Guru: Built for Destruction

CM: Looking back at your book from 1986 titled Innovation: The Attacker's Advantage, I couldn't help but think that the third chapter sounded familiar.

FOSTER: You mean "The Innovator's Paradox"?

CM: Yes.

FOSTER: Yes, well, Clay Christensen's book, The Innovator's Dilemma, published in 1997, picked up on the observations that periods of technological discontinuity are the time periods in which changes in competitive leadership occur. This observation led naturally to the question about, "Well, who does make it in the long term?"

CM: And your answer to that question is companies that adopt creative destruction.

FOSTER: Yes. Creative destruction is the core process of the capitalist system. It's actually a couple of processes. The first is the emergence of corporations and the conditions under which that happens, and the second is the extinction of corporations and the conditions under which that happens. And the balance between emergence, extinction, and performance of the corporations is what Schumpeter talked about when he coined the phrase "gales of creative destruction" back in the '30s. In Schumpert's view, creative destruction was the most important process of the economy. And by implication, he was talking about the capitalist economy.

And Schumpeter said at the time — and it's quoted in the book as well — that the measure of a society is not how well it administers its institutions, but how well it creates and destroys them. I think we've seen that in spades in the past 20 or 30 years in the United States. One of the characteristics that distinguishes the U.S. from other economies is the pace and scale of creative destruction.

CM: In your first book, you described a sort of ensemble of a hundred attackers, where the first 35 get crushed by a competitive response …

FOSTER: They throw them up on the beach. Because these guys didn't have enough financial resources, they couldn't keep pace with development. Think about EMI — the first CAT scanner came out of that company we now we think of as the Beatles' music company.  But they just couldn't maintain the pace of development when compared to GE and Philips and Toshiba and all of those. So those guys fail.

There's another 35% that fail because they enter too late. They wanted to be risk-avoiders. So they wanted to be sure the change was real. And by the time they came in, all the positions were locked out, so they couldn't get in, so they fail.

The remaining 30 companies are contenders. Out of those, 80% can't make it because they can't figure out how to implement. They can't take their grand designs and really pull it off. So that's 80% of 30%, so that's 24%. The remaining 6% make it.

That was based on historical evidence. If you go back and look at railroads, the automobiles, coming of power, the chemical companies — the numbers are surprisingly consistent over the years. There were, I think, about 2,000 automobile companies in the world that formed in the first 20 years of the automobile industry. It's not wildly different from today, actually.

The thing about the Internet revolution that is, I think, surprising to many people is how similar it is to the revolution in railroads and the revolution in electric power and the revolution in automobiles and the revolutions in airplanes and aircrafts, airline companies, and all those.

CM: Do you think that first 35% of the Internet attackers have already been left on the beach? How far into the attackers are we?

FOSTER: Well, I'd say we're certainly at a new stage of seriousness. I notice that applications at Stanford Business School seem to have rocketed up this year, somehow or other. And probably most business schools saw a similar rise.

I think we are at least through the first third of the Internet revolution.  If you think about the Internet as a 30-year exercise — which may not be a bad way of thinking about it — it's not hard to imagine that we've been through the first 10 years of that, right now. And we're going to go into the second 10 years.

CM: In light of the collapse of so many dot-com businesses, are corporations likely to abandon some of their transformation strategies?

FOSTER: The trends discussed in "Creative Destruction" are very long-term trends. You'd have to believe that some of the most fundamental forces that are ongoing in the United States are being reversed at this very moment for it to make sense to abandon a transformation strategy. I just don't believe it. Corporations who don't transform themselves will suffer their fate in the markets. And they will, in the long term, start to underperform, and, eventually, they will be bought out and they will go away. They will be replaced on the S&P 500, and new companies will come along.

CM: What impact will the loss of liquidity have on the creative destruction?

FOSTER: Well, we've taken five trillion dollars of liquidity out of the market in the last year. That's a pretty good start. Even today with all of the horrible things that are going on, we're back to where we were halfway through '98 or something like that. This is not yet as bad as '73, '74.

And, by the way, the peak was really in 1998, not March 2000 as many think. The number of advances versus declines in the stock market actually peaked in '98. And in '99 — the median S&P 500 return was four-tenths of one percent. The mean was much higher, but the median may be a more representative figure.

I think it is likely that  we're in a negative bubble now, in my judgment. And this bubble, too, will go away. And then we'll be back in a period of more normal returns.

But we'll have a revised competitive set. There are a lot of companies that won't be there in a couple of years, and there will be some new starter companies coming along. And the companies like Enron and Corning who understand these things at a deep level will be making use of the most advanced technologies to lower the cost of doing their transactions with their suppliers and their customers, and life will go on.

So, I really believe that the messages of creative destruction are fundamental. They're enduring, they will endure. And they're important for American companies and presumably for other companies as well.

CM: Are those alliances likely to remain intact? And are VCs — are they likely to help these corporations discover some of this new traction in areas? Is that sort of a likely …

FOSTER: Well, you know that the venture-capital industry has been crucial to this whole process of creation. Just as the leverage buyout industry has been crucial for improving the processes of transforming these companies or eliminating those that really aren't very effective. And the VC industry and leverage buyout industry will stay intact. The VC industry, like any other industry, has its stronger and weaker players. The weaker players will undoubtedly have extraordinary challenges over the next couple of years. The stronger players will be fine. It's a business that got started in the '30s with Venrock, and has been around ever since. And has been creating great companies in waves since the '30s.

CM: One of the companies in the book is J&J. And we'd love to hear just some thoughts about all of what you believe has happened with this company — as it relates to creative destruction.

FOSTER: J&J is almost a perfect model of a company that has taken the notion of creative destruction inside, and you can see that by the number of acquisitions that they make. You can see that in the number of divestitures that they make, which is very high compared to the U.S. average. And an example of the creative destruction is J&J's entry into laparoscopy.

J&J in the '80s entered a line of mechanical sutures to sew up surgical wounds that was in direct competition to its own suture business. So, they don't really have a major fear of cannibalization. They understand that these things are going to go on in the marketplace and they are doing all they can to bring the marketplace into the corporation.

CM: What are the characteristics of leadership you believe most likely to leverage creative destructions?

FOSTER: Well, I'll go back to J&J and to Robert Wood Johnson, who said in 1959, "Intellectual stagnation is the great problem of large organizations. It's paramount to increase fertility in the field of ideas. The greatest responsibility of modern management is to develop the human intellect in order that it may express its talent. The greatest mistake of all corporate leaders is not to be able to utilize the talent in the corporation." It is the supreme testimony to great leadership that it's able to identify that talent and let it express its talent. And this confidence in the collective creativity and good sense of the organization, I think, is a prerequisite. This is one of J&J's key strengths, the ability to find and utilize the talent of the corporation.

Second, it's the determination not to fall into the trap of focusing on operational excellence alone. The mistake is confusing the central importance of having the best operations in the world under good, solid, control systems with the reality that that alone will not be enough to ensure superior performance for investors. Other companies are finding new ways to compete, and if you can't change, you'll never discover your own.