The Last Samurai
Nishiyama Onsen Keiunkan. No, this is not the next location for a scene in The Last Samurai but a hotel located by a hot spring in Japan and it’s also the oldest known company according to the Guinness book of records. Founded in 705AD, it has been operated by 52 generations of the same family – now that is staying power. Whilst operating in family hands as opposed to being a public company, has no doubt added stability and longevity to this operating company the nature of its business also makes it hard to materially disrupt. Online booking engines and other forms of hotel competition provide natural competitive pressures but its unique location adjacent to a sought after hot spring has no doubt provided some moat against competition. The hot spring and the business “moat” are topics I’m going to refer back to as significant in assessing business duration.
Innovation and change are two constants running in the background of every business. This means that unless your business is in some way evolving each year is it likely to be gradually losing relevance to its customers and employees. I’ve talked in previous articles about some of the technology innovations enabled via the two mega trends of the internet and the ubiquity of fast mobile broadband which are starting to inexorably disrupt several industries. Airbnb – the hotel industry, Uber – the taxi industry, Priceline/Expedia – travel agencies are just a few examples. But another less obvious change is the broadening out of the competitive set for ANY business to entrepreneurs and innovators who understand how technology advances and how the internet have opened previously closed markets. The moats of a number of previously unassailable companies have suddenly become a lot narrower, with far fewer sharks. A great example here is the media industry. Several years ago the only way for good journalists to earn their living was to work for a well-established media masthead – The New York Times, Financial Times, The Australian and others were the likely abode of the world’s best journalists. The leading papers bought the audience and the journalists informed and entertained them. Journalists were an important ingredient but the papers would have survived if the talent had decided to leave. Today, journalists can publish their own content to a global audience at virtually no cost via their own mastheads called Blogs (Weblogs). This is creating a large number of new news sources which better cater to expanding media tastes. Worse still for incumbent news purveyors, the prevalence of smart phones with superb high definition video cameras enables almost anyone to break news to the world. Case in point being the tragic Sydney siege late in 2014. Whilst all the TV stations were lamely broadcasting no news, the real story was unfolding in real time on social media platforms.
One more example will serve to highlight the emerging risk in other industries. Only a short while ago the shaving market was dominated by two global brands – Gillette and Schick. Trying to launch a new shaving brand would have been tantamount to throwing sacks of cash into a blazing furnace. Since the internet has made all consumers effectively omniscient and global logistics all products omnipresent, new ideas can much more easily reach consumers. New products no longer have to pass through the eye of a needle necessary to get listed on the shelves of a Coles or a Woolworths (or their foreign equivalents). Furthermore, once established, these new brands will likely be able to exist at much smaller scale than the previous consumer behemoths that comprised Gillette and Schick meaning the competition will be sustainably able to nibble away at the established brands for years. I haven’t counted how many new online razor brands there are but I can name several (dollarshaveclub, Oscar Razor, 800razors.com and check out Aussieshave.com for a laugh). The point is that branding is changing, distribution methods are changing and if you are gouging your consumers your business is going to start to struggle as moats everywhere are shrinking.
This brings me back to business sustainability, duration and moats. The best businesses I’ve ever invested in worry about their duration and moat as much as their growth. Managers who concern themselves with duration are likely to create more value through market share gains. Gaining growth via market share is always a more sustainable strategy than raising prices as it gives your business more scale whilst correspondingly diminishing your opponents.
Raising prices whilst demonstrating the strength of a business can, if done egregiously (viz Gillette’s continual price increases) eventually come back to bite. Those enormously fat operating margins had better have some large and unassailable moat to hold out the inflow of competition. There are few examples of companies in the Australian context who have expanded their moats via market share gains and operating leverage. Domino’s Pizza is one, who recently lowered the price of its pizzas in a meaningful way. This drove share gains and much greater volumes through its system further strengthening their relative position versus key competitors who have responded via store closures. In a global context, businesses like Amazon.com, Costco and Aldi have all reinvested their operating leverage in reducing their prices or offering their customer more value via things like free or subsidised delivery. In contrast a number of companies in Australia have pulled the price lever at the expense of duration. Examples here we believe would include Realestate.com.au who seem to have stretched their pricing well beyond what is justifiable from their additional audience share over Domain.com.au and now run the risk of having to retrace pricing to hold their customers who are starting to defect to other sites. We would also highlight the risks at businesses like Ozforex, who although earning high returns on capital with high margins at present, are allowing competition to price under their umbrella. With competition rising and the cost of customer acquisition also increasing, it feels like only a matter of time before these forces start to crimp current business growth, margins and thus business duration.
Further evidence of the increase in the speed of change has been put forward by Prof Richard Foster who has pointed out that the average lifespan of a company listed on the S&P has declined from 67 years in the 1920’s to around 18 years today. The process of innovation, disruption, critical mass, breaking point and destruction has been dubbed “creative destruction” in a nod to that fabled Austrian economist Joseph Schumpeter. Not all companies go out of business of course, some are bought out, broken up or merged such that they cease to exist in their independent form. But the trend, particularly when we use perpetuity valuations to work out fundamental values in equities, is cause for reflection. What appears certain is that business duration risk is rising and this is something few investors or management teams seem to be addressing. Our best form of defence in these circumstances is to try to find good companies with business moats by virtue of their location next to the metaphorical hot spring or by superior business strategy and execution.
The IPO cycle is in full force with Venture Capital firms exiting at full tilt, interest rates still remain at record lows and housing is booming in key Australian cities. None of these facts give us cause for celebration as investors as we would rather be loading up our portfolios with heavily discounted securities in poor markets. However, a bit like miners who seem incapable or thinking against their business cycles, most investors would rather pour more money into an expensive consensus bull market than hold their ammunition for less consensual and thus more bargainladen times. Our team, curmudgeon like as it is, tries to resist the call to follow popular paths and we remain on the lookout for opportunities in less popular segments of the small and microcap markets.
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