equity risk premium using Finbox API

At the end of the day, it’s up to everyone to determine which method they feel most comfortable with.

DateIERPS&P 500RiskfreeMarket CapEarningsDividendsBuybacksIssuancesCash to EquityNet Cash to EquityY1 Growth FC
5Y CAGR FC
Sust. Payout
7/55.32% $2,848.42
0.68%
$25,858,786
$124.80
$48.17
$72.40
$8.85
$120.57
$111.72
-6.49%
6.51%
94.83%
5/55.37% $2,842.74
0.63%
$25,754,934
$125.34
$47.29
$70.34
$9.15
$117.63
$108.47
-6.62%
6.48%
95.25%
2/55.45% $2,830.71
0.64%
$25,663,832
$135.88
$47.49
$65.61
$9.05
$113.11
$104.05
-10.50%
4.90%
95.56%
28/45.35% $2,878.48
0.65%
$26,110,130
$136.92
$48.12
$65.03
$9.11
$113.15
$104.03
-9.52%
4.64%
95.51%
25/45.45% $2,836.74
0.60%
$25,755,891
$136.89
$47.80
$64.75
$9.07
$112.55
$103.48
-9.55%
4.64%
95.90%
24/45.55% $2,797.80
0.59%
$25,424,113
$137.47
$48.08
$64.85
$9.15
$112.93
$103.78
-9.65%
4.62%
95.90%
23/45.61%
$2,799.31
0.61%
$25,423,785
$139.59
$49.97
$66.09
$9.19
$116.06
$106.87
-10.23%
4.58%
95.88%
22/45.76% $2,736.56
0.57%
$24,842,817
$139.60
$50.18
$66.35
$9.19
$116.53
$107.34
-1.77%
4.42%
96.15%
18/45.49%
$2,874.56
0.66%
$26,187,071
$140.75
$50.82
$66.58
$9.20
$117.40
$108.20
-1.68%
4.41%
95.59%
15/44.76%
$2,846.06
0.75%
$31,096,085
$119.08
$48.06
$67.69
$7.90
$115.74
$107.84
0.61%
4.81%
95.08%
14/44.75%
$2,761.63
0.77%
$31,096,085
$115.55
$46.63
$65.68
$7.67
$112.31
$104.65
0.61%
4.81%
94.89%
10/45.20%
$2,789.92
0.73%
$28,441,035
$127.63
$51.51
$72.55
$8.47
$124.05
$115.59
0.61%
4.81%
95.18%
9/45.20%
$2,749.98
0.74%
$28,446,945
$125.78
$50.61
$71.06
$8.26
$121.67
$113.41
0.61%
4.82%
95.07%
8/45.42%
$2,659.41
0.72%
$27,412,696
$126.25
$50.80
$71.42
$8.29
$122.22
$113.93

0.64%
4.82%
95.27%
7/45.86%
$2,663.68
0.69%
$25,399,347
$136.64
$54.91
$77.43
$8.96
$132.34
$123.38
0.64%
4.81%
95.48%
4/46.61%
$2,488.65
0.59%
$22,688,946
$143.37
$57.54
$81.08
$9.37
$138.62
$129.25
0.62%
4.81%
96.12%
3/4
6.66%
$2,526.90
0.62%
$22,539,572
$146.55
$58.81
$82.87
$9.58
$141.68
$132.10
4.81%
95.89%
2/4
6.69%
$2,470.50
0.59%
$22,533,323
$143.32
$57.52
$81.04
$9.37
$138.56
$129.19
4.81%
96.11%
1/4
6.50%
$2,584.59
0.67%
$23,562,438
$143.39
$57.54
$81.08
$9.37
$138.63
$129.25
5.36%
95.60%
31/36.38%
$2,626.65
0.71%
$23,917,050
$143.56
$57.58
$81.18
$9.39
$138.76
$129.37
5.36%
95.32%
28/36.55%$2,531.370.68%$23,376,274$142.19$57.04$80.68$9.31$137.72$128.415.37%95.51%
27/36.29%$2,630.07 0.85%$23,968,209
$143.51$57.57$81.43$9.39$139.00$129.605.37%94.39%
26/36.68%$2,475.560.86%$22,600,960$143.38$57.46$81.36$9.38$138.82$129.445.37%94.46%
25/3
7.13%$2,447.330.86%$21,340,638$150.09$60.32$85.59$9.89$145.91$136.025.64%94.33%
24/3
7.49%$2,237.400.76%$21,103,134$142.92$57.44$81.50$9.42$138.94$129.525.64%94.99%
21/37.18%$2,304.920.89%$21,160,519$142.92$57.44$81.50$9.42$138.94$129.525.64%94.13%

