A striking performance gap is appearing throughout global equity markets. In industry after industry, spanning both the new and the old economies, a small set of companies is creating almost all of the new shareholder value. Simultaneously, the value of their less successful competitors is actually declining, and to an unprecedented degree.

The polarization of winners and underperformers is intensifying. Once, a chief executive officer could claim that the performance of the industry, not the company, was the prime mover for stock prices. But with the advance of globalization and technology, companies whose products or service models have the slightest edge over the competition can quickly exploit that advantage. Investors are scrutinizing companies one by one, screening out those with merely average performance and investing the bulk of their money with the top one or two players in each arena. This phenomenon has created a "winner-takes-all" dynamic in which 5 to 10 percent of the companies in a given industry create all of the shareholder value.

In most industries, the new winners are "atomizers," which focus on narrow industry segments where they can achieve a dominant position, even though they may hold only a small fraction of the assets or revenues in their industries. Some of the atomizers are first-to-scale newcomers, which capitalize on wholly new markets that are usually created by technological discontinuities. Others are attackers, which extract value at the expense of industry incumbents. Both types of atomizer launch and expand focused businesses that capture returns highly disproportionate to their size.

This new model is, of course, in stark contrast to the old scale-driven notions of successful corporate strategy. But the evidence is compelling: size, scope, cost economies, and vertical integration are much less important than they used to be. In this brave new world, the evidence suggests, start-ups and attackers are capturing the lion's share of value. Nevertheless, several large incumbents, including Enron, IBM, Nokia, and Texas Instruments (TI), have transformed themselves and emerged as winners.

A bull market or a few good bulls?

Stock market observers have described the past few years as history's biggest bull market. Yet in reality, just a few very successful companies have powered it. Between 1985 and 1995, the median S&P 500 company closely tracked the mean performance of the index: that is, about half of the companies performed above the average and half below it. But in the latter half of the 1990s, the situation changed dramatically. While the overall S&P 500 delivered annual returns of 26 percent, more than half of the companies in the index averaged less than 15 percent, with median returns falling below 0 percent in 1999 and 2000. In other words, a few strong bulls lifted the overall market to a rate of return nearly double that of the median company.

Comparing the results of the top and bottom 10 percent of the 1,000 largest global companies traded in the United States further illustrates this divergence (Exhibit 1). Through 1997, the results were fairly stable: the top decile averaged a return of roughly 95 percent, the bottom decile a negative 26 percent. That picture began to change dramatically in 1998. By 1999 or 2000, companies had to triple their stock price to make the top 10 percent. The laggards fell further behind.

Measuring shareholder value creation

Because company size can skew comparisons of percentage returns, we have measured performance in terms of absolute dollars, using a metric we call shareholder value creation, or SVC (see sidebar, "Calculating shareholder value creation"). Compared with the more conventional metric—total returns to shareholders (TRS)—SVC has three key advantages. First, as we have noted, it measures economic impact in terms of absolute dollars, thus making it possible for us to compare companies of different sizes. Second, TRS reflects only the returns to shareholders who hold a stock throughout a given period; SVC reflects the value created for all shareholders—an important distinction when companies issue substantial numbers of shares for M&A or other purposes. Third, our central thesis—the winner-takes-all dynamic—emphasizes the importance of specialization, but SVC inherently favors large companies. By creating a bias counter to our thesis, the SVC metric tests it more rigorously.

The SVC results for the 1,000 global companies are staggering (Exhibit 2). Of the companies in the sample, we defined the biggest winners as those achieving value gains of more than $10 billion each. Only 13 percent of the companies were among these winners, but they created $4.7 trillion in value for their shareholders. At the other extreme, the 15 percent of the companies categorized as big losers —defined as those that lost more than $10 billion in SVC—delivered an equally stunning result by destroying more than $4.2 trillion.

A universal effect

This bifurcation in performance has occurred roughly proportionally across most industries, in both the old and the new economies. Even the most problematic of sectors, such as banking and energy, have had big winners. Citigroup, for example, created $129 billion in SVC over the past five years, while ExxonMobil created $59 billion. Meanwhile, even the best-performing sectors, including telecommunications and computers, include big underperformers. AT&T and EDS, for instance, lost $202 billion and more than $38 billion, respectively, over the same period. Clearly, not all boats have risen or fallen with the industry tide.

The large number of big winners and big underperformers represents a substantial change from the picture only five years ago. Of the global 1,000 companies, 28 percent created or lost more than $10 billion in value from 1995 to June 2000, up from only 3 percent in the 1990–94 period. Even after indexing the $10 billion hurdle for the rise in the market's overall value, the number of big winners and underperformers has more than doubled.

