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Investing in the Right Kind of Business

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

“A horse that can count to ten is a remarkable horse—not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company—but not a remarkable business.

Warren Buffett (1985)

The above quote from Warren Buffett can be a valuable lesson for investors; even the best company can be a lousy investment when it’s operating in a declining industry. For this reason, a truly great company is the one which adapts to changing industry dynamics and business conditions.

A Tale of Two Tech Stocks

IBM (NYSE: IBM) is a great example about the importance of flexibility and ability to change. In 1993 the company posted what at the time was the biggest loss in the history of corporate America: $8 billion. Management realized then that the hardware business was being rapidly commoditized, and it needed to shift its portfolio towards software and services.

Not only did the company invest heavily in the right direction, it had to divest in businesses like memory chips, technology components, printers, displays and personal computers. These kinds of decisions can be hard to make, but the long term consequences of failing to adapt can be even harder. Investors in Hewlett-Packard (NYSE: HPQ) understand this painfully well.

It took too long for HP to try a change of strategy, and the decisions taken in times of desperation have been no solution for the company's problems. HP has made a series of acquisitions in different companies without any clear strategic direction over the last years, and the result has been a disastrous destruction of value for the company and its shareholders.

The chart illustrates the difference in earnings per share for IBM versus HP since 1992, and the difference has been astonishing. When it comes to future perspectives, there is really no sign of a turnaround in the future of these two companies. IBM is one of the most innovative and financially solid companies in the tech industry, while HP is fighting for its survival in an increasingly hostile environment.

The Really Great Companies

Adapting to changing conditions is very important, and that's why McDonald's (NYSE: MCD) will be fine in the long term in spite of falling same store sales lately. Changing consumer habits towards healthier alternatives and increased competition from fast casual restaurants are serious challenges for the fast food giant. But the company is responding with revamped stores, healthy food choices, premium products and even new product categories like its successful McCafé business.

McDonald's still owns the most recognizable brand in the industry, and the company has stores in many of the most valuable locations around the planet. As long as the company keeps working to improve its offerings and adapting as well as possible to changing customer’s demands, the current weakness should be nothing but a temporary problem.

When it comes to change, there are good companies like IBM or McDonald’s and there are bad companies like HP. But there are also some exceptional companies like Starbucks (NASDAQ: SBUX) which is always trying to stay ahead of the curve.

Starbucks has recently acquired tea retailer Teavana (NYSE: TEA) for $620 million in a move to increase its presence in the tea business. The move comes after the acquisition of juice company Evolution Fresh in November of 2011 and the purchase of Bay Bread, and its La Boulange-branded cafes, for $100 million in June of this year.

Starbucks has been doing great in the coffee business, so these acquisitions are not reactive, but clearly proactive. The company is running the risk of biting off more than it can chew, as these new purchases can be a distraction for management and generate all kinds of complications. On the other hand, Starbucks is creating the future instead of adapting to it.

Tea is not as popular as coffee in the US, but the company has ambitious expansionary plans in countries like China and India, where putting more focus on tea seems like a very convenient idea. Just like Starbucks changed consumer tastes by successfully introducing all kinds of sophisticated coffee offerings, there is no reason to believe it can't benefit from innovating in other product categories like tea, juice or food offerings.

McDonald's will always depend on hamburgers, and coffee will always be a big product for Starbucks. But the company didn't wait for changing industry dynamics before introducing new product categories; Starbucks is anticipating and creating that changing demand, which is a much healthier and proactive approach to change.

Bottom Line

If change is the only constant in life and in business, companies need to adapt to fluctuating conditions if they are going to survive and add value to shareholders in the long term. When analyzing the next investment idea, it may be wise to closely watch management's attitude towards change and transformation.

 


acardenal owns shares of IBM. The Motley Fool owns shares of International Business Machines, McDonald's, Starbucks, and Teavana Holdings and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend International Business Machines, McDonald's, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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