3 keys to an emerging company’s success

These principles come from close observation of a single undeniably successful startup: Morningstar (MORN). When I joined the company in 1988, it had $1 million in revenue. Last year, it reported $1.02 billion. Adjusted for inflation, that makes for a 22% annualized revenue growth rate. Good work if you can get it!

My perspective is that of a historian, not a participant. True, I worked at the company during those three decades--but as somebody who obeyed the key decisions rather than make them. Also, these comments address single-line firms. They mainly concern Morningstar’s early days--from the firm’s 1984 inception through the late 1990s, when its rivals were small, and they targeted most of Morningstar’s operations, rather than only a small sliver.

The three main items, then, in order of importance:

Capital commitment

Nothing matters more than management’s commitment to grow its business. My previous employer was much the same size as Morningstar. It also had 18 employees, and only slightly higher revenues, at $1.2 million. That had long been the company’s size, and long would be, because all surplus cash went toward the owner’s mini-mansion, pheasant-hunting excursions, and Florida condo. None remained for reinvestment.

In contrast, Morningstar’s owner lived in a one-bedroom apartment and paid so heavily for expansion--by hiring new-product developers, additional researchers, and increasing advertising--that the firm sometimes couldn’t meet its Friday payroll, and was forced to postpone until Monday. Painful for employees and, to be sure, also risky. Many people quit, taking positions at larger organizations.

Their actions were not foolish, as Morningstar could easily have cratered. There are valid reasons for workers to choose safety over potential growth. But not so much, I think, for investors in emerging companies. Such firms must stretch if they are to fulfill their potentials. Find companies with owners who are willing to take such risks.

Competitive weakness

Sports fans deeply, fervently believe their teams control their own destinies. If they play well, they win; if they don’t, they lose. Consequently, their discussions almost entirely consist of praising or blaming their own team’s players, with little attention paid to the other squad.

Corporate managements, boards of directors, and shareholders, behave in a similar manner. When things go well, large bonuses are paid. When they go badly, heads roll. Those reactions are natural. We realize that employees are responsible only for their own actions. If those at rival companies perform brilliantly, that should not penalize workers any more than they are rewarded for their competitors’ flaws.

That is a polite fiction. In truth, the quality of a company’s competitors is critical--more so than even the success of the industry itself. Many have observed that Morningstar’s timing was terrific, because the company was founded in year one of the Great Mutual Fund Boom (1984). But few have noted that when Morningstar began, several companies already tracked mutual funds, and several more would soon enter the industry. All fell by the wayside.

No doubt, Morningstar benefited from its own management’s decisions. But it also gained significantly from its rivals’ mistakes, the largest of which was to violate this column’s first principle: They didn’t pony up the capital. The private companies pocketed their profits, while the public firms, which competed against Morningstar with only a sliver of their overall operations, were preoccupied with their overall margins. As a result, their efforts were undercapitalized.

Rising tide

Those first two maxims came to me easily, but the third required a bit of thought. Possibilities include: 1) operating in an industry that is only lightly regulated (as is the case with investment research); 2) building a recognizable brand; and 3) creating an attractive corporate culture. Each of those is useful. (And, to give managements their due, the latter two are achieved through company actions. Strong brands, and a healthy workplace reputation, do not occur by accident.)

Somewhat reluctantly, I settled on industry prospects. I have already downplayed the strength of sector effects. Mutual funds behave differently than companies. If U.S. stocks soar, all U.S. equity funds benefit. One fund’s success does not damage another’s. The same does not hold for companies that operate in growing industries. One may consume every new crumb (possibly even more), leaving the others hungry.

Therefore, I don’t think identifying fast-growing industries is the most important skill for selecting successful emerging companies. (It may not even be a necessary condition, given how some startups in mature industries have thrived by “rolling up” frail rivals.) The microeconomics trump the industrial backdrop. Better to own the best company in an indifferent sector than to hold a weakling in fashionable one.

At some point, though, reality must intrude. Companies can flourish when the tide is neutral, or even slightly negative, but no buggy-whip manufacturers continue to exist. Sometimes, the effort will inevitably fail. As Warren Buffett has stated, in slightly different words, when an irresistible corporate manager meets an immoveable industry, the industry is the party that preserves its reputation.

Morningstar would have not survived its childhood if the mutual fund industry had flopped. I do not believe that the company required a boom, but it did need to avoid a bust. To that extent, industry effects are indeed critical.

Final word

As I hope has been clear, this article was not written to promote Morningstar’s early achievements. It’s not possible to buy Morningstar’s stock at 1999 prices. Besides, if you could locate a time machine that could take you back two decades, you would be better off purchasing Apple (AAPL). Rather, my intent was to draw history’s lessons. Those being, primarily, that the emerging companies with the best prospects are those that go all in, with the determination and capital to see their efforts through.