I consider myself a pretty rational investor. I mostly
look for value stocks, companies trading cheaply with a
history of success. However, I do like to take risks -- I
just make sure the risks are weighed in my favor.
Can we all be geniuses?
I admit it -- sometimes I have delusionary thoughts of
myself as Matt Damon in 1997's
Good Will Hunting. As I'm
casually impressing women with my thoughts on the evolution
of market economies and the capital-forming effects of
military mobilization, my friend turns to a nearby female and
says in the heaviest of Boston accents, “My
boy's wicked smart.†And of
course on top of that, I'm self-taught in
algebraic graph theory and high finite mathematics.
But let's get serious -- that
ain't happening for me, and I certainly
can't promise you mathematical genius. But
I can show you how the simple tenets of game theory have
continually helped companies strategize for success, and how
you can use those same doctrines
to make astounding stock picks.Â
Game theory
When applied to business, game theory shows how
companies can benefit from focusing not just on themselves,
but on others. It urges management to
look forward, and then reason backward. It promotes
cooperation, not just competition.
As Adam Brandenburger and Barry Nalebuff write in
Harvard Business Review, "successful business
strategy is about actively shaping the game you play, not
just playing the game that you find."
When applied to investing, game theory helps you
distinguish between the two types of companies out there:
those that are breaking the rules, and those that are just
playing by them. Let's focus on three
methods companies can use to reshape the game in their
favor:
Game-changers of the past
Here are three companies that have used these tactics
very successfully:
Changing the players : Thanks to
NutraSweet's household-name status in
the 1980s,
Coca-Cola (NYSE: KO) used the low-calorie
sweetener exclusively in its products. As
NutraSweet's patent was due to run out
in 1987, Coke urged the Holland Sweetener Company (HSC) to
enter the market. After HSC built a sweetener plant,
NutraSweet's manufacturer announced deep
price cuts, and Coke signed long-term contracts with
NutraSweet that all but put the smackdown on any future for
the Dutch company. Didn't Coke want
another possible supplier? Nope. What they wanted was
NutraSweet -- the brand consumers were familiar with -- at
a lower price. Coke advocated a new entrant only to act as
a threat to NutraSweet, and the result was an estimated
savings of $200 million annually for Coke and
PepsiCo .
Changing the added value : In 1985, video
game maker extraordinaire
Nintendo swiftly became popular in the U.S.
with the introduction of
Super Mario Bros.However, the
game's value to Nintendo was limited
because it couldn't compete with the
buying power of the mega-retailers it sold to, like
Wal-Mart (NYSE: WMT) and Toys
R' Us. So in 1988, Nintendo sold 33
million cartridges, even though the market could have
easily soaked up 45 million. Nintendo-mania consumed kids
across America, and angry parents waiting in line began
cursing the ill-equipped retailers. With games now in short
supply, Nintendo was able to add extra value to its
products, shifting the power structure dramatically.
Changing the rules : As of late 2007, the
average U.S. company spent 4.5% of its revenue on R&D
-- and even though most companies continue to internalize
R&D and spend boatloads of cash every year, one company
decided to play by its own rules. In 2006,
Netflix (Nasdaq: NFLX) offered a $1 million
prize to anyone who could improve the accuracy of its movie
recommendations by 10% or more. For a paltry $1 million,
the company is due to reap huge rewards both operationally
and from media attention. Already, the company has
announced a Netflix Prize 2, with more money and some
“new
twists.†Rules for R&D --
what rules?
Not coincidentally, each of these companies has crushed
the market over those respective time frames:
Â
Company
Average Annual ReturnÂ
S&P 500 Return Over Same Time Period
Coca-Cola
11.6%*
7.7%
Nintendo
5.5%**
(2.7%) Continued... |