The end of moats

"Strategy is stuck" - this is how the preface to the book The End of Competitive Advantage begins. Written by Prof Rita Gunther McGarth of Columbia Business School, the book points out that the tools that businesses have relied on to develop long-term sustainable advantage' are not going to cut it in a world where competitive advantages are transient at best.

Besides business strategists, investors too need to take a hard look at the lessons from this book as 'moats' (analyst shorthand for competitive advantage) around businesses shrink, and yet equity markets around the globe touch stratospheric valuations to the point where the word 'valuation' seems meaningless.

'Transient competitive advantage'
Prof McGarth points out that the notion of sustainable competitive advantage - the holy grail of business strategists - is a thing of the past. Businesses like music, technology, travel, communication have for long faced short cycle times, where advantages get copied or customers seek other options. These are now percolating down to more traditional industries as well.

I recall when I studied business management, one of the data points that struck awe was that Hindustan Lever (as it was known three decades back) had a distribution reach across two lakh retailers. That number was daunting enough to cool the ardour of the most energetic competing marketer. In today's scenario, online marketing, brand building, organised retail and hyper-local delivery companies all combine to offer a very competitive option to someone looking to launch a product in the fast-moving-consumer-goods space. The rapid growth of Patanjali and the distribution reach that it has managed to acquire in a short span of time are illustrative of the fact that physical moats - number of distribution points - perhaps are now not so high a barrier to climb.

Prof McGarth refers to Nokia, Sony and several other examples in her book. Her conclusion: the assumption that "once achieved, advantages are sustainable" doesn't hold true any more. She goes on to point out that presumption of stability "allows inertia" and concentrates power in the hands of current business leaders. This inhibits innovation and prevents a company from moving into newer directions that may be needed to satisfy emerging customer needs. Ian MacMillan, another researcher in business strategy, points out that competitive strategy could be thought of in waves, with the job of the strategist being to launch ever-new waves to seize strategic initiative.

Competitive advantage can, therefore, be thought of as a series of transient waves, each of which needs to be caught early, ridden to the crest and eventually exited. Existing advantages cannot be milked forever without exploring new opportunities. This obviously has tremendous bearing on the nature of the organisational structure, resource allocation and governance structures.

Very few outliers
As part of the research for the book, the researchers looked for companies that grew at least 5 per cent over 10 years (2000-2009) in revenues and net income. Their dataset (companies with market cap over $1 billion at the end of 2009) led them to only 10 companies. These included Infosys and HDFC Bank from India. Further research indicated that "this group of firms was pursuing strategies with a long-term perspective... but also with the recognition that whatever they were doing today wasn't going to drive their future growth." They had found ways of "combining tremendous internal stability" with "external agility" - not something easy to replicate.

While the book offers some ideas on the strategy playbook companies can use to help them navigate through more tumultuous times, there are several questions that this assumption of shorter and ephemeral competitive advantage throws up for investors.

Importance of management reiterated
Often, evaluation of management when analysing companies is cursory in nature. At least in India, it is focused more on whether it is friendly to minority shareholders or not. Management actions on resource allocation, manpower strategy and innovation are rarely analysed or commented upon. Yet the corpses littering the path of disastrous resource allocation and consequent business destruction are too numerous to be ignored. Mindless global acquisitions in the decade of 2000-2009 basis cheap capital led to many Indian groups to acquire businesses in terminal decline in overseas markets without any serious understanding of what advantage change of ownership would bestow on those companies. Many of these mistakes are slowly getting rectified but at a great cost to shareholders and lenders. And this was at a time when the only unfavourable variable was a general decline in economic activity. Imagine their plight if they had simultaneously witnessed a change in customer preference for products other than theirs or an unforeseen change in technology.

Flexibility is the key to success
Innovation is inherently risky. To ensure success, innovation must be parsimonious with the use of capital till the hypothesis is tested in the market. Once the proof of concept is established, only then does it make sense to scale up and deploy rapidly. This requires nimbleness not only on the part of decision makers but also the workforce and managers. It also emphasises 'availability' of assets for use rather than ownership of assets. A simple example is adoption of 'cloud' for technology-based products. Ownership of hardware is no longer deemed essential. Quick availability, scalability and rapid deployment are at a premium. This applies to other assets too - whether it is manufacturing facilities or manpower.

In a market scenario where longevity of a business model is severely under threat, Prof MacGarth suggests that the 'net present value' of a business is not the ideal way to decide whether the economic life of a business had been reached. She suggests that constant investment is required to reinvent the business and long-term value extraction may not yield the results as assumed.

For the investor, this immediately throws up some questions. In using discounted cash flows, the terminal value of a business makes up at least half of the value, if not more. If we were to assume that the terminal value is far less 'valuable' because of obsolescence or need for further investment to realise it, the current value of business should fall significantly. However, we see that markets are willing to value businesses that can be disrupted at significant premium to what they were even, say, five years ago. Where is the catch?

Going forward as more 'flexible' organisations emerge, job 'security' will likely become a thing of the past. This can have long-term impact on society, with a larger number of the workforce working part time across several organisations. How would this change consumer demand for services insurance and even perhaps housing? Will, for example, 'availability' of housing, i.e., renting be preferred to 'ownership'? Will that change generation-long trends of increasing home mortgage business for example?

I have to admit that I have no answers. What I do find puzzling is the certainty with which investors in India look at the future, without trepidation.