Sunday, April 24, 2011

Dominant firms and Wide moats : How moats are breached

Incumbent dominant firms typically have a strong competitive position. These companies are dominant because they have out-executed the competition, and have found the most successful playbook for their ecosystem. If the firm's dominance came after years of open competition, then chances are that the winning playbook has been battle tested against almost every other type of competitive strategy. In other words, you'll be hard pressed to find a better way to win in the ecosystem. These firms have identified (consciously or unconsciously) what their customers value, and have built their operations structure (systems, social proofs, measurements, infrastructure) to delivering to that need in the most effective way.

For example, a dominant FMCG firm is likely to have found the best mix of how to elicit customer needs, carry out chemical R&D, design and manufacture, sell through retail channels, and build mind share in the consumer consciousness. A dominant retailer is likely to have found the winning formula for selling to a particular consumer segment, delivering the desired products at the desired price to consumers at the time and place that they prefer. These companies are likely to have shaped themselves to exploit any and every edge and efficiency in the business, to dominate over their competitors.

Some industries are not amenable to concentration or lack structural economic effects, for example: the business of mining and supplying construction aggregate, flour milling and cement manufacturing. In these industries, the dominant firm is likely to be an extraordinarily canny executor. In industries where there is an economic effect (for example, economies of scale or the network effect), the incumbent will have an even wider-moat around its business.

Investors often bet that these companies will be able to keep the competition at bay, and provide a stream of earnings that can be estimated with a higher degree of certainty. So one of the key risks that these investors need to assess is the probability that the company's moat will be breached. In other words, "What Can Go Wrong?" or "How might a competitor breach the moat and dethrone the king?"

Dethroning a dominant firm in an ecosystem is very difficult. A look at history and the world of business suggests that a competitor can only make headway if (a) the management screws up and destroys the business from within, or (b) some facet of the ecosystem has changed and the incumbent has not recognized or reacted to it. The former is entirely a function of how competent management is, and as investors, the question is whether shareholders will be able to effect management change if the executive office goes sour. Management can go sour when incompetency sets in, or when management simply forgets the playbook that made the company successful.

Ecosystem changes on the other hand can cause an irreversible decline in a company's prospects under certain conditions. A business ecosystem can be broadly thought of as the combination of: (a) the nature of source of demand, (b) the nature and source of supply, (c) the tools, regulations, technologies and factors of production which companies use to create value for customers. Ecosystems typically change in one of the following ways:

(1) a disruptive ecosystem changes occur (such as the internet changing the playing field for newspapers, or the change in zeitgeist from one fashion trend to another). These typically cause the incumbent and the industry to go into terminal decline. Mature established businesses rarely have the organization tools, social proof mechanisms and culture to allow them to operate like startups in a greenfield area. Further, the organizational imperative and social proof will drive management to defend the established cash-cow at all costs, which causes the organization to dig itself into the dying ecosystem further.

(2) the ecosystem experiences incremental changes that change the shape, but not the essence, of how businesses operate in the ecosystem. These changes typically come in the following forms:
  1. A new way of running operations (for example, brought about by technology, new thinking, or infrastructure changes) appears. In this case, a competitor can leverage this new approach to become better at the game than the incumbent. For example, Walmart took the approach of going after 2nd tier towns and building geographically contiguous logistics facilities, and achieved a lower cost of operations than K-Mart. By failing to take on this new operating approach, K-Mart allowed upstart Walmart to grow and eventually dethrone it.

    Dominant firms need to be constantly adopting incremental changes to keep operations and its business at the forefront, and to minimize any comparative efficiencies that competitors can exploit to operate more effectively than the company.

  2. A new market segment starts to become viable.
    (a) For example, the rising incomes in China and India make it imperative for dominant firms like KO and PEP to start selling there even if profits are not apparent. Apart from the need to build a future consumer base, allowing someone else to serve these large new emerging markets first would sow the seeds for a big competitor to come up in future, and dethrone the incumbents. (The corollary is that the maxim "China is market you have to be in" is really only true for large dominant firms that need to defend their positions. If you are a small enterprise, plunging into a big foreign market isn't something that needs to be front-and-center on your radar)

    (b) as another example, major banks in the United States are trying to serve the market of "the un-banked" blue collar immigrant workers. Failing to do this may allow lateral players who have relationships with these consumer, such as WU, WMT, cash advances and pawnshop operators to build a firm foothold which could allow them to gradually expand and one day challenge the banks in the financial services arena.

  3. Not responding the shifts in consumer demand or zeitgeist. A dominant firm that fails to read its consumers can cede ground to competitors. For example, for quite sometime Coca-Cola focused primarily on its flagship cola, even as consumer tastes gradually become more disparate. If KO had not reacted in time and diversified its product line, it is entirely likely that a competitor could have grown large enough to challenge KO simply by selling the sodas, still waters, teas and other drinks that the public wanted. If that happened, one pillar of KO's moat - it's dominant distribution system, would have been severely compromised.

  4. A new form of supply emerges. A dominant firm fails to respond to changes in sources or nature of supply. For example, consider how Les Schwab managed to compete against the dominant tire-store chains (who were tied to then dominant American tire manufacturers) by selling Japanese made tires. (An equally intriguing question is how did the Japanese tire manufacturers compete against the dominant American tire manufacturers? The answer is that they rode the wave of Japanese car exports. Which begs the question of how did Japanese car manufacturers manage to invade the home turf of the US automobile giants? They likely made headway by leveraging the oil crisis shock to the automobile-industry-ecosystem, which caused consumers to start looking for more fuel efficient cars. Japanese manufacturers wedged in through that shock and then continuously out-executed the competition through innovation and product quality)
For a competitor to exploit these, speed is of the essence. The competitor must quickly build itself up before the dominant firm realizes what is happening. Dominant firms are typically very well placed to close these gaps because:
  1. the incumbent has an in-place infrastructure and cash flow, giving it a whole lot more resources than the upstart competitor. (In many cases once a dominant firms starts addressing a gap that a competitor is trying to fill, the economically sensible outcome is for the competitor to sell itself to the dominant firm)

  2. the incumbent has customer share of mind; Customers know the incumbent firm, and the inertia of customer behavior allows the incumbent to swing the customer back to its offering once it closes the gap with the competitor.

Because of the advantages of incumbency, It is often the case that incumbents (apart from situations of disruptive ecosystem change) cede ground to competitors only when (a) an ecosystem change occurs, and (b) management fails to reach because of hubris, inattention, or other reasons, and (c) the new competitor has extremely good execution capability.

For investors, the takeaway is:
(1) at the right price, buying the incumbent dominant in an ecosystem is a good bet
(2) but you must assess the parameters of the industry ecosystem in which the firm operates, and watch for changes to it

* In addition to the other things you would need to assess for any investment. For example, factor additional risks for industries where non-economic actors are likely, for example strategic industries prone to government intervention (e.g. Petrobras, power utilities), or vanity industries like sports teams where owners are looking for "fun" and not profits - in both examples, competitors can operate at a loss for long periods of time and destroy any dominance an incumbent may have.