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The Economic Analysis of Stocks: Sigma Design

June 4th, 2008 · No Comments

In this short analysis, one concept plays a key role, core capabilities. Sigma Design, the stock we’ve been covering is in trouble, and this concept could offer a way out. Luckily, management seems to have some understanding of it, and we have to delf into a little economics of knowledge to make things clear (hopefully). 

The concept of ‘core capability’ was introduced by Prahalad and Hamel in the book Competing for the Future, which was a runnaway success in the early 1990s. Actually, the book rose out of a couple of earlier articles that were published in the Harvard Business Review.

In fact, the way of thinking comes organically comes out of the so called resource based view of the company, an approach that emerged in the 1980s that argued that the strategy process got it exactly wrong until then. Instead of analysing the industry or markets, strategy has to start from the companies strengths, it’s resources and capabilities.

The core capability idea can be seen as a popularisation of that resource based view of the company, and the idea is actually relatively simple. In it’s broadest sense, a capability is something that a company can do, at which it excells. A core capability is therefore someting that the company excells at and which is central to its functioning, it’s competitive position.

If this sounds abstract, let me give an example. One of Sony’s core capabilities would be its ability to make products really small, miniaturization. Now, by describing this, it will become immediately obvious that this capability is applicable in more than one product.

Sony not only excels in making very small, but yet fully functional laptops (the TZ series come to mind), but it is good at making many electronic products very tiny. Ideally, a core capability is applicable to more than one product or process.

This is extremely important, because according to Prahalad and Hamel there are twin forces at work ensuring that developing new products becomes ever more expensive.
∙    with increasing complexity and the advancement of science and technology, developing products becomes increasingly expensive
∙    worse, product life-cycles have generally shortened considerably.

Now, core capabililities that are leveragable over more than one product offer a way out of these pincer forces. You just apply the core capabilities to a stream of products. Or these do not even have to be end products, they could be components.

Components can even be sold to competitors, something which happens very frequently (you might be surprised). Examples abound. When Sony’s batteries malfunction, it’s not only them that have to recall a lot of laptops. It was also Apple.

Core capabilities are nothing else than collective tacit knowledge. English management guru John Kay compared collective knowledge to several people each having a couple of digits of a code to a safe. Only by working together are they able to open it.

The concept of tacit knowledge,  introduced by Michael Polanyi, refers to the phenomenon that we “know more than we can say” (in the famous words of Polanyi himself). It’s hard to explain how to ride a bike. It’s know how, but it’s near impossible to articulate.

A good analogy for collective tacit knowledge is that of a football team. When players play together for a long time, they develop routines, they know what to do when another player does something specific, but this is hard to explain for anyone involved (apart from Cruyff, of course).

These kind of routines play an extremely important role in business organizations as well. By performing collective tasks together, a team will perfect coordination without the necessity for much verbal communication, speeding things up.

Doing this over and over again, they will become better. This is behind the phenomenon called ‘economies of learning’. That concept grew out of a simple observation, efficiency seemed to be related to accumulated output. With the surge in interest in ‘the economics of knowledge’, the knowledge based organization, and similar concepts, we now know why.

It explains why similar organizations, with similar (or even exactly the same) machines, might have wildly different efficiency rates. Polanyi described two identical light bulb factories, one in Germany, the other in his home country Hungary.

The factory in Germany produced flawless light bulbs at lightening speed, while the Hungarian factory wasn’t able to produce a single working bulb in a year. This is a dramatic example, but it shows the importance of knowledge, especially the tacit collective knowledge that infuses routines, which are the backbones of the capabilities of a firm.

Now, if it is possible to apply these core capabilities to different products, we have a winner. Knowledge can multiply, and components and products can be infused with knowledge that is very hard for competitors to replicate.

Because that’s a crucial advantage of tacit knowledge, it cannot be made explicit, so it is hard for the competition to get hold off. They have to reproduce it themselves. Compare that to explicit knowledge, which is knowledge that can be articulated, like a recipe.

Once the recipe (say, for Coca Cola) is out, anyone can make it. They might not be as efficient as Coke itself (there might be a tacit part to it, just like I will never be able to reproduce the food of a masterchef, even if he gave me the recipes), but it will come pretty close.

Now, back to Sigma (sorry for the suspension). They specialize in design, and we’ve commented earlier that we liked the idea of a fabless chip producer. It’s because they can concentrate on their core capabilities, involving designs for chips used in multimedia stuff.

This knowledge is leveragable, and hard to get for competitors. Leveragable to different products, or different versions of the same products. Now, Sigma might be in trouble because their two main markets (IPTV and Blue ray) seem to have some teething problems, but we know two things; these markets will take-off some time in the near future, and Sigma has a head start.

And, the company is actually focusing on leveraging their core competencies. Probably not anytime real soon, but we have a feeling that this company will be back.

Tags: Economics of stock analysis