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Strategies vs Business Disruption: Seeing Disruption as Opportunity

For companies, industries and investors, business disruption can actually be a powerful force that drives growth. The key to success is identifying those disruptions that are most likely to support a competitive advantage and a healthy business model.

Investors cannot afford to ignore disruption

Disruption is occurring all around us, to the extent that we now live in a world where the world’s largest taxi company (Uber) owns no taxis, the world’s most popular media site (Facebook) creates no content, the world’s largest accommodation provider (AirBnB) owns no property, and one of the world’s most valuable retailers (Alibaba) owns no stock. For business owners and investors, this creates both opportunities and risks alike, as many traditionally sound business models are turned upside down, and threatened with either disruption or outright extinction.

Investors – particularly long term investors – cannot afford to ignore disruption, as it threatens the existence of every successful company. As growth investors, our analysis often leads us to specific industries or companies experiencing high growth rates, but what distinguishes the good investment from the bad investment is not the level of growth per se but the sustainability of that growth. The biggest risk to growth stocks, where valuations are rarely cheap, is often the erosion of their market leadership or previous competitive advantages in the face of new competition. Such instances invariably lead to a swift collapse in the stock’s multiple with share prices falling even faster than they rose. On the positive side, since almost all financial analysts incorporate fading growth rates into their valuation models, there are rich rewards for companies that can either sustain or further increase their growth rates over the longer term.

For any company analysis it is crucial to also understand the long term sustainability of a business model

It is for this reason that we believe any company analysis should focus not purely on the financials, but crucially also on understanding the long term sustainability of a business model. This is gauged not through financial modelling but by analysing many of the softer factors that make a business unique. One must look for “the economic moat”, or barriers to entry that can enable a company to sustain a competitive advantage, and maintain or ideally improve its market positon over the long term. Such factors vary from industry to industry but include brand or product differentiation, economies of scale, access to distribution channels, supplier relationships and customer loyalty. This competitive analysis is not new and is similar to what Michael Porter famously coined with his Five Forces, but becomes all the more relevant in this disruptive age, and is vital to any investment decision the growth team makes.

Perhaps the clearest example of strong barriers to entry is through the creation of a brand. Brands, and the associated product reputation, generate barriers to entry and customer loyalty in almost any industry or product line. Perhaps most obvious is the luxury goods market, where the brand arguably assumes greater importance than the good itself. Take for example luxury brands like Louis Vuitton or Cartier – in many markets purchasing such a brand has become viewed as indicative of social status. This ensures consumers are usually willing to pay a premium above goods of a similar quality in order to own that brand, providing the luxury brand with not only pricing power and margin uplift, but also crucial barriers to entry. Since luxury brands take decades to build and refine, the incumbents benefit from high barriers to entry, and a relatively low threat of disruption from new entrants.

The best defence against disruption is to make a product indispensable

In technology this is increasingly done by no longer owning the good itself but by owning the customer interface (e.g. Uber or Facebook), whereas in industrials it is achieved through integrating a product/solution within a supply chain. One company that does this successfully is the French Industrial company Legrand, which sells electrical components (power sockets, circuit breakers, etc.) largely to professionals. In order to breed customer loyalty, Legrand has created free training seminars for electricians and engineers to enhance their skill set. Naturally these training seminars are usually run with largely Legrand products, so when the electrician comes to practice, they find themselves reliant on the Legrand devices from which they learnt the trade.

Disruptive threats are not always easy to identify as an outsider, which is why it is important to analyse a business from all aspects of the supply chain. At Allianz Global Investors we benefit from the use of our GrassrootsSM Research1 platform in order to better understand the strength relationships at both a supplier and end-customer level. For example, when one of our holdings within the hospitality industry decided to trial a coffee company spinoff in France (and thus become a disruptor), rather than wait for results, we were able to speak directly with the French store managers to gauge the customer reaction to the product offering, and likely sales trends. Other examples of surveys we regularly run on our holdings include those designed to gauge the likelihood of a customer switching product/supplier, or the impact of potentially disruptive new products or legislation (e.g.e-cigarettes or plain packaging for cigarette producers). This research and dialogue across the entire supply chain helps with early recognition of both disruptive threats and opportunities.

At a product launch in Toronto, the subsidiary of British American Tobacco (BAT) introduced Vype

Despite attempts to disrupt existing businesses models, only a few succeed and develop into interesting investment opportunities

One industry that is clearly undergoing significant structural disruption at present is the auto industry, through megatrends such as fully autonomous driving, safety regulation and emission reduction etc. These trends are leading to greater component content in cars (the average car now includes more than 170 sensors and 150 actuators), which means it is not the car makers that are profiting but largely the auto suppliers, with the suppliers now building nearly 85% of a car’s internal systems. The challenge, as ever, for the suppliers will be to both substantially differentiate their product from the numerous other competitors and create barriers to entry. This is where companies such as Continental and Infineon appear to be succeeding by working in tandem, rather than against, the autos makers, by customising and integrating their software and systems into the cars. This inevitably makes the car makers more reliant than ever on their suppliers, tying them to their auto supplier in much the same way the electrician becomes tied to Legrand products. As Warren Buffet said, any company disruptor or not, needs to establish their own economic moat to survive.

Marcus Morris-Eyton | 31/08/2015
1GrassrootsSM Research is a division within the Allianz Global Investors group of companies that commissions investigative research for asset-management professionals. Research data used to generate GrassrootsSM Research reports are received from reporters and field force investigators who work as independent, third party research providers, supplying research that is paid for by commissions generated by trades executed on behalf of Clients.


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