S&P 500 Intrinsic Valuation Using Finbox

In the previous blog post we used the Finbox API service to calculate the implied equity risk premium of the S&P 500. Using the Finbox API service we can also do an intrinsic valuation of the S&P 500.

Background

We live in extraordinary and challenging times. The novel Coronavirus (SARS-CoV-2) and related disease (COVID-19) has been spreading around the world for almost three months now. People around the world are urged or forced to stay at home to help governments and communities get the virus under control. The coronavirus will undoubtedly have a lasting impact on our lives.

The virus has already made severe impact on businesses around the world. First, when the Hubei province in China shut down, many global supply chains were also shut down. Now, as more people around the world are no longer able to go to work, many businesses are suffering from a steep decline in demand. For example, the tourism and airline industries have come to a complete halt as people stay at home. A lot of businesses may go under and a lot of people may lose their jobs. And without people earning money to spend, businesses will see a further decline in sales.

Stock markets around the world have also dropped significantly. The Dow Jones dropped more than 35% from 29,551 points on February 12, 2020, to 19,174 points on March 20, 2020. Similarly the S&P 500 Index fell almost 32% from 3386 points on February 19, 2020, to 2305 points on March 20, 2020. The German DAX Index fell over 38% from 13,789 points on February 19, 2020, to 8,442 on March 18, 2020. Fueled by an oil price war, we’re looking at the “fastest bear market” ever.

(source: schwab.com)

From February 26, 2020, NYU Stern professor Mr. Aswath Damodaran began covering the impact of the virus on the markets on his blog and YouTube channel:

  • 26/02: A Viral Market Meltdown: Fear or Fundamentals? (blog, youtube)
  • 09/03: A Viral Market Meltdown Part II: Clues in the Debris! (blog, youtube)
  • 16/03: A Viral Market Meltdown III: Pricing or Value? Trading or Investing? (blog, youtube)
  • 23/03: A Viral Market Meltdown IV: Investing for a post-virus Economy (blog, youtube)
  • 31/03: A Viral Market Meltdown V: Back to Basics! (blog, youtube)
  • 08/04: A Viral Market Meltdown VI: The Price of Risk (blog, youtube)
  • 24/04: A Viral Market Update VII: Mayhem with Multiples (blog, youtube)
  • 13/05: A Viral Market Update VIII: A Crisis Test – Value vs Growth, Active vs Passive, Small Cap vs Large! (blog, youtube)
  • 04/06: A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation (blog, youtube)
  • 19/06: A Viral Market Update X: A Corporate Life Cycle Perspective (blog, youtube)
  • 02/07: A Viral Market Update XI: The Flexibility Premium (blog, youtube)
  • 23/07: A Viral Market Update XII: The Resilience of Private Risk Capital (blog, youtube)
  • 20/08: A Viral Market Update XIII: The Strong (FANGAM) get Stronger! (blog, youtube)
  • 05/11: A Viral Market Update XIV: A Wrap on the COVID market, premature or not! (blog, youtube)
Damodaran S&P 500 intrinsic valuation

In the third blog post, Damodaran provided an updated intrinsic valuation of the S&P 500 index ranging between $2,547.91 (20%) to $2,986.04 (80%).

