This article has a very broad scope, as it describes ideas that underpin my view on how the world is evolving, and which companies will win in the future. These insights are crucial for long-term investors, but much less important for short-term traders. So, traders: feel free to turn away now.
In the decade since the financial crisis there have been two themes that have dominated how companies compete and the cash flows that they generate for their shareholders. First, we live in a world awash with money, which is lowering the capital hurdle rates for companies to enter an industry, remain in an industry, or fund new product launches within their own industry. Second, the internet has come of age, and it has powered a host of new business models that are changing what it means to have a competitive advantage, and helping small firms breach what once seemed to be the impenetrable economic moats of their larger competitors.
My focus today is on this second trend, which I call the “Digital Economy”. It’s the slice of the economy that is built or empowered by the internet. It is led by the tech titans – Alphabet, Amazon, Apple, Facebook & Microsoft – but it is also providing a turning point for corporate strategy for all businesses. I believe that the changes brought about by the Digital Economy are so fundamental to the way our society is operating that, one hundred years from now, historians will likely compare it to the industrial revolution in terms of the scale of its impact on the economy and the lives of its citizens. Perhaps a better name for it then is the “Digital Revolution”, but I will hold back from that for now.
In this article I’ll show why these changes matter for all investors. Markets are made on the margin, so our success as long-term investors is dependent on seeing trends before the average analyst does (and it therefore gets priced into the market). Analysts typically focus on the firm’s performance over the next four quarters, so if we can make informed judgments about how a firm’s prospects will evolve 2-3 years from now – and be right more often than we’re wrong – then we’re well on the way to beating the market.
The tech titans
The Digital Economy is led by the tech titans: Alphabet, Amazon, Apple, Facebook & Microsoft. These firms have dominant business models, economic moats around their sources of competitive advantage, and influence well beyond the (often) narrow function that they make most of their profits from.
Other businesses have a similar profile with investors, but don’t have quite the same strengths. Netflix, doesn’t (yet) have the dominant business model or breadth of influence of the other firms, despite being part of Jim Cramer’s FANG grouping. Tesla is, in my opinion, still an early stage, sub-scale business. Chinese firms Alibaba, Baidu & Tencent have the business profile to qualify, but I am focusing on the US-firms for now as any investment in the Chinese firms exposes investors to risks over who owns the underlying assets of these businesses.
One stage in my investment process (explanatory video coming soon) is to evaluate each potential investment on the: (1) uniqueness of the customer (user) offer; (2) ability of firms to profit from their customer offer (competitive advantage); and (3) durability of that competitive advantage against the competitors that will arise (their economic moat). I will explain how I believe each of the titans, and other firms, stack up in future articles. My focus for now is on how the tech titans form much of “infrastructure” of the Digital Economy, and the implications that has for almost every business on earth.
Scale is less of a competitive advantage that it used to be
In the second half of the 20th century a firm’s size – more specifically it’s scale relative to its competitors within each market – was a key source of competitive advantage.
Such an advantage has long existed in manufacturing, as machinery & automated processes add scale with little loss of efficiency. But it has not always existing in other activities, as organizing large groups of people comes with frictions and inefficiencies. Ronald Coase pointed this out way back in 1937 in his seminal article The Nature of the Firm: “as a firm gets larger, there may be decreasing returns to the entrepreneur function, that is, the costs of organizing additional transactions within the firm may rise”
But for more than fifty years firms overcame these organizational inefficiencies because their greater size allowed them to: (1) produce higher gross margins due to greater bargaining power over suppliers and customers; and (2) spread other costs of doing business, such as distribution, R&D, marketing, and the investment required to incubate foreign operations, across their larger sales base.
In contrast, smaller companies faced many headwinds. Their products cost more to produce, reaching customers was more expensive (through placement fees in retailers or any direct distribution), and investment in R&D, brand advertising, or expansion into new markets cost much more per unit sold. It was extremely difficult to get new products off the ground, and even harder to build them into a profitable business.
For larger firms, this meant that success was almost self-fulfilling, and shareholders of such global firms benefitted. Those trends should apply in an industry like beer, as it has scale efficiencies in production & distribution, and the products suits mass-market TV advertising that is only economic for the larger brands.
But in the past five years, this happened:
Welcome to the Digital Economy.
The Digital Economy
The Digital Economy is breaking down many of the advantages of being bigger. The internet has improved communications (lower costs and faster speeds) dramatically, and this means that it is much easier for firms to work together to achieve their common goals. Small firms can “rent the scale” of larger partners. In brewing, for example, a small firm can develop a brand with the help of independent specialist brew-masters, independent branding experts, and some local celebrity marketing talent. The brand-owners can then outsource brewing and distribution to larger facilities (renting their scale) and use Google or Facebook to promote their product through efficient, targeted advertising. It’s a great mix of smaller businesses working together with larger partners.
The Digital Economy is creating many winners. As consumers we have much more choice of which products we want to consume, and they’re generally available at lower prices than before. Many small independent businesses are doing well, as more people take the opportunity to strike out on their own. See the chart below that shows the number of craft breweries is up 2.5x in five years. I realize this isn’t a perfect proxy for the success of these businesses, but it does show that many more people are successfully operating independent businesses than has historically been the case.
And the large infrastructure providers are benefitting from all these new firms, of course, as they aggregate supply to share the cost advantages of their scale. Take Amazon, whose role can be as the retailer (selling and fulfilling orders), the marketplace service (selling only) or the logistics service (fulfillment only). Amazon wants everyone on their systems, as more volume lowers per unit costs and increases the economic moat around their business. This approach would not have been possible twenty years ago, as communication tools were not efficient enough, but it works very well for all parties concerned in today’s Digital Economy.
These trends do have consequences however. As small brand owners are winning share from larger brands in many consumer product categories, not just in beer, they have been crimping the growth of the larger brands. Consider this chart from the Boston Consulting Group:
North American FMCG sales grew at 2.5% p.a. over a five-year period, slightly ahead of inflation. But almost all the growth was in smaller firms. The larger firms, which are the publicly listed ones most of us can invest in, are generally losing share to smaller firms. Their sales grew a paltry 1.2%, which is below the rate of inflation and so profits likely fell. That is not good news for long-term investors, as most of our potential investments are in “larger brands”.
What does this mean for investors?
There are a couple of logical investment conclusions to make from these insights. The first is to consider investing in the infrastructure providers for the Digital Economy (the tech titans, and other firms such as payment providers), as they will have many opportunities for growth in the coming years. I agree with this view.
The second would be to avoid large consumer goods firms, as they’re losing out to the smaller firms. But I think this second conclusion goes too far. We need to be wary of the challenges that these firms face, but then recognize that some firms are leaning into these challenges and using the Digital Economy to their advantage, and these firms may be excellent investments as a result. Consider Nike (NKE), which has fantastic content marketing (I use their free training app for workout routines instead of signing up to a gym), and initiatives such as this have helped them to build strong relationships directly with their end-customers rather than via wholesalers like Foot Locker. Online sales contributed $9.1bn of sales in 2017 (26% of the total) and these sales generate much higher gross margins for the business.
There’s a broader point here too. These insights are not just for consumer goods firms. They apply in finance and healthcare as well, but they’ve had less impact to date due to the regulatory complexity and greater needs for trust in both sectors. But those barriers are being overcome. In finance there is more scope for an independent view as to how people should manage their finances (which is one reason I’m starting this business) and in healthcare I expect we will see more pressure on expensive middlemen over time. Perhaps the new initiative from Amazon, Berkshire Hathaway and JP Morgan is the start of this.
Note: This article was originally posted to the Seeking Alpha website on April 16th, 2018.