“No one has a crystal ball,” some say.

When it comes to business-related predictions, I believe that everyone has some form of crystal ball but some are more careful than others in selecting the glasses they wear to look into the ball. It is challenging to assess a business’s future value based on its past or even present performance. Even those closest to a business’s operations—its leadership team—may be well off the mark in predicting the future.

Take giant retail club Costco Wholesale Corp. (COST), for example. Early on, when Jim Sinegal and his founding partners tried to project the business’s potential, they “aggressively” pictured a total of 12 stores, with a stretch goal of $1 billion in revenue. That’s less than 1% of Costco’s annual sales today.

What Sinegal and colleagues lacked in the prediction department, they more than made up for in the execution domain. Over recent decades, as competitive threats grew dramatically in their retail space, Costco’s leadership team has continually reinvented the business, adding offerings in food (such as meat, fresh fruits, fish, bakery goods and alcohol), jewelry, pharmacy, gasoline and many other areas—while maintaining the low prices and substantial profits that have made Costco a high-value investment. Thanks to its strong leadership, Costco’s stock value rose an estimated 5,000% between 1985 and Sinegal’s retirement at the end of 2012.

The point of this article is that amidst the many signs and signals investors face in decision-making, the ability of a company’s leaders to handle major setbacks and truly existential crises (those that threaten a firm’s very existence) is particularly valuable to examine. Specifically, can they reinvent the business in the face of these value-destroying circumstances? By understanding the real problems a business faces and the feasibility of the solutions it embraces, smart investors can learn to look for signs of reinvention that others may miss. Likewise, investors need to understand whether the firm’s leaders can identify and capture opportunities without which their business’s full potential can’t be realized, assuring that they will be left behind.

I will illustrate this idea using several case examples from my book “Invent, Reinvent, Thrive” (McGraw-Hill, 2014).

Setbacks and Comebacks

New mergers and acquisitions stumble. New products fizzle. New leaders languish. There is no shortage of setbacks a business at any stage can face. The question is how well those in charge can field any challenges that arise. Not surprisingly, major setbacks are particularly likely when there is an ownership or leadership transition, especially if coupled with market shifts. In some cases, a return to the original leaders proves the most value-generating recourse—as long as the leaders can harness effective vision, values and strategy to reinvent the company, often based on their original ideals. This was the case for household-name companies Charles Schwab Corp. (SCHW) and Starbucks Corp. (SBUX).

Charles Schwab Corp.

Chuck Schwab was a business pioneer, one who disrupted the investment industry profoundly by forming Charles Schwab & Co. Inc. in the mid-1970s. Starting from a small room lit by a single light bulb, Schwab took on decades-old brokerage practices regarding cartel-based commissions, complex and redundant record systems, and other entrenched features. He attracted customers from Silicon Valley, media coverage that led to national exposure, and buzz from a growing number of the curious, building a much more affordable, transparent, free-market brokerage system that still holds today.

Having grown Schwab dramatically, Chuck sold to Bank of America (BAC), aka BofA, in 1983 for about $55 million. That meant new challenges, including having to introduce novel products such as mutual fund shares on a large scale. Growing Schwab proved difficult in the face of BofA’s large international loan losses and strict bank-regulation restrictions, both of which made it challenging for BofA to fulfill obligations to fund Schwab, despite Schwab having nothing to do with its parent firm’s problems. Seeing his former company facing these pressures, Chuck bought back the firm in 1987 for $280 million. Under his guidance, the Schwab firm grew, especially as fueled by the dot-com boom in the late 1990s.

But alongside that growth came mounting competition and more efficient technologies. “Our uniqueness, to some degree, became not so unique,” Chuck told me. In fact, after Chuck left the firm in the hands of his former co-CEO, Schwab’s commissions rose above market rates, going against everything the company had stood for. Chuck was well aware of this irony, one that I likened to Pogo’s lament: “We have met the enemy, and he is us.”

