Everyone knows the Marshmallow Test, a psychological experiment where you defer one marshmallow now to get more later. The premise is simple: You are rewarded for taking the long-term view despite current emotional cravings.
Parents use marshmallows to get their kids to eat vegetables, mow the lawn, or empty the dishwasher. Employers use them to retain their most talented employees. The goal is to train the employees (or children’s) minds that it’s often in their best interest to defer gratification a little longer.
This model not only works for parental discipline and employee retention but for businesses trying to innovate and change an industry.
Here’s a straightforward way to think about the marshmallow test for businesses. Any company deferring today’s profits for tomorrow’s success is building a Marshmallow-Test Business Model.
Clayton Christensen, the renowned business innovation thinker, explained this phenomenon in his book Seeing What’s Next (emphasis mine):
“Solving the hard problems allows firms to capture value. Forward-thinking firms move to solve tomorrow’s hard problems, because solving tomorrow’s hard problems creates tomorrow’s profits.”
Solving tomorrow’s complex problems has its issues. There is never a guarantee that deferring for tomorrow’s profits will reap rewards. The timeframe may change, new entrants may destroy your chances, or management simply makes poor decisions.
Yet for the winners, solving tomorrow’s challenging problems lead to mega-riches for the company, its employees, and its shareholders. And that’s why we love investing in these businesses.
Take Redfin (RDFN), for example. RDFN is building a business based on a completely different set of industry-wide assumptions — this is that real estate commissions will eventually go to zero.
RDFN made its real-estate agents full-time salaried employees with health/401K benefits to capture tomorrow’s profits. They’re buying homes from customers via iBuying. Most importantly, they’re returning all of those savings back to the customer: the home buyer/seller.
RDFN’s business model is perfect for tomorrow’s industry if/when it gets there. In the meantime, the model represents a significant risk. Why would a deeply cyclical company add full-time employees to their expense stack?
Investing in Marshmallow Test businesses requires a strong stomach. After all, these companies will forgo profits today in the hopes of making more tomorrow. Investors should expect lower revenue and earnings growth during recent quarters.
Ask yourself questions like, “Do I know on a per-unit basis what the company could make in five years?” or “If the company stopped investing in expansion tomorrow, what would its margin profile look like?”
Also, scan earnings transcripts for phrases like “long-term mindset” or “deferring profits.” Ensure that management’s actions and words are consistent with its Marshmallow Test model.
Finding these businesses is hard, too. A good “Marshmallow Test” screener might look something like this:
Yes, it’s wide, but that’s on purpose. Marshmallow Test businesses should experience high revenue growth rates and GM % expansion. Whatever you do, don’t filter on operating income. Remember, these businesses are optimized for long-term value creation, not short-term operating profits.