Why this article?
2018 was a wild ride in the stock markets. In fact, it wasn’t just stock markets; investors in general hardly had any pockets of refuge. It’s gut-wrenching to watch your portfolio jump around violently as the market swings from euphoria to pessimism and back. From October to December, it felt like a long, drawn out phase of pessimism, with fleeting moments of euphoria. Instead of feeling down-and-out, market “corrections” like this should bring a smile to our faces.
“When investing, pessimism is your friend, euphoria the enemy.”– Warren Buffett
Pessimism is our friend because most investable assets are much cheaper today than they were a couple of months ago. This is the time to shop for good deals. Long-term investors like us have time on our side. Volatility is uncomfortable but it’s not fatal – its impact is simply emotional rather than lasting financial damage. So, what to buy? Another Buffett-ism gives us a sense of direction:
“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.”
During these pessimistic times, prices tend to be on the comfortable side. We just need to look for comfortable businesses now. Easy-Peasy. Well, not quite. Traditionally, investors like to move to “defensive” stocks during a market downturn or an economic recession. Traditionally, defensive stocks tend to fall in the Utilities and “Consumer Staples” buckets – think Power Generation, Water, Food and Alcohol companies. The thinking is that those stocks will hold their ground because of their less volatile earning streams. We’ll look at some of these. But times have changed. Being defensive now, to me, means that we should look at companies that dominate their turf, irrespective of which official sector the company is assigned in a benchmark like the S&P 500. And amongst those companies that dominate today, the question is: which ones have a wide moat around them that protects them from competition and from the threat of startups? I’ll bring that back to the way we do things at The Buylyst: which of these companies have a massive competitive advantage today and one that’s durable in the future?
It’s possible that one or two of these “Global Dominators” are suddenly trading at “comfortable prices” because of a panic-induced selloff. And if they are, lollapalooza! This leads us to some follow-up questions:
- Who are these Global Dominators?
- Will their dominance last?
- Why or why not?
The List of Global Dominators
Below is a list of companies that, in my view, qualify as the 800-pound gorillas in their respective fields. The list is not meant to be exhaustive. It is obviously limited by my worldview and my inclinations. You’ll notice that there are lot of technology companies in the list below. But, in my defense, it just so happens that:
- Many of the largest global dominators are technology companies.
- For reasons we’ll discuss, tech companies have arguably wider Moats around them compared to their pre-internet-era, industrial giant predecessors.
Also, I’ve left out commodity-based companies like Oil & Gas or Mining companies, for reasons I’ve discussed here and here.
Ok, so here’s a list of dominators I could think of:
- Coca Cola
The criteria for this list was simple:
- Who are the biggest investable companies in the world?
- Do they have limited competition – just 1 or 2 competitors?
- Do I think that the threat from the startup ecosystem is very low?
It turns \that just 6 of these are not “Tech” companies. Everything else is normally categorized as Tech, but I look at them slightly differently. As far The Buylyst worldview is concerned, the best representation of it is the Themes page. It clearly lays out where The Buylyst’s bets are and why. Some of those themes can be directly categorized as Tech. Some are not. But in taking a stake in Progress, the presence of Tech in every Theme is indisputable. This is the world in which we live. Data is the new Oil. Computing Power is the new Automobile. And that’s regardless of destination, theme, sector, industry, country, product or whatever category you’d like to use. “Fintech”, for example, is redundant in my view. If you’re a “Fin” without “Tech”, you’re dying.
If history is any guide, big, dominant companies are bound to fail and give way to new, energetic upstarts. Incumbents don’t remain incumbents forever. Here’s an interesting way to put it:
“At the current and forecasted turnover rate, the Innosight study shows that nearly 50% of the current S&P 500 will be replaced over the next ten years.”
The data in this study suggests that the duration during which big dominant firms stay dominant has been shrinking over the last few years. But it’s also true that the world has changed significantly in the last 30 years. I keep saying this enough to sound like a broken record but its worth emphasizing:
- The PC went mainstream a little over 30 years ago.
- The Internet went mainstream a little over 20 years ago.
- Smartphones went mainstream a little over 10 years ago.
- And now AI via Cloud is going mainstream as I write this.
This article from The Economist paints the same picture from a more qualitative angle.
“The past is not regarded as a meaningful guide to the future in Silicon Valley and Chinese tech circles. But at the height of their powers, giant companies make blinkered, unreliable guides to their own futures.”
