Archive for November 4th, 2008

The adoption curve (The Financial Athlete #66)

November 4, 2008

It is not uncommon now for parents to pay for private lessons of golf and tennis for their preschool kids. Some do this in hopes their kid gains a head start toward a professional career in sports. These parents inadvertently deprive their kids of childhood. Too much pressure is placed on them to compete. Young children should participate in sports primarily to play, not compete. They should explore many sports activities, not limit themselves to one.

Also these days, it is common for older adults take on new sports after retirement. To be #1 in a sport usually does not drive them. Most participate for the challenge, fitness, and fun… a healthy attitude toward life, in contrast to those who impose their will on their young ones. However, older adults also should rein in a strong will so as to not push themselves beyond the limitations of an aged body.

A central concept in marketing is the “adoption curve”, which classifies people in 5 categories on the basis of when they adopt a product. In the situations described above, the product to be adopted is a sport. Clearly, there is an optimal time for rapid adoption of a sport and less opportune times to do so…. likewise with an investment product.

Below are the 5 types of people in the adoption curve in relation to investors of a sample stock which pays no dividends.

THE FINANCIAL ATHLETE ADOPTION CURVE FOR STOCKS

Innovators have vision for future trends and embrace technology. They are attracted to “not yet profitable”, emerging companies with new technologies. Consequently, they tend to invest too early. They underestimate in years the time it takes to develop a formidable business. Although the companies eventually may succeed, typically by then their shares have been diluted considerably due to a long series of quarterly cash burn to ever realize the substantial returns they had dreamed of.

Early adopters wait for most of the risk to abate. The target company has reached CF+ (cash flow positive) for operations and free cash flow. Its Balance Sheet is solid. Double digit growth rates are projected to continue for 5+ years. The stock trades at a reasonable value because it is still mostly “under the radar”. Here, the investor is poised to make the highest potential return and with reduced risk.

Demand from the early majority drives up the stock price considerably. They buy at or slightly above intrinsic value. This is of no concern to them. Their focus is on a projected forward P/E ratio, not the trailing P/E ratio. They love the business model and feel confident of a decent return. The early majority can reasonably expect above average returns.

The late majority are a reactive bunch. For example, they see a CEO grace the cover a financial magazine, and interpret this as sign to buy the stock. In the whole, they are clueless about valuations. They join the bandwagon too late and tend to buy when the stock price trades at a peak price range — the time to sell.

Non-adopters are afraid to make a mistake. They won’t buy the stock, no matter what! If you were to convince them the stock is trading at a tremendous discount to intrinsic value, they still will refuse to invest because “something might go wrong”.

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