Capitalism […] never can be stationary. […] The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. […] The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism – Joseph Schumpeter
In September’s letter we looked into some examples of the strong opportunities on the long side created by the current pace of innovation. In this letter we complete that analysis. If some companies are growing at 20% or more per year and the economy is growing at only 2% or 3% per year, some companies must be growing below that or even declining. Therefore, the innovation that spawns creators of value also opens up opportunities to short the companies with inferior customer value propositions.
Innovation can turn established industries upside down. It enables a better and more efficient way to serve customers. Take the newspaper industry. No entrepreneur today would successfully present venture capitalists the following idea: I will hire a lot of journalists. Collect news for 24 hours, chop down some trees, print the news gathered over the last 24 hours in the paper and then distribute to my customers for them to read. The internet allows for instant access to information, and by the time the printed paper arrives to the customer, the stories will be outdated. Therefore, a business model that was extremely profitable for decades became obsolete with the internet and proliferation of smartphones.
At Somar, our work to identify enduring and profound secular change, assists us in identifying short opportunities too. Here is a sample of companies we are or have been short:
- Fashion retail is undergoing two major secular changes: fast fashion and shift from offline to online. Incumbent fashion retailers that design collections more than 3 months in advance of putting them on their brick-and-mortar stores have a fashion stale offer to consumers much inferior to their fast fashion competitors. The growth of online channel also erodes the historical advantage of a large physical store chain. We have found good short opportunities both in the US and Europe of incumbents who have had trouble transitioning their models into the fast-fashion and online era.
- The advent of internet TV has offered consumers a wide array of options to watch their favorite shows both live or streaming at their own convenience, with or without commercials. Consumers historically have had only 2 options: subscribe to cable and pay for the full channel bundle or watch only the national broadcast networks. Taking advantage of this, some networks launched many marginal cable channels with sub-par content that customers barely watched and got paid fees per cable subscriber from cable providers for each of them. Internet TV is changing this. Consumers are no longer willing to pay for channels that they don’t watch and are instead signing up for individual channels or for more customized “skinny” bundles with a lower number of core channels. This is eroding customer count and revenues for some TV networks and opening short opportunities for Somar.
- Fast moving consumer products have applied for decades a tried and true formula for success: develop strong brands with national appeal and recognition, invest strongly in marketing and dominate the shelf space of retailers. This model worked so well and for so long, that most of these companies are perceived to be low-risk and trade at a premium to the market. The market is sanguine about two secular changes that are slowly disrupting this model: retailer consolidation and ecommerce. There is no shelf space limitation on the internet. This allows niche players to be displayed side by side with national brands, thereby erasing a barrier to entry that protected the incumbents in the past. E-commerce is also dominated be less than 5 companies. Mom and pop and local retailers are going out of business given the loss of sales to the internet and the lack of scale to develop an online offer of their own. This is leading to a gradual shift in the power balance from national brands to retailers that is leading to margin erosion and market share losses for incumbents.
- Grocery retailers are under threat from two secular changes: growth of hard discounters and move of retail online. Both are leading to margin erosion and market share losses for incumbents, opening up short opportunities for Somar. Hard discounters offer significantly lower prices to consumers by lowering the number of products and increasing the percentage of private label offered. This lowers costs in 3 ways: simpler operations; higher bargaining power in a smaller number of products; capture the margin from national brands. E-commerce offers a more convenient and economical way to shop for groceries therefore reducing the foot traffic to brick and mortar stores.
- The emergence of online commerce is reducing the foot traffic to shopping malls. This erodes the profitability of shopping mall REITs. There is a negative cycle in the shopping mall industry: brick and mortar stores are losing customers to the online channel, this is reducing the profitability of the physical stores and forcing some to be closed [including anchor stores]. This leads to further declines in the foot traffic to the shopping malls and further loss of profitability to brick and mortar stores leading to further closures. Like the newspaper industry example above, the current shopping mall industry structure is a product of historical evolution. Shopping malls wouldn’t be built the same way and in such a large quantity if they were being built today.
As always, we are delighted to expand on our thinking with you in person and phone conversations at your convenience. It is a wonderful time to be an investor and to be able to find opportunities on both the long and the short sides.