Today is a first for the Shares and Stock Markets Blog – a guest post.
Jason Tan is an experienced value investor currently nurturing a growing client list based on the early Buffet Partnership structure. A true value investor, Jason takes us through the impact that an unsustainable competitive advantage can have on companies and therefore stock valuations focusing on market share and economies of scale.
Since looking at stock price movements gives very little benefit to predicting long-term results, I’d like to talk about two very closely related things that are inherent in business that I look at to guide investment decisions:
- The first – high variability – is something that is found in businesses that my partnership will almost always try to avoid.
- The second – economies of scale – is a key quality we look for in companies that we very much like to be a part of.
By the end of 2008, 36% of cell phones sold around the world were by Nokia.
Samsung was a distant second at 15% market share but the discrepancy between the two companies was far wider when it came to a special category of cell phone called smart phones that were designed as pocket computers that could access the internet.
In that same time period, Nokia had an even more commanding 41% market share of smart phones while Samsung had a laughably insignificant 2%.
By 2012, a little over three years later, smart phones have become mainstream and what used to be known as regular cell phones are increasingly becoming obsolete relics with almost no profit margins left to speak of.
Now, business school commonly teaches us that “economies of scale” usually means that there is an inherent advantage in being the company with the largest market share because that company has the privilege of being the lowest cost operator.
Market leadership can be leveraged to undercut peers in price (or get a price premium without sacrificing volume), develop better product features, spend more on marketing and sell products to a wider distribution network.
In short, economies of scale make it very hard to beat a market leader.
If the cell phone industry had economies of scale, then Nokia should be at least roughly as dominant now in the smart phone era as it was in the pre-smart phone era.
Of course, we know that just the opposite is true.
Nokia’s market share in smart phones has crashed to 5% while Samsung is now the worldwide leader at over 30% – why was Nokia beaten? And perhaps equally as important, why was Nokia beaten so devastatingly in such a short period?
The simple answer is that during this time, Samsung chose to develop their phones based on a superior computing platform developed by Google called Android, while Nokia chose not to.
While this is basically true, it is an incomplete answer.
Since a smart phone essentially represents the addition of a lot more computer features to a single phone, there are now far more variables that you have to get right simultaneously in order to keep selling phones.
Today, the operating system, the graphic interface, the hardware design, the screen resolution, the camera resolution, the computing power, the energy efficiency, and the support of the service provider are all important to a new phone buyer.
Even if you have a 95% chance of getting each of these eight variables right for any given phone, this still leaves you with about a 34% chance of market failure (1 – 0.95^8) assuming all variables are equally important.
This does not even factor in non-product variables like marketing and retail strategy.
To make matters even worse, the average length of cell phone ownership is only 20.5 months, which means that a cell phone company has to not only get all of these many variables right over and over again, they also have to pray that new variables are not introduced by competitors and that they are able to better predict the correct mix of important variables year after year.
All the while, the prices of the previous year’s products go down by half, eliminating all margin for error for new products.
The opposite of this is a product like Coca-Cola, which customers actually demand to stay constant decade after decade even as they consume it on a daily basis.
It is no surprise then that the consumer electronics industry is littered with numerous former market leaders that are now radically weaker like Nokia, Motorola, Sony, HP, Nintendo, and RIM, while the beverage industry is still increasingly being dominated by Coca-Cola and Pepsi.
You might have noticed that the general media is often very excited about covering high variable industries like consumer electronics, consumer internet services, video gaming, teen fashion retail, restaurants, hotels, airlines, and motion pictures. This is precisely because these industries are constantly changing, which creates a lot of excitement, suspense and intrigue for the viewing public.
These industries can always be relied upon for breaking new developments that can determine the fortunes of the different participants in an instant.
Of course, this is the exact opposite of what we want.
As long-term investors, we are looking for businesses with high levels of predictability. We want companies that can reliably become more dominant over time.
One of the best ways to identify such companies is to find ones that do have economies of scale.
It follows that to have a sustainable advantage of scale, a business has to have very few variables to worry about.
The cost structure of the business should also tend to lean more towards fixed expenses (e.g. electricity, factory overhead) that do not rise in proportion to increasing sales. In other words, there should be few variables that influence both the revenue side and the cost side. And if you look at industries where these two conditions exist, the winners are often predictably the same and new competitors rarely enter.