What Makes a Business Great: Predictable Performance

This article is part of a series about What Makes a Business Great?

It is hard to overstate how unpredictable the future is. Precisely forecasting the performance of any business over an extended period of time is a fool’s errand. Even estimating a range for something like a company’s net income five years from now with any degree of accuracy is a daunting task.

But it is more reasonable to make such forecasts for some companies than it is for others. Some companies have certain characteristics that make their performance relatively predictable. The most important examples of those characteristics include:

Stable Market Demand. Few businesses can escape the ebbs and flows of the markets in which they operate. Businesses that operate in markets with relatively stable demand are inherently more predictable than those that operate in more volatile ones.

The nature of a market’s products or services always plays a primary role in determining the stability of the market’s demand. In consumer markets, goods enjoy more stable demand if they are necessities, non-durable or low-priced. Conversely, consumer goods that are discretionary, durable or high-priced tend to face more variable demand. In business-to-business markets, products or services used in customers’ everyday operations experience more stable demand than those associated with customers’ capital expenditures. Products with pronounced product cycles contribute to demand swings in both consumer and business-to-business markets.

Business-to-business markets are also affected by the stability of demand in downstream markets. Buyers that operate in – or sell into – cyclical markets can completely undermine the stability of a business-to-business market that might otherwise enjoy stable demand.

Recurring Revenue. Businesses have myriad different revenue models. Some of those models yield revenue that is inherently recurring in nature. A high degree of recurring revenue benefits the predictability of a business.

A few recurring revenue models are worth highlighting. The most predictable are revenue models based on long-term contracts, such as those for cellular phone service or some types of enterprise software. Next come models based on “connected” aftermarket revenue. In those models, an initial sale of a product drives a long tail of aftermarket revenue from related consumables, parts or services. Gillette’s razors and razor blades are the classic example. The parts and services that Rolls Royce sells to purchasers of its jet engines over the multi-decade useful lives of those engines are another. The useful life of the foremarket product and the strength of the connection between the aftermarket consumables, parts or services and the foremarket product influence the recurrence of the aftermarket revenue streams. Subscriptions, such as those to Netflix or a local gym, are a relatively recurring source of revenue as well. Short durations and flexible cancellation terms can work against the recurrence of subscription revenue though.

Long Product Cycles. The length of a business’s product cycle, whether driven by technology, fashion or something else, is like the speed of the treadmill the business is on. The shorter the product cycle, the faster the company needs to innovate just to stay in the same place. Product cycles are opportunities for companies to lose a step to competitors or simply misstep. The longer the cycles for a company’s products are, the more stable and predictable their competitive position is likely to be.

Diverse Sources of Demand. A business with diverse sources of demand benefits in much the same way that an investment portfolio with diverse security holdings does. Diversification lowers risk and improves predictability, albeit with diminishing returns. Sources of demand for a business vary across three primary dimensions: products/services, customers and geographies. Importantly, the benefits of diversification come not just from having numerous products, customers or geographies, but from having products, customers or geographies that are uncorrelated as sources of demand.

Limited Dependencies. Dependencies create the risk of sudden discontinuities in a business’s performance. Beyond customers, businesses can be dependent on suppliers, labor unions, certain raw materials, interest rates, regulators or legislative regimes, among other things. Dependencies may seem stable for extended periods of time, only to dramatically change without warning.

Flexible Operations. A business with flexible operations can rapidly adjust to changing market conditions. Variable costs are more beneficial in this respect than fixed costs. The degree to which fixed costs hinder a business’s flexibility depends on how large and how long-lived capacity increments are. Production lead times also affect a business’s flexibility. Businesses with long production lead times are inherently slower to react to changing market conditions than those with short ones. Industries populated by firms with inflexible operations can be prone to pronounced cyclicality even outside the economic cycle.

High Profit Margins. Profit margins that are high in an absolute sense contribute to predictable performance by dampening the impact of absolute changes in margins. A decline in margins of a given amount, say 200 basis points, leads to a much greater percentage change in the profits of a business with a 5.0% operating margin than in the profits of a business with a 30.0% operating margin.

Conservative Financing. Financing obligations, such as debt, affect the predictability of a business in two ways. They magnify swings in earnings and increase the risk of liquidity shortfalls. The composition of financing that is conservative will vary from one business to the next. A predictable business can conservatively support a higher level of debt than an unpredictable one. A conservatively financed company should have essentially no risk of a liquidity shortfall, even during a period of financial market stress.

It is rare for a business to have all or even most of these characteristics. More commonly, these characteristics will offset each other to some degree, often by design. For example, it is common to see companies with inflexible cost structures, such as wireless carriers and commercial real estate owners, lock-up customers with long-term contracts. The predictability of any business needs to be evaluated holistically.

Predictable performance is desirable because it lowers the total risk of a business. A truly great business shines not just on the return side of the ledger, but also on the risk side. Great businesses have some combination of these or other characteristics that on balance allows them to deliver relatively predictable performance and achieve a lower-than-average level of total risk.

Conclusion

All businesses are not created equal when it comes to predictability. Certain characteristics, such a stable market demand, recurring revenue, long product cycles, diverse sources of demand, limited dependencies, flexible operations, high profit margins and conservative financing, bolster a business’s predictability. The more predictable a business is, the lower the total risk of that business will be. Great businesses deliver relatively predictable performance. They not only generate superior returns, but also offer a lower-than-average level of risk.

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