These results greatly raise the stakes for the affected companies. Activist investors and boards are more and more willing to replace chief executive officers of underperforming companies, which often become targets for takeover. Winners gain a place on everyone's most-admired list, the ability to fund acquisitions, and, in the United States, an average of $1 billion to $2 billion in stock options to reward managers and attract their promising new talent.

More than irrational exuberance

Are stock market returns actually the product of what Fed Chairman Alan Greenspan called investors' mere 'irrational exuberance'?

It is fair to question whether the increasingly polarized capital markets reflect the economy's underlying performance. Are stock market returns merely the product of what the US Federal Reserve Board's chairman, Alan Greenspan, dubbed the "irrational exuberance" of investors?

Perhaps not. The winning companies in our sample delivered superior operating results along with superior stock market returns, suggesting that the winner-takes-all phenomenon also characterizes underlying performance. A comparison between the big winners and the big underperformers provides compelling evidence. During the first half of the 1990s, annual earnings for both groups rose by 8 percent. During the second half, though, the winners' annual earnings rose by 25 percent but the underperformers' by only 13 percent. During the first half of the decade, the two groups' return on equity (ROE) differed modestly: 19 percent for the winners, 17 percent for the underperformers. But in the latter half, the big winners achieved incremental ROEs of 32 percent, far above the 20 percent for the underperformers.

The winner-takes-all concept

Economists have long described winner-takes-all markets in which small differences in performance lead to big differences in rewards. Such markets include those for star entertainers and athletes. Julia Roberts and Tiger Woods, for example, make vastly more than average members of the Screen Actors Guild and the Professional Golfers' Association, respectively, make. By contrast, in business small differences in performance have traditionally generated only small differences in rewards. But the situation is currently changing. Notable examples over the past decade include the outsized performance generated by single product lines such as Microsoft's Windows operating systems, Intel's microprocessors, and Nokia's mobile telephones. Now this dynamic is spreading to other sectors.

Most likely, the gap between winners and underperformers will continue to widen. In this new economic landscape, companies that are not the very best at what they do will not create value, even if they have the foresight or good fortune to pick attractive industry segments.

Atomize to win

The vast majority of the new winners are atomizers. But many CEOs, supported by the teachings of leading business schools and consultants, still embrace traditional scale-based notions of successful corporate strategy. These traditional ideas are based on several core tenets: seek to be the biggest player in the industry, with the largest market share; maintain a strong balance sheet; establish a low-cost position; integrate vertically to capture incremental value and to control key channels; and pursue industry consolidation to capture additional scale and scope economies.

Unfortunately, this "industry leadership" model no longer works—at least if success is measured in terms of shareholder value. Consider the contrast between scale and SVC for the US companies in the global 1,000 (Exhibit 3). The Fortune 100 represents the 100 largest of these companies, ranked by revenue. They generated over half of the revenues in our sample but only 6 percent of the SVC. By comparison, companies too small to make the Fortune 500 generated only 10 percent of revenues but two-thirds of the SVC. In other words, small companies created more than 65 times as much shareholder value relative to their size.

Has the winner-takes-all economy erased the advantages of being the biggest? So it would seem.¹ Plummeting interaction costs, driven down by new computing and communications technologies, make it possible for companies to specialize more than ever before. New entrants thus find it much easier to cherry-pick the most attractive products, channels, and customers. This sea change, complemented by the emergence of global standards and protocols, has helped specialized players achieve dramatic growth and global scale rapidly, even in narrow market "slivers."

Meanwhile, the increased availability and mobility of capital have diminished the corporation's role as a financial-portfolio manager. For companies with a winning idea, access to capital is almost never a problem, so they can scale up quickly. At the same time, investors can more easily diversify risks and generally prefer pure-play companies to broad-scope ones. In addition, barriers that once protected large incumbents have crumbled under waves of deregulation, privatization, and new intermediary markets.

Two breeds of atomizer

Most successful atomizers deploy one of two strategies. First-to-scale newcomers typically take the lead in new markets. In more established industries, by contrast, attackers win by extracting value from their stodgier counterparts.

First-to-scale newcomers. The predominant atomizers in most high-tech arenas are first-to-scale newcomers, which capitalize on technological discontinuities by launching focused start-ups in new market spaces. Those that scale up rapidly can achieve an insurmountable lead over competitors—often incumbents that saw the same opportunities and had a better position to exploit them but didn't mobilize fast enough.

The US telecommunications and data communications industry provides many good examples. Only five years ago, it was dominated by a handful of large players such as AT&T, the regional Bell operating companies (RBOCs), GTE, and MCI. These established players saw the discontinuities that would be created by the Internet and mobile communications, and they launched a slew of initiatives to extend their reach beyond voice-based telephony. With few exceptions, however, they ceded the industry's SVC to newcomers. Eighteen US telecom companies have achieved SVC above $10 billion over the past five years, but they include only two of what in 1995 were the ten largest players: BellSouth and Sprint.

