To say that we live in an era of giants would be stating the obvious.
Large companies have been growing larger since before today’s generation can remember. This is naturally to the chagrin of academics and progressive policymakers alike; one of many recent angry articles reads “Britain is over-tolerant of monopolies.” Whether this is true or not, change is probably as likely to come as Donald Trump is to remain silent after he leaves the White House. The facts are on the table: power, financial or otherwise, is concentrating in the hands of a few at the top. From Amazon hoovering up 49% of the US ecommerce market in 2018 to Uber gaining a mammoth 55% of the UK ride hailing and taxi market, large firms dominating markets has become an indomitable maxim.
The point of this piece is not to opine on the various drawbacks and positives of today’s market structures, but to identify where this shift to the top leaves an investor interested in smaller companies. What moat can be relied on when the Alphabets and Apples can plough seemingly unlimited cash and technical expertise into a sector? Which nails can remain intact when giants have infinite multi-purpose hammers?
Let’s go through some of the options.
Cash/Balance Sheet: No. The giants will certainly have more cash than the minnows. Even if upstarts can somehow outspend their competition, the resultant dilution and/or leverage would considerably weaken the investment case. Examples like Amazon famously bullying Diapers.com into submission are notoriously difficult to ignore, not only because they have recently become commonplace.
Contacts/Distribution Channels: This is a common so-called ‘differentiator’ touted by firms who, to me, do not really have many others. Large conglomerates are involved in many, many markets. They thus have deep and broad relationships across the spectrum. To me, distribution is but a temporary hurdle to overcome. It’s not “sticky” enough to be a durable defence. Superior contacts only persist so far as the product is superior or of comparable quality.
Brand Reputation: As with the previous factor, this will only persist so long as one actually has a superior, or at least similar quality product. BlackBerry used to have a great reputation for phones; good luck finding anyone who uses a BlackBerry now. Without product, the company’s ‘moat’ isn’t so much a moat as a ticking time bomb.
This brings me to the question: how can you maintain quality and thus market position as a small firm vis-a-vis your mammoth competition?
I see two ways, the first of which is relatively obvious and the second of which has become a key additional component of my investment process.
Patents/Intellectual Property: It’s hard for a large firm to compete on price when they don’t have a good product. A good way to ensure you have the best product (until it is replicated using another method) are patents.
Arm Holdings, which was taken over for $31.4bn in 2016 by SoftBank, had this. In fact, over 4500 of these (either granted or pending). That is a huge part of why it survived. Defensible intellectual property is more than a speed bump to giants, it is a closed road altogether. This is because they must start again at point A, and redesign the wheel just to get on the same level as the company with patented technology. One of my favourite holdings, a pharma company without pharma risk, 4d Pharma (LON:DDDD), has over 950 patents, the largest number in its sector. A robust defence indeed. But in my mind, not the only one.
Data: In my mind, the fifth factor of production. It could be easily argued that data is just as important as established factors like land, labour or capital (without enterprise, we wouldn’t have the whole shebang). Large companies cannot hold a candle to this, no matter how significant the cash and resources invested are. This is because data is a tangible manifestation of the time invested in a project. Small companies may have an abundance, because they got there first. Instead of or in conjunction with an intellectual property estate, this is a must to brave harsh waters. Again, two of my relatively large holdings provide good examples of where data can be useful:
Seeing Machines (LON: SEE): SEE‘s Guardian tech has logged over 5 billion kilometres of naturalistic driving data from its various customers. This is a hugely important resource to optimise their Human Factors technology: understanding from a driver’s facial expressions and movements whether they are drowsy, distracted or intoxicated. You just can’t be as accurate if you don’t have enough data to go on. This veritable moat helps them save lives: as the CEO Paul McGlone likes to say, “everyone deserves to get home safely”. In addition to this, it’s a huge reason a larger competitor can’t just swoop in and take a significant percentage of the global driver monitoring market.
DeepVerge (LON: DVRG): This is a company that has many different revenue streams, but for the purposes of this article Labskin is most relevant. It is “the only commercially available lab-grown, full thickness human skin model with entirely human collagen production for cruelty free skin testing.” In the words of CEO Gerard Brandon at an investor presentation, it is “ring-fenced by 13 years of data collection”. As with Seeing Machines, this is not something that someone can wake up someday and do. Optimising the technology needs real world application, which Labskin have done plenty. This is what cements it as not only a market leader now, but in the future too.
Let’s be honest with ourselves: the avenues for small companies to compete are closing. This presents significant challenges to an investor focusing on these upstarts. It is now imperative for them to crystallise their first-mover advantage; patents work, but so, crucially, does data. This is why, to me, data is hugely underlooked and just as hugely valuable to the investment case for small companies.
Without it (or patents), you are at a large competitor’s mercy. With it, you can get that rare one up on today’s Goliaths.