Using the same Finbox tools we used in our previous blog post, we can also do an intrinsic valuation of the S&P 500.

Data Gathering

To value the S&P 500 index we need the following data inputs:

  • Long-term risk-free rate: 10Y US bond yield (Wikipedia)
  • Company information (Finbox API)
    • Current market capitalization (marketcap)
    • Dividends paid LTM (total_div_paid_cf)
    • Stock buybacks LTM (common_rep)
    • Stock issues LTM (common_issues)
    • Net income LTM (ni)
    • Book value of equity FY (total_equity)
S&P500 company data provided by Finbox.com API service
S&P500 company data provided by Finbox.com API service

To estimate the current value of the S&P 500, we want to use the most up to date information available. That’s why for most metrics we use the last twelve months data points.

Dividend and Buyback Computation

After gathering the raw data, we normalize by weighing the current S&P 500 index against the S&P 500 total market capitalization.

From S&P 500 raw data to index unit adjusted data points

At the moment of writing, March 23, 2020, the index units adjusted data points are:

  • Earnings: $142.92
  • Dividends: $57.44
  • Buybacks: $81.50
  • Issuances: $138.94
  • Cash to Equity: $138.95 (dividends + buybacks)
  • Net Cash to Equity: $129.52 (dividends + buybacks – issuances)

S&P 500 Valuation Inputs

  • Base Earnings: $142.52
  • Base Net Cash Yield: $129.52
  • Expected Y1 earnings growth: PERT distribution (min -25%, mode -5%, max 5%)
  • Expected Y2 to Y5 earnings growth: triangle distribution (min 4%, 7%, 10%)
  • Expected long term riskfree rate: triangle distribution (min -0.51%, mode 0.89%, max 1.5%)
  • Sustainable payout ratio in Y5: 1-g/ROE
  • Equity risk premium: triangle distribution (min 5%, mode 7.18%, max 9%)

S&P 500 Intrinsic Valuation

In the chart below you can find a histogram plot of the S&P 500 intrinsic value. It ranges from $2,001.58 (25%) to $2,425.66 (75%) with a mean of $2,211.15.

S&P 500 intrinsic valuation
S&P 500 intrinsic valuation (March 23, 2020)

Implied Equity Risk Premium Estimate Using Finbox

We can estimate the implied equity risk premium used for estimating the cost of equity in corporate finance and valuation using the Finbox API service.

Equity Risk Premium

Simply put, the equity risk premium is the price of risk in equity markets. It captures the premium investors demand to invest in equity over a risk-free safe haven investment such as treasury bills. It can also be understood as the expected return on equity compared to the expected return on risk-free assets. Estimating the premium plays an important role in estimating the cost of equity and cost of capital in corporate finance and valuation.

Most equity risk premium estimates are backwards looking historical risk premium estimates based on the historical performance of stocks. As Damodaran points out in his lengthy paper on equity risk premiums (Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2019 Edition), historical risk premiums carry an inherent bias towards the user’s preference of time window, type of average, and the chosen risk-free rate. Even for the most data-rich estimates, the standard error is still significant and thus the statistical value low.

Comparison of historical equity risk premium estimates (Mr. Aswath Damodaran)
Comparison of historical equity risk premium estimates (Mr. Aswath Damodaran)

The implied equity risk premium is a forward-looking method of estimating equity risk premiums. The idea is as follows:

“If you know the price paid for an asset and have estimates of the expected cash flows on the asset, you can estimate the IRR of these cash flows. If you paid the price, this is what you have priced the asset to earn (as an expected return). If you assume that stocks are correctly priced in the aggregate and you can estimate the expected cashflows from buying stocks, you can estimate the expected rate of return on stocks by finding that discount rate that makes the present value equal to the price paid.”