In 2004, as the company faltered, the board asked Chuck to return as CEO. He recalled the challenges he faced: “We were spending money like drunken sailors, based upon a commission level that was artificially high and coming down very quickly. [We had] unnecessary services that we were trying to offer, that weren’t very well structured. We had huge costs and expansion. All that had to come down. . . . [We] had too many executive vice presidents, with huge infrastructure and people costs below them, too big a structure, and that all had to be revamped.”

Through strategic reductions in labor (including difficult layoffs) and other costs, Chuck was able to make Schwab competitive again. As the founder, he had the necessary vision and strategy to rebuild the firm, where most other leaders would have struggled. Central to this was his customer focus. “It is really so critical when you get in a stressful situation, that you go back to the basics, to the fundamental value system that is baked in and from which you don’t deviate,” he said. Chuck’s ability to reinvent his namesake company—twice—helped Schwab gross $4.88 billion in 2012, with a pretax profit margin of 29.7%, a strong investment by any measure.

Smart investors observing Schwab early in this millennium would have understood that its prospects would be challenged as competition grew. Customers had many more brokerage options than in the past, including new ones more affordable than Schwab’s offering; it was very unlikely that all the new competitors would fail. Moreover, Schwab’s new position in the more crowded field went directly against Chuck’s original intent of providing more affordable, transparent brokerage. Taking the customers’ point of view would have led savvy investors to bet against Schwab. For those whose homework included studying the company’s history, it might have been clear that the founder’s return heralded a return to the firm’s original vision and values.

Starbucks Corp.

Howard Schultz, like Chuck Schwab, saw the need for change. Fueled by his vision of serving Americans premium coffee in a comfortable, club-like venue, Schultz built Starbucks into the ubiquitous coffeehouse it is today, despite early naysaying from prospective investors and others.

Schultz had a great vision, but stumbled at explaining it to early potential investors. He showed investors the equivalent of a 1,000-piece jigsaw puzzle, but not the picture on the jigsaw-puzzle box cover (that is, his vision). After a highly successful initial public offering (IPO) in 1992, Starbucks continued growing. Eight years later, Schultz was succeeded as CEO by longtime Starbucks executive Orin Smith, who himself was succeeded by Jim Donald in 2005. Donald did as instructed by the board and opened thousands of additional stores, especially overseas.

Despite being the board’s leader, Schultz was concerned that the expansion was changing the company. He wrote a 2007 internal memo to Starbucks’ leadership, subsequently leaked to the press, lamenting the “commoditization” of the Starbucks experience, such that stores no longer had the “soul” they once did. By 2008, Schultz was even more concerned, as financial markets declined.

Most thought that Starbucks’ revenue decline was caused by the tightening of consumers’ financial belts. That concern seemed warranted: Competitors like McDonald’s Corp. (MCD) and Dunkin’ Brands Group (DNKN) offered much cheaper alternatives, which they advertised in a way that strengthened everyone’s belief that the economy caused Starbucks’ problems. It was a “tremendous crisis,” Schultz recalled.

Stepping back in as CEO, Schultz visited stores, diagnosed problems and made changes, such as closing 500 stores, discarding automatic brewing machines and closing all the stores for one day in February 2008 to retrain all baristas. In my book, I explain how Schultz “reinvented Starbucks to regain the spirit (and the soul) he originally had breathed into Starbucks and to make it what it had been before.” By 2012, Starbucks had 20,891 stores in 62 countries. More importantly from investors’ perspectives, a $100,000 investment in Starbucks’ IPO would have been worth nearly $10.4 million 20 years later, an almost unbeatable 26% annual return.

How could an investor in a public company such as Starbucks know whether its problems in 2008 were due to the recession, which could have been devastating and possibly beyond Schultz’s control, or due to the changes Schultz observed? Many indicators seemed to suggest price was the critical factor, as customers struggled to pay Starbucks’ premium prices during the downturn and players like McDonald’s offered cheaper alternatives, as noted above. Moreover, given Securities and Exchange Commission (SEC) constraints on publishing information, the needed facts might have seemed beyond reach.

