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In a previous article in which Samsung (OTC:SSNLF) and Apple's (AAPL) approaches to innovation were compared I suggested that not only green innovations (e.g. hybrid cars or fuel cell electronic products) but also a strategic model used by high-tech firms that face "continual chaos", characterized by its reliance on new technologies, new entrants and new products, may give companies a sense of prestige and status which could in turn lead investors to increase their bets on the stock exchange market.

I also pointed out that even one of the most innovative enterprises in the world such as Apple could be penalized by the market if its expenditures on R&D do not keep pace with growth [of sales] or if the company simply thinks that once a significant portion of the market is captured, the value of its shares would continue growing regardless of what's introduced into the market.

As shown in Figure 1, from FY 2010 thru FY 2012 Apple's R&D expenditures as a percentage of sales reflected a clear downward trend, despite the tremendous growth of value of its shares. By contrast, Figure 2 shows Samsung's corresponding figures for the period 2010-2011 where it is apparent that both share values and R&D expenditures as a % of sales increased significantly.

Figure 1


(Click to enlarge)

Sources: Data on R&D Expenditures and Sales were obtained from Apple Three-Year Financial History; and FY average share prices were calculated using daily figures from finance.yahoo.com.

Figure 2

Sources: Data on R&D Expenditures and Sales were obtained from 2011 Samsung Electronics Annual Report; and annual average share prices were calculated using daily figures from finance.yahoo.com.

In my previous piece I already referred to how the new maps app in iPhone5 was a real embarrassment for Apple and how Samsung's Galaxy S3 has found a number of reasons to beat Apple's emblematic smart-phone and source of more than 50% of its revenue.

This supports the view that Apple's innovative behavior may have reached its peak in September 2012 after the release of the iPhone5, opening the way for a free fall of its shares afterwards. But what does innovativeness mean?

Following an article published more than 10 years ago, innovation addresses two important distinctions: First, the technological development of an invention combined with the market introduction of that invention to end-users through adoption and diffusion, and second, its iterative character which presupposes not only the introduction of a new product for the first time into the market but also the need for constantly improving it thereafter.

So, yes, Apple was capable of developing a series of inventions over the last 20 years or so which were then introduced into the market and adopted by an important number of consumers. However, it now seems like it's having trouble to face the challenge of innovativeness, namely the propensity to permanently innovate or develop and adopt new products. This, in turn, may be affecting its reputation. Hence innovativeness is at the heart of my concept of innovation as a way of living.

This takes us to establishing a new differentiation, this time between radical (disruptive) and incremental (continuous) innovations, where the first type of innovations pertain to new technologies that result in a new market infrastructure and the second type of innovations refer to products that provide new features, benefits, or improvements to the existing technology in the existing market.

It goes without saying that to implement either type of innovations any firm will require to spend a considerable amount of money on R&D. The question is: How much? Well, common sense dictates that R&D expenditures should be related to sales. Why? Because the larger the sales of an innovative company, the greater the need for innovation because otherwise the incentives created by the new market could attract imitators. As the above authors argue:

" ... if an innovator does not move quickly, and keep moving, the early imitators can play a major role in 'remaking' or 'creatively destroying' the market… Moreover, if they have more resources and already have a large market share, it is their imitative reactions that will have the most impact on changing the market and the rate of change and competitive dynamics in the market."

This is further complicated by the fact that imitators could eventually introduce not only incremental but also radical innovations into the market.

The situation pictured above appears to resemble what has begun to happen to Apple and Samsung in one of the most competitive markets of the world, even though the question remains as to the extent to which Samsung can be considered an imitator of Apple's technologies.

Regardless of that, in a study published in 2006, it has been argued that: "As the target market size for the firm increases, firms will shift the product development strategy from one of continuous innovation to focus more on radical innovations for new product development."

If, overall, it is reasonable to think that radical innovations are costlier than incremental innovations, this may explain why Samsung is expending almost three times more money than Apple on R&D for a comparable level of sales. Altogether, the set of events just described poses a serious threat to Apple.

Interestingly enough, in the last two months or so Apple has done very little to take care of this problem. Hence its situation only deteriorated while Samsung, particularly due to its original Galaxy S model, continued to improving its market position. As can be seen in Figure 3 below, a widening gap between Samsung and Apple beginning September 27, 2012 has emerged, one which could signify the end of Apple's leadership in the electronics industry.

Figure 3

A widening gap between Samsung and Apple (July-December, 2012)


(Click to enlarge)

Source: Reuters.

As shown in Figure 4, this indeed appears to be more than a temporary phenomenon. In fact, Apple's dominance over Samsung during the last 5 years (as measured by growth of share value) began on October 5, 2010. After a slight recovery between December 2010 and January 2011, and December 2011 by Samsung, Apple maintained its leadership throughout most of 2012 until December 10. From then on, Samsung started to run the electronics market once again.

Figure 4

Apple Vs. Samsung (2008-2012)


(Click to enlarge)

Source: Reuters.

A few more words on innovation as a way of living are in order. First, of course, Apple still has a lot of potential to recover its leadership but to do so it does need to change its approach to innovation. This goes beyond a simple increase in its rate of innovation. It points to a need for a substantial investment in R&D mostly directed to radical innovations.

Second, Apple's failure to change its innovation strategy is likely to continue collapsing its shares while contributing to ruining the most valuable asset of a company nowadays: its reputation.

Third, as Apple's recent experience has shown, reputation loss could be a rather rapid and cumulative phenomenon particularly in highly competitive markets. Some time ago no one would have imagined that Apple's shares could go down by more than 30% in about three months. This explanation as to why Apple shares collapsed since September 2012 seems more convincing than that recently put forward by other Seeking Alpha analysts, such as those pointing to a tax issue or different financial questions as the main source of the problem.

Fourth, lack of quality innovation is certainly not the only source of reputation loss; failure to deliver certain advertised, promised or understood services (such as the new maps app) for which shoppers bought the products in the first place may be another one.

Lastly, in terms of some investment implications, until Apple shows clear signals of change I would highly recommend to sell Apple shares and buy Samsung ones.

Source: Apple Vs. Samsung: Further Evidence On Innovation As A Way Of Living