Digital Disruptions – Moats in the Age of Disruptions

This article first appeared on Advisor Perspectives.
“When people say that an entrant is disruptive in an industry, what they really mean is that customers are adopting that new way. At Amazon, we’ve had a lot of inventions that we were very excited about, and customers didn’t care at all. And believe me, those inventions were not disruptive in any way. The only thing that’s disruptive is customer adoption. If you can invent a better way, and if customers agree that it’s a better way, then they will use that.”
– Jeff Bezos, emphasis ours

We live in interesting times. There have been significant advances in automation, artificial intelligence and robotics. Experts are of the view that these advances have the potential to dramatically increase the velocity of change and that the rate of innovation has already increased substantially. As investors in high-quality businesses, we seek to invest in those that possess durable competitive advantages. Clearly, as these advances achieve their expected outcomes and the pace of innovation quickens, they will result in disruptions to many existing business models and give rise to a few new durable ones.

However, as Bezos’ quote highlights above, technologies and innovations are not disruptive on their own. Disruptions occur because of customer adoption. In that respect, potential disruptors are no different from any other business. They have to identify customer’s pain points and offer a way of satisfying the customer’s needs in a manner that appeals to the customer.

Smartphones, social media and the road to consumers

Proliferation of smartphones globally and the increasing use of social media platforms have resulted in new means of reaching consumers by bypassing traditional channels. The effect of these technologies has been to dramatically increase the rate of adoption. This in turn allows businesses to scale up relatively quickly, especially those that don’t need large physical infrastructures to scale up. As is seen in Figure 1 , whereas it took nearly 75 years for the telephone to reach 50 million users and it took 14 years for the television to reach that milestone, it took all of 35 days for Angry Birds to reach 50 million users.

Figure 1: Declining adoption rates

Declining adoption rates

Innovators, equipped with advanced technological systems are able to innovate rapidly and by employing digital distribution mediums, are able to garner market share far quicker than was possible in a largely physical age. Figure 2 shows the impact of Whatsapp on the traditional SMS businesses . Whatsapp designed a better way for its customers to communicate than preexisting technology. Its adoption rate was heightened by smartphones and social media.

Figure 2: SMS Business Gets Disrupted

SMS Business Gets Disrupted
Digital disruptions: Increasing recognition

Not surprisingly, disruptive innovation has occupied an increased amount of the mindspace. As is seen in Figure 3, the term ”disruptive innovation” has acquired increased significance over the last few years.

Figure 3: Interest in Disruptive Innovation

Interest in Disruptive Innovation
This same behavior is seen in the expectation of business executives. As seen in Figure 4, an increasing proportion of companies are starting to recognize that digital disruption will have a significant impact on their industry. Nearly 30% of executives surveyed expect digital diruption to be transformative as compared to a near dismissal of such a prospect two years earlier.

Figure 4: Increasing recognition of digital disruption risk

Increasing recognition of digital disruption risk

Digital disruption does not spell trouble for everyone

However, the extent of disruptive force is not the same for all businesses. Figure 5 shows industry rankings by expected impact of disruption with industries in the center facing more disruption than those on the edges . One of the key differentiators is that businesses that are facing highest impact of digital disruption derive most of their revenues from business-to-consumer (B2C) business models.
Indeed, considering that the digital disruption as discussed here is primarily about access to the consumers, these transformations have a more significant impact on B2C business models versus business-to-business (B2B) business models.

Figure 5: Industry ranking of expected impact of digital disruption

Industry ranking of expected impact of digital disruption
Moats and the digital disruption wave: Benefiting from disruption or getting disrupted
As discussed thus far, digital disruption is a potent force. However, it is not a net negative force for businesses. For every business that is being disrupted and for which such disruptions are a negative force, there are others that are benefiting.

In the discussion that follows, we provide short case studies on four businesses. One of these is treated as a high-quality business by those who rely primarily on historical profitability of the business. The other three are a part of our high-quality investment universe. These case studies highlight that careful analysis and application of a structured decision making framework are helpful in identifying disrupted business models and staying clear of those that are being negatively impacted.

The disrupted: Campbell Soup Company

Campbell Soup is a leading packaged foods producer with brands like Campbell’s, Page, Prego, V8 etc. The company has a long history of successful operation with superior profitability. As is seen in Figure 6, Campbell has had healthy profitability and returns on capital over the years. Campbell’s strong historical financial performance means that purely quantitative systems designed to identify high-quality companies are likely to identify Campbell as such a business.

Figure 6: Campbell’s high profitability

Many other investors categorize the business as a brand-based moat. However, as we discussed in our article on consumer preference moats , we do not use the brand-based moat classification. Our rationale is that such a classification gives rise to the possibility of behavioral errors. We do not find a strong consumer preference to be associated with Campbell’s products. As a result, Campbell failed to meet our criteria for a high-quality business and has not been a part of our proprietary universe of high quality businesses, namely the Global Moats Index.
Campbell is currently facing challenging operating environment as the traditional retailing model which was the primary source of its distribution is experiencing disruption. To compound matters further, social media has accentuated the trend towards healthier food. Additionally, the ability to reach consumers through social media is allowing locally produced food items to take market share from commercially produced food. When combined, these factors have resulted in disruption to a business that has been around for more than 100 years.