Actually, the key was in the public domain: Schultz’s leaked memo, which was covered extensively in the press. While no one linked the memo directly to the firm’s downturn, an investor who had done her homework and really learned about Starbucks past and present might have understood what Schultz actually meant when he said the stores had lost their soul. Many thought he meant this in a less actionable way, specifically that growth and resulting size were incompatible with the company’s original style. Actually, he was referring to the loss of the essence of the business: its purpose, values and culture, or things that he could help restore with strategic changes. Again, a smart investor could have then confirmed what Schultz meant with store visits to see and feel what was missing. After all, even Schultz needed such visits to spot the problem. While the investor still wouldn’t know whether Schultz could restore his firm’s soul, she could have made a more educated guess when Schultz closed all stores in February 2008. That month, Starbucks stock was selling for under $20 per share, compared to over $80 per share as of this writing (early December 2014)—a good investment by any measure.

Schwab and Starbucks, both of which faced serious setbacks, are not unique. Multiple once-great brands and businesses quickly reverse course, prompting some investors to believe the companies were akin to fads, riding a short-term wave of popularity or opportunity, or crashing onto the shore of a new economic environment that can’t sustain them. But that may be a short-sighted view, as the examples above suggest.

At Schwab and Starbucks, the founders were able to return and re-inject key elements of company spirit, principles and practices that had been lost amid a leadership transition and difficult market environment. Chuck Schwab and Howard Schultz enabled high-value, sustainable comebacks by reinventing their companies in line with their vision and values. Investors who studied the firms and their market environments carefully, as described above, along with maintaining faith in the original visionaries’ ability to reinvent, would have reaped large rewards from betting on Schwab and Starbucks as the businesses found their way back to profitable growth.

Table 1. Characteristics of Successful and Unsuccesful Corporate Reinventions

Existential Challenges and Reinvention

Schwab and Starbucks faltered under industrial challenges before their original leaders helped right the ship through reinvention. But while those challenges may be seen as setbacks, other firms faced truly existential crises that had the potential to make their product lines effectively worthless, unless their leaders could reinvent in meaningful ways. Two very different examples from the broad technology sector illustrate how opportunities for reinvention in the face of existential industrial challenges can be missed altogether or exploited for maximum value.

Eastman Kodak Co.

For decades, Eastman Kodak (KODK) was synonymous with photography, bringing the world the concept of the “Kodak Moment” though affordable products for an average family to capture their most cherished memories on film. Profits poured in from sales of cameras, film, and film processing to consumers and businesses alike, and Kodak was able to ward off the few competitors it faced through the brute force of its outsized market share and loyal distribution channels.

The company also made small technology improvements and priced aggressively when necessary, such as when Polaroid sought to expand its share. Similarly, when upstart Japanese rival Fuji (FUJIY) rose in the early 1990s, Kodak brought in former Motorola (MSI) CEO George Fisher, who locked up the China market for the U.S. firm, thwarting Fuji. But when Fisher tried to trim the fat at Kodak, he met deep resistance built on decades of complacency.

In general, too many years of “easy” success had stunted Kodak’s ability to think innovatively, whether in regard to internal efficiencies, new products, or rising competition. The business relied excessively on its film processing, blinding it to other opportunities. Ironically, in 1975 a Kodak engineer created and patented digital photography—the product that ultimately proved Kodak’s downfall—but the company did nothing to capitalize on it.

As I wrote in my book, as the photography industry went digital, Kodak was “blindsided by cataclysmic change and became the poster child for Schumpeter’s creative destruction theory,” a victim of widespread shifts in technology and consumer tastes. While the idea of digital film was understandably daunting for Kodak, which made most of its profits from film processing, in retrospect it would have been best off capitalizing on the new invention before others did. Again as I wrote in my book: It’s “better to move profit from one pocket to another before someone picks your pocket.” So Kodak’s demise was arguably self-inflicted.

It’s unclear why Kodak hid its digital photography invention, whether the product of arrogance or low confidence. But it’s clear that the company’s many missteps added up to massive failure—for the firm and its investors. By betting the future on the past, Kodak couldn’t see beyond itself and lost any prospects for reinvention and growth.