Mr. Aswath Damodaran
Example of an implied equity risk premium calculation by Mr. Damodaran
Example of an implied equity risk premium calculation by Mr. Damodaran

Every month Damodaran updates the Implied ERP on his NYU Stern website. I urge you to read through the many teaching materials available on his website to get a better understanding of the mechanics of the implied equity risk premium.

Finbox Inc

Finbox Inc ( https://finbox.com/ ) is a Chicago-based online toolbox for investment and financial professionals that covers over 95,000 companies worldwide through their partnership with Standard & Poor’s Market Intelligence. I found this platform late 2018 and signed up for a membership in June 2019. I personally use their powerful stock screener to identify potential investment targets and pull relevant financial data into excel spreadsheets using their Excel spreadsheet add-on. Here you can find a complete list of supported API metrics.

For the purpose of estimating the implied equity risk premium, I use Finbox’ API services primarily to pull in data of the companies included in the S&P 500.

Data Gathering

To estimate the implied equity risk premium of a mature market, we need the following data inputs:

  • Mature market index: S&P 500 (Yahoo Finance)
  • Long-term risk-free rate: 10Y US bond yield (Wikipedia)
  • Company information (Finbox API)
    • Current market capitalization (marketcap)
    • Dividends paid LTM (total_div_paid_cf)
    • Stock buybacks LTM (common_rep)
    • Stock issues LTM (common_issues)
    • Net income LTM (ni)
    • Book value of equity FY (total_equity)
S&P500 company data provided by Finbox.com API service
S&P500 company data provided by Finbox.com API service

To estimate the current premium, we want to use the most up to date information available. That’s why for most metrics we use the last twelve months data points.

Dividend and Buyback Computation

After gathering the raw data, we normalize by weighing the current S&P 500 index against the S&P 500 total market capitalization.

From raw data to index unit adjusted data points

At the moment of writing, March 22, 2020, the index units adjusted data points are:

  • Earnings: $142.92
  • Dividends: $57.44
  • Buybacks: $81.50
  • Issuances: $138.94
  • Cash to Equity: $138.95 (dividends + buybacks)
  • Net Cash to Equity: $129.52 (dividends + buybacks – issuances)

Estimating Implied Equity Risk Premium

To estimate the intrinsic value of the S&P500 index, we only need a couple of inputs:

  • Current level of the index
  • Expected earnings growth for the next 5 years (top-down analyst forecast provided by Finbox)
  • Expected earnings growth in terminal year (equal to the long-term risk-free rate)
  • Expected returns to equity for the next 5 years (net cash to equity)
  • Expected returns to equity in terminal year (sustainable payout ratio)
  • Discount rate (implied equity risk premium)

The current level of the index is a single data point anyone can find in a matter of seconds.

The expected growth in earnings is a bit more difficult as we’re trying to predict future cash flows. In Damodaran’s worksheets you’ll find several options to determine your choice of growth rate though he seems to prefer a top-down analyst forecast of the S&P 500 index level. Following this idea, I rely on Finbox’ Net Income Forecast CAGR 5Y (ni_proj_cagr_5y) as main growth input.

Net income growth forecast by finbox as foundation for expected growth
Net income growth forecast by Finbox API

The forecast data is sourced from Standard & Poor’s aggregate of forecasts by various brokers and equity research institutions. Finbox’ Data Explorer allows you to check how many analysts contribute to the forecast of a specific stock. For example, Apple’s net income forecast is based on 73 estimates. While not all companies are covered equally (or accurately for that matter), the sample size of total estimates for all S&P 500 companies should give us a solid base as growth input.

As terminal growth rate we choose the risk-free rate (US 10Y gov’t bond yield).

To estimate expected returns, I slightly diverge from Damodaran’s preferred choice and opt to include dividends, stock buybacks as well as stock issuances (Net Cash to Equity). I feel it’s a more fair representation of return to all shareholders (existing and new). To estimate the returns between year 1 and year 5, I draw upon what Damodaran calls the sustainable payout level. The sustainable payout is computed using the stable growth rate and the trailing 12-month ROE and equal to 1 – g/ ROE. The payout ratio is adjusted over the next 5 years in linear increments to this value.