The negatively affected: Coca-Cola

As against Campbell, Coca-Cola is indeed associated with a very strong consumer preference endowing the company with a strong moat. Having enjoyed the advantages of its moat and having compounded shareholder’s money at above average rates for nearly a century , Coca-Cola has recently started to experience stagnating to declining volume trends. As seen in Figure 7, Coca-Cola Company’s volume growth has been trending downwards and has been coming in close to zero percent.

Interestingly, Coca-Cola’s slowdown is not driven by any new disruptive product that is serving the cola needs of the consumer in a better fashion. Instead, the carbonated drinks market is declining as consumers steer towards healthier options due to growing concerns about the health effects of sugar. A modern audience with access to instant information have been able to quickly obtain and spread awareness regarding the health effects of sugary drink.

Figure 7: Coca-Cola Company’s Volume Growth Trends

Coca-Cola Company's Volume Growth Trends

As we discussed in our framework for consumer preference moats , an important element in assessing the strength of such moats is the customer interaction delta, i.e., the number of customers and the number of times on an average that a customer uses the product. The negatively trending volume growth for Coca-Cola highlighted to us a weakening of its competitive advantage.

No real impact: Givaudan

Givaudan is the dominant player in the fragrance and flavors (F&F) industry with a 25% market share globally. As against both Campbell and Coca-Cola that are both B2C businesses, Givaudan is a B2B business. As shown by Figure 8, while fragrances and flavors account for a relatively small portion of the customer’s COGS, they act as the most dominant criteria in the decision-making process of the end consumer. As a result, a company like Givaudan becomes an indispensable part of the customer’s business processes.

As we discussed in our article on our process for evaluating mission critical products and services-based moats , one of the keys in understanding the risks such businesses face is related to the demand for the customer’s end products. While it is possible that the ongoing wave of disruptions could end up disrupting the businesses of some of its customers, as long as consumers continue to consume perfumes and products that utilize flavors, Givaudan will likely be immune to such disruption.

Figure 8: Fragrances and flavors act as key drivers for consumer’s decision making

Fragrances and flavors act as key drivers for consumer's decision makingBenefiting from disruption: Wabco

Wabco Inc. manufactures and sells control systems, including advanced braking, stability, suspension, transmission control etc. to the commercial vehicle industry. The advanced braking and stability control systems are mission-critical products as they play an important role in vehicle safety and performance that requires technological know-how and expertise. Wabco collaborates closely with major OEM customers to design and develop the technologies used in the end vehicles.

With increasing convergence towards autonomous driving, Wabco will likely be a beneficiary as these technological advancements require better stability mechanisms. Figure 9 shows that Wabco’s growth will likely be driven by the convergence of content per vehicle across regions and the content per vehicle itself will be driven upwards by technological adoption. Wabco continues to stay at the forefront of innovation and is continuing to develop advanced driver assistance systems which help avoid potential collision as well as other mechanisms for functioning and evolvement of self-driving vehicles.

Figure 9: Technological adoption expected to result in higher content per vehicle for Wabco 

Expanding reservoir For Organic Growth

Summary

Technological advancements, smartphone ecosystems and social media are combining to create potent disruptive forces that are causing many existing business models to become obsolete or finding themselves in the need to reinvent. However, disruption is not a result of technological advancements. Instead, it is driven by customer adoption. This in turn means that digital media are truly potent disruptive forces as they have the ability to accelerate the rate of customer adoption.

However, as we have shown via the summary case studies, it is incorrect to assume that all moats are being disrupted and that all moat businesses are under threat. The disruptive forces currently being observed don’t mean that moats are not relevant any more. What they do mean is that a process that equates high past profitability to a high-quality business will be unreliable as it will end up acquiring many businesses that face disruptions.
Importantly, the thinking that a high-quality investment strategy is equivalent to a buy-and-hold strategy is erroneous. The analyst needs to not only identify a high-quality business but also needs to regularly evaluate the business for signs of disintegration of its moat and how digital disruption is affecting the strength of the moat via changes in customer adoption.

As we continue to point out via our articles that lay out our framework for evaluating competitive advantages, factors that need to be monitored for signs of disintegration are different depending on the source of the competitive advantage of the business, and accordingly will behave differently to the impulses of digital disruption.

Baijnath Ramraika, CFA, is a co-founder and the CEO & CIO of Multi-Act Equiglobe (MAEG) Limited and is the Executive Director at Sapphire Capital. As a portfolio manager, he manages the Global Moats Fund and the India Moats Fund. Baijnath’s thoughts and ideas can be read at his blog at www.symantaka.com
Prashant K. Trivedi, CFA, is a cofounder of MAEG and the founder and chairman of Multi-Act Trade and Investments Pvt. Ltd.

MAEG is an investment manager and manages the Global Moats Fund, an investment fund that invests in a global portfolio of high-quality businesses with sustainable competitive advantages.
Sapphire is an investment manager and manages the India Moats Fund, an investment fund that invests in a portfolio of Indian high-quality businesses with sustainable competitive advantages.
Multi-Act is a financial services provider operating an investment advisory business and an independent equity research services business based in Mumbai, India.


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