Collectively, the 16 atomizers created more than $600 billion of SVC while AT&T and the RBOCs were losing more than $200 billion

Not surprisingly, the other 16 winners were first-to-scale newcomers that staked out attractive slivers. Juniper Networks, for example, created $51 billion of SVC by focusing on high-end routers for long-haul data transport. Qualcomm (next-generation wireless technology) created $25 billion. JDS Uniphase (fiber-optic equipment) captured $71 billion. Other winners included Level 3 in backbone wholesaling ($17 billion SVC), Exodus in Web hosting ($15 billion), and Sycamore in optical networking ($25 billion). Collectively, the 16 atomizers created more than $600 billion of SVC while AT&T and the RBOCs were losing more than $200 billion.

Similarly, newcomers dominated the computer hardware and services industry: EMC (data storage) created $182 billion of SVC; Texas Instruments (mostly digital signal processors), $40 billion; and Applied Materials (wafer-manufacturing equipment), $23 billion. In the software and Internet services industries, almost all of the big winners have been focused, first-to-scale atomizers, such as Ariba ($28 billion SVC), eBay ($17 billion), i2 Technologies ($27 billion), Siebel Systems ($39 billion), and Yahoo! ($22 billion).

Attackers. In more traditional industries, such as banking, energy, and retailing, the predominant atomizers are attackers that prey on incumbent players. Typically, these industries have not experienced the technological discontinuities necessary for start-ups to succeed as first-to-scale newcomers. Instead, industry attackers thrive by building a better business model and challenging the status quo.

Consider Enron, which created $38 billion of SVC in an energy industry that as a whole destroyed value. Enron has built a reputation as one of the world's most innovative companies by attacking and atomizing traditional industry structures—first in natural gas and later in such diverse businesses as electric power, Internet bandwidth, and pulp and paper. In each case, Enron focused on the business sliver of intermediation while avoiding the incumbency problems created by a large asset base and vertical integration. Enron no longer produces oil and gas in the United States, no longer owns an electric utility, and has never held a large investment in telecom networks. Yet it is a leading value creator in each of these industries.

Or take Dell Computer, which created $73 billion of SVC by successfully attacking in the personal-computer market. Competitors such as Hewlett-Packard and IBM were at first reluctant to match Dell's direct-sales model, for fear of antagonizing their traditional channels: dealers and sales forces. They were also slow to match Dell's low prices, which ultimately turned PCs into commodities. Dell capitalized on its early lead to build an insurmountable supply chain advantage and an extremely strong and loyal customer franchise.

Charles Schwab first attacked in the brokerage industry with deeply discounted commissions. It then upped the ante and cannibalized its own business model to become the leading on-line brokerage. Schwab enjoys a market-to-book ratio that is five times the industry average. The company created $34 billion of SVC, despite competing in a banking industry that had a negative SVC.

Many dot-com companies also are attackers, hoping to create new Internet-enabled business models that will allow them to extract value from incumbents. Despite the NASDAQ correction in 2000, several dot-com attackers, including Amazon.com, Inktomi, and RealNetworks, were able to create significant SVC.

Implications for incumbents

What does this winner-takes-all dynamic mean for the large, integrated corporations that still generate most of the revenue, employ most of the people, and deploy most of the capital in the economy? How can these corporations overcome an increasingly competitive global economy and skeptical capital markets to secure a place in the winner's bracket?

Pick your race

In an atomized world where attackers enjoy large advantages, focus is critical. Jack Welch aside, this arena has very few successful decathletes, for broad-based companies are very vulnerable to attackers. Furthermore, in most companies, a scarcity of managerial and technical talent limits the number of winnable races to, at best, two or three. Large incumbents need to pick their races carefully by focusing on the market slivers in which they have, or can build, a leading global position. They will have to divest everything else.

Some leading players have already demonstrated the merits of this approach. By the early 1990s, IBM had fallen from its status as the leading light of US capital markets and become a laggard facing stiff competition. IBM responded by shedding several large businesses, ultimately reducing its book value by half—a move that many analysts viewed as a retrenchment bordering on liquidation. But in the mid-1990s, IBM began to build businesses. It acquired two software companies, Lotus and Tivoli, and dramatically increased the revenues of its Global Services business, which became the engine of its turnaround. By 2000, IBM had created $80 billion in SVC.

Texas Instruments, through the early 1990s, was a moderately performing conglomerate comprising semiconductors, defense systems, and other businesses. In the middle of the decade, TI's leadership decided to bet the company on a single product line: digital signal processors. TI sold its defense business to Raytheon, sold off or closed down several lines of semiconductors, and invested billions in its chosen segment. These moves proved extraordinarily successful: TI positioned itself at the center of the wireless digital revolution and created $40 billion in SVC.