Once all this is set up, we’re ready to solve for the equity risk premium using Excel’s built-in Goal Seek function.

Example of estimating the implied equity risk premium using excel goal seek function
Example of estimating the implied equity risk premium using excel goal seek function

On March 22, 2020, my estimate for the implied equity risk premium is 7.18%. For your reference, you can compare this number with the implied equity risk premium published by Damodaran on his website at any time (5.77% for March 2020).

Conclusive Thoughts and Spreadsheets

I don’t think there’s a fundamental difference between the method for estimating the implied equity risk premium outlined in this blog post and the method used by Damodaran. However, the API service provided by Finbox facilitates gathering relevant data. Also, it offers a larger sample size of analysts for the top-down S&P 500 earnings growth forecast. Lastly, with the latest updated company and analyst information we can calculate the implied equity risk premium on a daily basis.

The value of this “instant” data point remains to be seen. Does it really matter to have the absolute latest information? Is having today’s estimate more useful than relying on Damodaran’s monthly ERP update? I’m not entirely sure so I’ll leave that up to you to decide. In case you’re also a Finbox user, I will link my spreadsheets below, so you open them and play around with them yourself.

To end this blog post, I would like to express my gratitude to Mr. Aswath Damodaran for his generous attitude towards teaching and sharing information. I don’t have the opportunity to join his classes at NYU Stern, but I do have access to his study materials and classroom via the online videos and webcasts. I highly recommend you to check those out if you want to learn more about corporate finance and valuation. While you’re at it, also check out his YouTube channel and blog for more content and insights.

Business Theory of Disruptive Innovation

The theory of disruptive innovation, introduced by Joseph L. Bower and Clayton M. Christensen in 1995 , deals with the question how an organization can drive growth through innovation. The theory of disruptive innovation builds on the jobs to be done and aims to help organizations focus on innovation-driven growth

While the theory extends much further than described in this post, I find it particularly helpful when evaluating new opportunities. Although the theory will help you understand how to appropriately allocate the organization’s resources, I feel the topic fits the Opportunity question as outlined in the Strategic Blueprint Structure better.

innovation in business
Innovation in business

Consumption vs Non-Consumption

A first important topic in the theory of disruption of innovation is recognizing there are different type of consumers and non-consumers. Whereas traditional businesses think of a market as the amount of people buying a specific product or service, it’s more useful to think of your market as everyone who needs to get a certain job done. From that perspective, you can separate four types of people

  • Consumers: people who are using your product or service to get the job done
  • Non-consumers (A): people who are not able to use your product or service, but would like to if they had the means to acquire or hire
  • Non-consumers (B): people who refuse to use your product or service because it does not meet their needs or desires
  • Non-consumers (C): people who have no idea your product or service exists and are currently using a different product to get the job done

Note that while we recognize a distinct difference between the groups, they do share certain characteristics. For example, the group of consumers, non-consumers (A), and non-consumers (B) have in common that they all know about your product. They are either a customer already, or feel your offer either over-serves or under-serves them. Similarly, the group of all non-consumers share the fact they’re not using your offer, however they all have a different reason.

The theory of disruptive innovation states that organizations benefit most when they compete against non-consumption. This seems logical as the group of non-consumers would typically be much larger than the group of consumers. However, in day-to-day operations we often get caught up in trying to sell more or newer to those people who are already buying our solutions.

The terms under- and over-served will return later in the post but for clarity purposes let’s define them as follows:

Under-served customers are people for whom the product offer does not meet the desired performance while over-served customers are people for whom the product provides too much performance. Product or service performance, in this context, is measured against the set of specific attributes and values a customer is willing to pay for. You can read more about this topic here: Attributes and Values: Business Strategy Core.

