This is the continuation of my post from last Friday.
A generation ago, establishing a competitive edge in a business was about having plant and equipment, operating that physical capital efficiently and, for consumer-facing firms, advertising to create and maintain a brand image.
First mover advantage was often key, since it might allow the initial entrant to achieve economies of scale (lower unit costs) in manufacturing or marketing that would discourage potential rivals by making their path to profits prohibitively long and expensive.
The Internet, and the rise of China as a low-cost contract manufacturing hub, changed all that. Supply chain management software did allow vertically integrated companies to coordinate actions much more efficiently. But it also gave smaller, more focused firms the power to create virtual integration using third-party supply chain partners.
Today’s competition, particularly in the consumer arena, is as much about services as physical products. The development of internet-based social media has made it much easier for a fledgling niche product to find a voice without spending heavily on traditional advertising.
Knowledge and relationships have replaced plant and cumulative advertising expense as “moats” that protect a firm from competition.
These developments present two problems for stock market investors:
–the first one is straightforward. Comparing a stock price with the per share value of tangible balance sheet assets (Benjamin Graham) may no longer provide relevant buy/sell signals. Nor will supplementing this analysis by including intangibles (Warren Buffett), using, say, the sum of the past ten years’ advertising expense.
A very successful value investor friend of mine used to say that there are no bad businesses, there are only bad managements …and bad managements will invariably be replaced. In an overly simple form, he thought that so long as he could see large and growing revenue, everything else would take care of itself. Broken companies were actually better investments, since their stock prices would leap as new managements created turnarounds.
As I see it, in today’s world this traditional approach to valuation is less and less effective–because assets no longer have the enduring worth they formerly did.
–first mover advantage is probably more important today than in the past. But while network effects are readily apparent, a company’s development stage, where the network is growing but the source of eventual profits is unclear, can be very long. And it may be difficult in the early days to separate a Fecebook from a Twitter.
So while we can all dream of finding a profit-spinning machine that has high turnover and negative working capital, today’s versions are inherently more vulnerable than those of a generation ago. They may also come to market in their infancy, when what kind of adults they’ll tun into is harder to imagine or predict.