Savvy investors would have seen signs of this downfall in the firm’s hidebound culture, resistance to changes (including those suggested by George Fisher) and helplessness in the face of new technology. Specifically, they would have understood that Kodak had shifted from delivering highly affordable products and services to meet consumer needs and tastes to merely protecting the massive income it generated from traditional film products and film processing.

As digital photo products—which required no processing for most consumers—rose in popularity, Kodak faced an increasingly certain demise. In fact, a truly diligent investor might have checked U.S. patent records and found that Kodak actually held a digital-camera patent. That would have solidified the perception of the company as one truly unable to reinvent. That inability, especially in the face of industrial change, usually signals an unsustainable business model and poor investment.

Intel Corp.

Technology innovator Intel Corp. (INTC) offers a very different example of reinvention—a positive one. Launched in California’s Bay Area, Intel could easily have been another Kodak story: It grew dramatically on sales of its core computer memory chip product, only to face massive competition from low-cost manufacturers.

But unlike executives at the failed film company, Intel’s co-founders Andy Grove, Bob Noyce, and Gordon Moore addressed the challenge head on, as described in my book: “Intel’s old stalwart memory chip was becoming a commodity. Prices were starting to swoon in reflection of fierce competition, largely from the Far East. Intel might have continued to compete in memory chips. However, Intel’s founders, who still managed the company, saw the writing on the wall and were too smart to ignore the coming cataclysm. They decided that Intel would instead start over as a manufacturer of microprocessors. They wisely followed an old Yiddish proverb: ‘You can’t control the wind, but you can adjust your sails.’”

Intel’s founders recognized the need for reinvention before it was too late, and saw opportunity in remaking the firm as a manufacturer of microchips, such as those found in wireless phones, digital music-players, and countless other electronics. Because Intel was in strong financial condition and a market leader at the time of the reinvention, Grove and his co-founders faced a major challenge convincing the firm and its shareholders of the dramatic shift. They were able to do this by presenting sound evidence of the industrial challenges the company faced—so it wasn’t a crystal ball that saved Intel, but sound business insights and strategy on the part of its leaders. As I noted in my book, they knew the “status quo was a death march.”

Thanks to its leadership’s foresight and implementation skills, Intel is now the world’s largest (based on revenue) and highest-valued chipmaker. Again, investors would have done well to pay close attention to the thinking and actions of the executives, this time a group that addressed industrial challenges impeccably.

At the time, anyone could have observed the rapid commoditization of memory chips, Intel’s original flagship product. The bigger question was whether Intel could pull off a complete reinvention of its business model. This might have been harder for the average investor to gauge, given that Intel doesn’t make consumer products, unlike the other companies discussed here. Still, faith in Intel’s leadership likely led shrewd investors to bet on the company’s future.

Of note, Intel faces new industry challenges today as consumers move from personal computers and laptops to tablets and mobile devices, many of which are powered by Quark chips made by Intel’s competitors. The firm’s leaders will be tested once again in facing these issues, and investors should keep a close eye on their moves and rationales.

Invest in Reinvention

While there’s no such thing as a perfect crystal ball, smart investors can pay careful attention to a key factor to predict a firm’s financial future: its ability to reinvent. Whether carried by Chuck Schwab’s deep commitment to customer focus, Howard Schultz’s understanding of Starbucks’ departure from his original vision, or Andy Grove and his co-founders’ foresight in the face of major industrial shifts, the ability of leaders to reinvent is crucial to generating value for their businesses and shareholders.

In contrast, a company’s inability to reinvent often means major losses in profits and stock value, as illustrated by Kodak’s story. The secondary challenge is timing an investment well: Here, too, clear signs of reinvention can be important guideposts, such as the day Schultz closed all Starbucks stores to retrain baristas. This can be a bit easier to gauge for consumer-focused businesses.

In short, learning to assess management’s reinvention skills is paramount to making the right investments in the short and long term. The key is identifying those who can transform setbacks into comebacks and existential crises into unprecedented opportunities.

Related

Value Investing

Investment Wisdom From Wall Street’s Legends

Related

Stock Strategies

Insights on Warren Buffett From His Friend and Editor

Related

Stock Strategies

What You Can Learn From Shareholder Letters