Sustaining and Efficiency Innovation

In his theory of disruptive innovation, Clayton Christensen distinguishes three type of innovation in business: sustaining, efficiency and disruptive innovation. The fundamental difference between both types of innovation is easily understood. Simply put, sustaining innovation is making a good product better while efficiency innovation is making the same product using fewer resources.

Product Development Sustaining InnovationEfficiency InnovationDisruptive Innovation
Capital Required+++++++++
Free Cash Flow++++
Jobs Created+++++++++

The key difference between the different types of innovation lies in the capital requirements and its uses, and its impact on the free cash flow.

Product Development (“Empowering Innovation”)

When a new product is developed for a certain job to be done, it demands a lot of capital. In fact, often starting the business requires much more capital than is available to the founders of the business. That’s why we would get a bank loan or venture capital firms to invest in our business. Both the bank and the investor help us obtain the capital required to start the business. Christensen refers to this phase as “empowering innovation” because it creates jobs for people who build, distribute, sell and service these products.

Sustaining Innovation

Once a product is in the market and establishes itself as a profitable business, a big driver to engage in sustaining innovation is the rivalry that takes place in the marketplace. Different firms will try and compete for the same customers by improving their offer vis-à-vis your offer. While significant re-investment in the business is of course necessary to survive in the marketplace, the amount of capital necessary for the re-investment is not that large. You can usually rely on the same people who made the product to also improve its attributes and performance. You can often use the same facilities and factories although maintenance and upgrading may be needed. Your inventories will not drastically expand either since people who buy the new product are not also buying the old product.

Efficiency Innovation

At a certain point, the sustaining innovation will reach a point of diminishing returns. The product improvements are not significant enough to convince customer to buy the new product. This will hamper the revenue growth potential and it is at this moment the financial folks will step in. The focus shifts from re-investing to improve the product, to re-investing to improve the gross, operating and net margins. The idea is that by improving the margins the business generates more free cash flow, which then can be reinvested in new projects or opportunities. The financial folks have plenty of efficiency measures at their disposal to determine what’s the best way to improve margins, but usually it boils down to either outsourcing operations to a business with lower operating costs.

“Efficiency innovations pay off really quickly. Empowering innovations take five or more years to pay off. So, they invest in efficiency innovations, and more capital comes out.”

Clayton Christensen, 2013 (source)

Clayton Christensen is very specific in his criticism of efficiency innovation. While jokingly referring to the “invention of the spreadsheet” as the root cause of the demise of economies, fundamentally the criticism is that companies get used to the short-term profits of efficiency innovation. In addition, instead of using those profits to invest in innovation businesses choose to re-invest further in the efficiency optimization practices in order to realize even more profit. The efficiency cycle repeats itself, until there’s no more efficiency to squeeze.

Disruptive Innovation

Disruptive innovation is similar to empowering innovation in the sense that disruptive innovation also ends with a new product or service offered on the market. However, the disruptive innovation theory distinguishes two types of innovation as particularly powerful: low-end disruptive innovation and new market disruptive innovation.

Low-End Disruptive Innovation

low-end disruptive innovation
Low-end disruptive innovation

Low-end disruptive innovation begins with offering low-cost products to over-served customers using a lower cost business model than established players. As the product improves over time through sustaining innovation, the product will eventually over-serve the initial customers. However, you’ll find that up-market there are now under-served customers with greater performance demands you can serve with the lower-cost business model.

A couple of clarifications are necessary.

The term “performance” refers to the specific offering level of the set of attributes or values offered by your product or service. The performance evaluation of a product is entirely dependent on the customer needs and desires. The better the value offered by your product matches the performance demanded from the customer, the less likely the customer will switch to a different solution.

The term “over-served” indicates that the performance demanded by the customer is lower than the value that is offered by the product. Thus, the customer is paying for things they don’t really need, and the customer may prefer a lower quality but cheaper solution.

Generally, fueled by rivalry and associated drive for sustaining innovation, the performance offered by the market increases at a much faster pace than the performance demands by the customer base. This causes companies to look for market segments that are willing to pay more for higher product performance. This is called going “up-market”.

