This “Law” Predicts Which Businesses Will Make It

Harvard professor Clay Christensen is a global superstar. His idea “the law of conservation of modularity” is a powerful way to think about business strategy.

Steve Jobs only read one business book in his life.

Jeff Bezos, the CEO of Amazon, makes all his executives read it, and The Economist called it one of the six most important business books of all time.

The book is called The Innovator’s Dilemma, and it’s by a Harvard Business School professor called Clay Christensen. It’s pretty much a sacred text for high-flying tech executives. It’s all about “disruption”, a term Christensen coined to describe how small businesses take over an industry by focusing, at first, on the bottom of the market.

The Innovator’s Dilemma made Professor Christensen into a global superstar. He followed it up with his difficult second album in 2003, a new book which he innovatively titled The Innovator’s Solution.

I want to talk about an idea from that second book today, one which is important for any investor in fast-growing companies.

It’s called “The law of conservation of modularity” (he’s a business professor – don’t expect plain speaking!). It takes a little while to get your head around. But it’s an incredibly useful and powerful way to think about business strategy.

Solve x in terms of £

The theory starts with a product.

Think of a product as a company’s solution to a problem. For example: “people need a device to help them work while they’re at the office.”

In order to solve this problem, the company builds a desktop computer.

But the computer is really a number of different solutions in one. It has a screen to solve one problem, a hard disk to solve another problem, and so on.

Now, for any product, there’s always going to be one part of the problem that’s harder to solve than the others. In the example of the desktop computer, the hardest single problem to solve is making a processor that’s fast enough.

Making a fast processor is the single biggest challenge. So the computer engineers optimise the entire computer around the processor. Optimising around the processor means making all the other components – the mouse, screen, motherboard, RAM and the like – interchangeable.

In a nutshell, that’s Christensen’s Law. He says that for any given product, a company optimises around the single hardest problem to solve, and the remaining parts of the problem become interchangeable.

Still with me? Good! Next up: what this means for profits, business models and investing.

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Where the money’s at

The business implication of all this is that there’s no money to be made from solving the less difficult parts of the problem. All of the value, and all the profits, are made from solving the hardest part of the problem.

Going back to the computer example – Intel, which makes microprocessors, is a richly profitable company. The same can’t be said for the no-name companies that made hard drives, screens, mice and the like.

Here’s how Christensen himself described it in 2003. He’s talking about how Intel’s advantage in desktop computers didn’t translate to handheld devices, because in a handheld device the processor isn’t the hardest problem to solve.

“If you think about it in a hardware context, because historically the microprocessor had not been good enough, then its architecture inside was proprietary and optimized and that meant that the computer’s architecture had to be modular and conformable to allow the microprocessor to be optimized.

“But in a little hand held device like the RIM BlackBerry, it’s the device itself that’s not good enough, and you therefore cannot have a one-size-fits-all Intel processor inside of a BlackBerry, but instead, the processor itself has to be modular and conformable so that it has on it only the functionality that the BlackBerry needs and none of the functionality that it doesn’t need. So again, one side or the other needs to be modular and conformable to optimize what’s not good enough.”

Any business, any time

I know this sounds jargon-y and technical. But the beauty of this idea is that you can apply it to any type of business.

Take hotels for example. Hotels are a solution to the problem: people need a place to stay when they’re far from home.

So what’re the components of that problem?

  1. Travellers need physical buildings
  2. They need to trust that the person who lets them stay won’t rob them
  3. And they need a way to make reservations

The hotel industry solved the most difficult parts of that problem. It built trusted brands and hotels where they were needed.

Then AirBnb came along. AirBnb found an easier way to solve the “trust problem” – a reservations system which allowed you to check on the record of every AirBnb host.

And since the online reservation system is now the hardest problem to solve, the system is optimised around it. The rooms have become interchangeable. And the profits flow to AirBnb.

Once I started thinking about business in this way I saw it everywhere. Think of Uber in taxis, Netflix in TV or Amazon in retail. And it applies just as much to the tiny businesses I analyse in the Penny Share Letter as the biggest businesses in the world.

If you’re interested in learning about the four fast-growing technology companies I’ve already recommended to my Penny Share Letter readers, click here. It takes you to Glenn Fisher’s compelling new research.

There’s a link to subscribe at the end of the page.

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