Overcome the incumbent's curse

Picking the right race is only part of the battle. It is crucial to address the problems that generally make traditional companies lag behind start-ups in building businesses. After all, incumbents start out with industry expertise, established brand names, up-to-date technology, and, in many cases, the very same people who later leave them to direct the management teams of successful start-ups. Why then have incumbents fared so poorly? In general, four challenges combine to create what we call the incumbent's curse. To become a winner, established companies must address these challenges head on:

1. Start-ups, with their "get rich or go broke" mentality, attract entrepreneurial talent by providing incentives that few incumbents are willing or able to match. Incumbents must raise the ante in the war for talent.
2. Incumbents naturally face pressure to keep the best people in today's most important jobs, where they manage billions in revenue and thousands of employees, rather than transferring them to new growth ventures with few if any employees, revenues, or profits. In most large companies, smaller and newer business ventures tend to be run by mid-level managers. But an attacker directed by an entrepreneurial CEO and a highly motivated leadership team will almost always win the fight against the middle management of a large corporation.
3. Attackers have everything to gain and nothing to lose. Incumbents must adopt a comparable ruthlessness and be willing to cannibalize core business models, customer relationships, and brands.
4. Attackers benefit from initial-public-offering mania, while mature companies with no track record in building new businesses are often "guilty until proved innocent." This phenomenon impedes the incumbents' ability to finance dilutive ventures, to attract talent, and to form key partnerships.

Is it possible to adopt a new-business-building mind-set and overcome the incumbent's curse? Once again, Enron provides an example of success. Over the past ten years, the company has built at least five major wholly owned greenfield businesses, which collectively provide more than 90 percent of its market capitalization. In achieving this track record, the company has directly attacked all four dimensions of the incumbent's curse. It has regularly deployed its top talent in new start-ups and provided these managers with entrepreneurlike incentives: when Enron launched its broadband business in 1999, for example, it reassigned the top two executives of its largest business unit, and its corporate president devoted 80 percent of his time to running the new company. Enron also proved its willingness to cannibalize its core business by launching an on-line gas and power site that discloses, in real time, the prices at which it is prepared to buy and sell.

Just as important, Enron has convinced Wall Street of the favorable long-term prospects of its new businesses; about half of its current market cap is attributable to businesses that have yet to generate annual earnings. As a result of this persuasiveness, Enron trades at a price- to-earnings ratio of 60, in contrast to an industry average of 14. A few other companies—for instance, IBM, Nokia, and TI—have also succeeded with a go-it-alone model for building new businesses. However, the short list of successful examples shows just how hard it is to succeed at building businesses organically.

Another way of addressing the incumbent's curse is to spin off new growth initiatives as independent ventures. For most companies, this is the best choice, and the almost daily announcements of spin-off plans demonstrate its popularity. Notable examples include NTT's DoCoMo, Telefonica's Terra Networks, and Wal-Mart's joint venture with Accel Partners.

No matter which option fits best, success at building businesses will continue to be the primary driver of breakout shareholder returns. Incumbent companies that hope to win against focused new entrants dedicated exclusively to business building must expend disproportionate energy on overcoming the incumbent's curse.

Today's winner-takes-all capital markets signal a new era. Determined companies that build focused businesses in atomized market slivers will capture most shareholder value; those that fail to do so will fall far behind. This environment poses tremendous challenges and tremendous opportunities. To be the world's best in a broad set of markets is almost impossible. By contrast, successful niche strategies, scalable as never before, will generate tens or even hundreds of billions of dollars of value for shareholders. The risks and rewards of corporate strategy have never been greater.

Calculating shareholder value creation

To compare the relative performance of companies, we have developed a metric called shareholder value creation (SVC). The exhibit, using AT&T, Corning, and Morgan Stanley Dean Witter (MSDW) as examples, illustrates the methodology for calculating SVC.

We start with the overall change in equity market value and then make several adjustments to determine SVC. First, we subtract required performance, defined as shareholder returns relative to the beta-adjusted S&P 500 index. This measure reflects an opportunity cost against which investors generally benchmark performance. (Everyone, after all, has the low-cost investment option of buying an index fund.) AT&T started as a very large company, so its shareholders would reasonably have expected it to expand its market capitalization by $190 billion just to stay even with the market on a risk-adjusted basis. That $190 billion should not be counted as part of AT&T's SVC.

The next adjustment involves share issuance, which accounts for much of AT&T's increase in market value, reflecting the impact of large acquisitions. Finally, we adjust for dividends and share buybacks. AT&T returned substantial cash to shareholders over the period. It must be credited for delivering this value.

Thus, though the three companies enjoyed a comparable overall increase in their equity values, their SVCs varied dramatically. AT&T, which increased its total market capitalization by the largest amount, destroyed over $200 billion in value. In contrast, Corning and MSDW both delivered tremendous value for their shareholders.

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