Not only are the customers in this segment willing to pay more, generally the profit margins are also higher in the up-market segments. So, companies find it natural to dispose of their lower-margin business and prefer the higher-margin new customers. However, the more up-market you go, the more you find yourself catering to a niche market with niche demands.

The disruption takes place every time the low-cost business model enters a new market. The disrupting company is able to take on the incumbents thanks to the cost advantages inherent to its low-cost business model. It can repeat this every time it moves up-market as incumbents are usually slow to adapt to new business models.

Notice how the low-end disruption model appears cyclical in nature. As the low-cost business models improve the product performance and moves up-market it will eventually over-served certain customers. Those over-served customers will eventually be looking for cheaper alternatives. New low-cost disruptive businesses can then take their piece of the market.

New Market Disruptive Innovation

new market disruptive innovation
New market disruptive innovation

New market disruptive innovation focuses on under-served or non-served customers (non-consumption). Typically, this requires a low-cost business model combined with a new value chain as non-consumption performance demands are different from existing customers.

The term “performance” refers to the specific offering level of the set of attributes or values offered by your product or service. The performance evaluation of a product is entirely dependent on the customer needs and desires. The better the value offered by your product matches the performance demanded from the customer, the less likely the customer will switch to a different solution.

The term “under-served” indicates that the performance demanded by the customer is higher than the value that is offered by the product.

Often, this under-served market is interpreted as a low-end market segment with cheap customers. This is wrong. The customers in this segment are misunderstood as cheap because they are not willing to pay for the attributes offered by the company, regardless how low the price is. Their willingness to pay is low because they don’t value those specific attributes. They value different attributes; attributes which the company isn’t offering.

For an existing business to venture in new market disruption, it’s often required to establish an entirely new team separate from the current team. Everything is different: the customers, their needs, the profit-formula, the value and supply chain, the volumes, and so on.

Attributes and Values: Business Strategy Core

The core of each business strategy centers around identifying and addressing those attributes and values your customers care about most.

In the Strategic Blueprint for Business World Domination I outlined three fundamental questions for each business that wants to achieve sustainable growth. In this post we continue expanding on the opportunity question. When you figured out the raison d’etre of your business – the job to be done – and have carefully considered the business macro- and micro-environment, it’s time to move forward with the business strategy.

business strategy
Fundament of business

Business Strategy Definition

In a blog post I wrote one year ago I used the following definition of business strategy.

“Thus, we can propose the following definition: a business strategy defines the unique set of specific attributes the firm chooses to focus on aiming to achieve superior long-term return on invested capital.”

While the definition above still holds true, I’d like to expand on that definition and be more specific.

“A business strategy sets out to identify the existing and potential attributes or values of a product or service, choose those attributes and values your target customers are willing to pay for, and focus on achieving market-leading performance on those specific attributes and values.”

Notice there are four important aspects of the business strategy.

  1. Identification all the existing and potentially new attributes that your target customer may or may not care about
  2. Championing of those attributes you believe the customer values most and therefore is willing to pay for
  3. Satisfying those attributes your customer deems as a minimum requirement but isn’t necessarily willing to pay for
  4. Eliminating those attributes your customers don’t value at all

The identification process is rooted in the job-to-be-done analysis. The better you understand what your customer is trying to get done, the more specific you’ll be identifying the attributes. Note that we mention both the attributes your customers care and those they don’t care about as both are significant. In strategy formulation it’s important to not only know what you want to do but equally important to know what you don’t want to do.

Eventually you should have a list that comprises of three distinct types of attributes: the ones that you absolutely need to get right (champion), the ones you need to have (satisfy), and the ones you shouldn’t have (eliminate).

Categories of Attributes and Values

We can identify two broad categories of attributes and values and further segment into five distinct categories.