The point of both those articles is that when companies get too big, they become lethargic, bureaucratic and too slow to adapt to a changing world. The last point – failure to adapt – is the most potent killer. Companies tend to be laser focused on their industry or product niche. They thrive in a certain “state of the world” and become massive. The company – its management, structure, employees, and capital expenditure decisions – are all built around that state of the world in which they’ve thrived. Why fix something that ain’t broken?
But as they become the 800-pound gorilla in their favorite state of the world, they lose sight of the problem they’re trying to solve. They “shape the buildings” and then the “buildings shape them”. They become married to a certain kind of company. And then the world changes. It always does. The state of the world that made the company the 800-pound gorilla doesn’t exist anymore. And then the company fails to adapt, partly because it doesn’t want to. It’s too invested in the “way things used to be”. Their CEO probably rose through the ranks in that comfortable state. US Steel is a prime example. Coal companies are another – they thrived in a world where there wasn’t any Renewable Energy technology or any way to dig out more Natural Gas. But those things came along, and Coal is not so relevant any more. The 800-pound gorilla in the Coal Industry is the big fish in a small pond. Many Automobile companies today are facing a changing world. In the developed world, car sales are slowing. Those lazy, entitled millennials (my cohort) aren’t buying enough gas-guzzlers. Automobile companies tend to think of themselves as an automobile company – one that’s fully invested in the idea of families living in suburbs who buy a sedan and a minivan. Well, that is probably going to change (is already changing) and if car companies don’t adapt, they will die a slow death. But if the car company thinks that its role in the world is “transporting people”, then it has the mindset to adapt. If that’s its mission, it’s business, then the company doesn’t care if they need to sell sedans, minivans, SUVs, Electric or even Autonomous Vehicles. Ford’s CEO Jim Hackett wants to redirect Ford from being a “car company” to a “mobility company”.
The Ice Factory
Guy Kawasaki, who was once the Chief Evangelist of Apple’s Macintosh division, gave a reliably entertaining TED talk about Innovation. And in it he tells us the story of an ice factory. Back in the early days of the 20thcentury, there were people whose job it was to go out into the countryside to cut an bring back blocks of ice from frozen lakes to sell in cities. Then somewhere along the way, somebody invented an Ice Factory. The company who sold ice from frozen lakes went out of business. A few years pass, and someone invents the refrigerator. Boom – the Ice Factory goes out of business. Now, if the person who had the “Ice-picking” business had thought of himself as being in the business of “keeping things cold”, he might have adapted. Ultimately, the refrigerator and the block of ice from the frozen lake did the same thing. But technology changed the way things were kept cold.
I mentioned the Automobile company in the previous section. The more they think of themselves as Mobility companies, the better their chances of survival. In the Entertainment industry, Netflix is a great example. It’s in the business of video entertainment. How it started and where it is today look and feel completely different. They had started off by mailing DVDs and ended up with a Streaming Service. Blockbuster stuck to the business of being a “video rental store” instead of being a video entertainment company. It didn’t adapt. Netflix did. It found a way to make things easier for people who wanted to watch video.
Now, Netflix did this through innovation in software. It saw where the future was going to be – broadband internet and Cloud – and it took its entire business there. This – innovation in software – is the main survival tool for most companies in most industries today. Almost no company is simply lukewarm on employing AI and Big Data. Almost every firm is investing heavily in it – either on the front-end to help customers or on the backend to help their production processes. Companies are using software to basically do 2 things:
- Differentiate their core offering.
- Widen the Moat.
During the days of the Robber Barons, or even as recently as the 1990s, economies-of-scale was the name of the game. The Global Dominators of those days had mastered it. The Modus Operandi was to aim for the cheapest marginal cost of producing a physical product (via economies of scale) and then spend big money on advertising and distribution. Dominators like Coca Cola created a brand through superior distribution networks across the world. Produce Big, Advertise Big, Distribute Big – that was the modern remnant of the Industrial Revolution.
The odd thing about software is that marginal cost of production and selling are very low. Most of the costs are incurred upfront and are fixed. Then software can be replicated ad infinitum, instantly. Then came the internet. Now distribution costs practically became $0. Software could be downloaded instead of buying and inserting a clunky CD into a CD-Drive. Then, just a few years ago, came the Cloud. This has again changed the game. Now companies can practically push their latest software products onto the customer in real-time, as soon as it is developed. Windows, for example, is slowly but surely moving on from being an Operating System to a Platform-as-a-Service, delivered via Cloud.
Here’s the combination that’s changing almost every industry’s business model: Constantly updated, state-of-the-art AI-infused Software, delivered via the Cloud to any Edge device – smartphone, laptop, tablet, VR/AR machine, IoT objects – any time. The part of the business model it has changed is Distribution. But we’re not talking just about distribution of products or service. We’re talking about disintermediation on a massive scale. This is a double-edged sword for the Dominators.
Software can take out the middleman in many industries. If every company can sell on the internet, why do we need distributors? For those of you who were forced to read Michael Porter’s Competitive Advantage in university, you’ll recall that one of Porter’s 5 forces of barriers to entry was Supplier Relationship and Buyer Relationships. Well, with software that talks to each other, these have become direct, real-time communication channels between buyer and supplier. There must be thousands of “marketplace apps” on the App Store.
Take Uber, for example. It digitized Trust, Availability and Reliability and took the middleman (the city taxi authorities) out of the equation. This highlights an important point. Incumbents who invest heavily in digitizing parts of the business model can widen the moat very quickly. But these 20thcentury type barriers to entry like relationships with suppliers and distributors no longer serve as Moats. Anyone with enough imagination and resources to hire a few top-notch developers can disrupt big industries by attacking just one part of the incumbents’ business models. That’s the double-edged sword.
The bottom-line is that the faster incumbents can digitize most parts of their business with AI on the Cloud, the less susceptible they are to those pesky startups. If incumbents are in the Ice-Factory business and not in the “keeping things cold” business, they will be disrupted. Software infused with AI, delivered via Cloud to any Edge Device, real-time, will find a way to disintermediate some process that will create havoc in incumbent business models.
The Buylyst Checklist
When we look at the 800-pound gorillas of the business world, we don’t want to invest in the Blockbusters of 1999. We don’t want to invest in the Ice Factories that refuse to get into the Refrigerator business. We want the companies that have a clear Core Competency, who use Software to adapt, differentiate and widen the Moat between them and their competition.
The Buylyst uses a consistent checklist to analyze all its investment ideas. The same checklist is a useful format to analyze the effect of software in keeping the 800-pound gorillas well fed and strong. This is a good set of questions to ask when looking through that list of Global Dominators.
Every Buylyst Investment thesis has 3 main categories with 3 sub-categories each:
- 1.Competitive Advantage: The Castle
- Core Competency: What does it think is its core business?
- Products – Better or Cheaper: Is it using software – AI & Big Data – to differentiate its products? Is it using software to enhance user-experience of its customers?
- Evidence – Revenue Growth: This is obvious – do people still want their product?
- 2.Durability of Competitive Advantage: The Moat
- Competition: Who’s the main competitor? Can startups disrupt its business model by disintermediating a small part of the incumbent’s business model?
- Protection: Is it using software – AI and Big Data via Cloud – to build a voluminous river that collects so much silt along the way that its competition can’t catch up?
- Cash Flow Resilience: Can it get into a subscription model in which recurring cash flows are less susceptible to competition and disruption?
- 3.Management Quality: The Generals
- Strategy & Action: Does Management have a clear mission? Or is it fostering an ice-factory like culture?
- Financial Productivity: Does Management have a track record of making high returns on their “Moat-widening” expenditure?
- Sustainable Free Cash Flow: Does Management focus on Cash Flow instead of Earnings?
For some companies on the list that aren’t categorize as “Tech”, this list may be harder to answer. But it still applies. Boeing and Diageo are certainly using AI and Big Data to differentiate themselves. The question again is: Are they creating a wide moat by doing so? Are they doing it to differentiate their product, their customer service or their customer experience?
The Dominators Checklist
So, in short, what am I looking for as I look through the list of 25 dominators?
- What problem are they solving? Will they go the way of the Ice Factory?
- Will they adapt with technology?
- Are they using the AI-Cloud-Edge revolution to make things easier for their customers?
- Are they investing heavily in software to differentiate and widen the Moat – both against competitors and against startups?
- Are they cash-flow focused? (This probably rules out Netflix, but we’ll see.)
This checklist goes on top of the customary Buylyst First-Date Screener.
Let’s break some ice!