  • Functional Attributes
    • Attributes related to quality (how well does it get the job done?)
    • Attributes related to reliability (how long can it perform at the right quality?)
    • Attributes related to convenience (is it easy to acquire or hire?)
  • Emotional Attributes
    • Attributes related to personal needs or desires
  • Social Attributes
    • Attributes related to social needs or desires

Generally, the functional attributes are the most important to any product.

When thinking about attributes and values related to the business strategy formulation, it’s useful to link two related topics. First, the Blue Ocean Strategy and second the relationship between Value and Price in marketing strategy.

Blue Ocean Strategy

Blue Ocean

Blue Ocean Strategy is a business theory and published book written by W. Chan Kim and Renée Mauborgne, both professors at INSEAD. The theory asserts that business should systematically focus on unexplored new market areas (blue oceans) rather than endlessly compete in existing markets and industries (red oceans).

Red oceans are red because they feature cutthroat competition between companies targeting the same customers with similar products. The companies fight for market share by constantly trying to outperform their rivals. As more companies enter the market space, the prospects for profits and growth come under pressure. The cutthroat nature of the rivalry makes the market blood red.

Blue oceans are blue because they untainted by competition. They are in fact unexplored markets. The demand is created rather than competed over. Neither the total market size nor the profit formula is set in stone, meaning there’s plenty of room for growth and profit.

business attributes blue ocean value innovation

The cornerstone of Blue Ocean Strategy is Value Innovation. Value innovation is the simultaneous pursuit of differentiation and low cost, creating a leap in value for both buyers and the company. The point of value innovation is to make the competition irrelevant by reducing the total cost as well as increase the overall value. Cost savings can be achieved by eliminating and reducing the attributes an industry is currently competing on while value is lifted by creating attributes the industry has never offered.

This is very much aligned with the process outlined above. Cost savings are essentially a satisfying the identified attributes the customer doesn’t really care about but deems a minimum requirement. Satisfying doesn’t mean matching the industry standard, but in fact matching the customer expectation. Value lifting is championing the new potential attributes that the customer cares a lot about.

On the Blue Ocean Strategy website, you can find plenty of useful tools to help you explore the framework. One tool I find particularly useful is the Strategy Canvas which visually captures the difference between current market landscape and the future prospect of your business strategy.

Value and Price

In a blog post titled Value and Price Dynamic, I covered the dynamic between three distinct perspectives:

  1. The firm’s perspective on the value offered
  2. The customer’s perspective on the value perceived
  3. The firm’s perspective on the price

Whether a customer is willing to pay for your product or service depends on whether they believe to capture a significant amount of value. That value is the difference between the value perceived by the customer and the price to pay. The higher the customer incentive to purchase (CIP), the more likely the customer is to purchase.

From a company perspective, the goal is to maximize the value perceived while minimizing the cost. This can be achieved by following the process of Value Innovation as proposed in the Blue Ocean Strategy or by following the steps outlined earlier in the post.

  1. Identification of attributes will help you understand what the customer perceives as valuable and what they perceive as not valuable
  2. Championing attributes ensures that the customer will perceive your product as more valuable than competitor products as you offer the best performance
  3. Satisfying attributes ensures that the customer isn’t paying for things they don’t inherently find valuable while avoiding removing attributes they deem a necessity. These are crucial attributes because including them doesn’t add much value but excluding lowers the value significantly
  4. Eliminating attributes ensures that the value gap between the firm’s offered and customer’s perceived value is low, and reduces the overall cost

Economic Moat

As the business is increasingly proficient at identifying, championing, satisfying, and eliminating those attributes and values the customer cares and doesn’t care about, two things will happen. First, your product or service value proposition becomes increasingly unique in the marketplace and more difficult for competitors to copy. Second, you become increasingly more proficient at optimizing the total cost ownership of the specific set of attributes that makes your product unique. This makes it difficult for a competitor to copy your product with a lower cost.

With the right business strategy and the right execution, inevitably your business will develop inimitable sustained competitive advantages and economic moat.