Letters

Incumbents, Disruption, and Short Opportunities – June 2018

Incumbents, Disruption and Short Opportunities

“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction”
Bill Gates

“You can resist an invading army; you cannot resist an idea whose time has come”
Victor Hugo

“Your margin is my opportunity”
Jeff Bezos

This past month, General Electric (GE) was dropped from the Dow Jones Industrial Average after more than 110 years in the Index. GE was the last founding member of the index in its current format. This watershed moment calls our attention to the fragility of business success, constantly under attack by competitors, technological innovation and regulation.

Somar is relentlessly searching for short opportunities created by the abundant innovation we see in the world right now. We look for incumbents with high market shares and inferior consumer offers. The current strong and accelerating pace of innovation creates a fertile environment to find such opportunities. We are excited and believe that the Somar investment method positions us well to take advantage of them.
We have seen a larger number of former leaders go through hard financial times in the past few years. The accelerating disruption of large incumbents can be seen for example by analyzing the number of companies dropped from the Dow Jones Industrial Average index (composed of 30 companies). As Fig. 1 illustrates there has been a growing trend over the past few decades.

Fig. 1

Technological innovation and entrepreneurial prowess are allowing new innovative challengers to offer a
vastly superior value proposition to consumers: in the form of significantly lower prices, wider assortment
or better service. This leaves incumbent companies with the difficult task of sustaining their high market
share with an inferior consumer offering. If they can match the challenger’s offering this normally entails
lower margins. Frequently, challengers possess advantages that incumbents can’t even match (e.g. network
economies, superior customer information / customization, embedded in business processes).

To appreciate the impact that innovation has on the value of companies and their contribution to the overall
economy at any point in time it is instructive to look at the Dow Industrials components for different periods
of time. In 1884, Dow’s predecessor index was mostly composed of Railway companies1. By 1905 it was
composed mostly of Basic Materials and Utility companies2 After the Great Depression, in 1939 the
components were more diversified (see Fig. 2).

However, a lot of these companies no longer exist, others have gone through bankruptcy proceedings (e.g.
Bethlehem Steel, Chrysler, GM, National Steel) and others are under significant pressure to survive today
like Sears Holdings Corp. for example. This analysis is a clear reminder that size and leadership alone are
not guarantees of future financial success in the face of innovative competitors.

 

Fig. 2

Successful disrupters succeed by changing the source of competitive advantage. For example, for many
years, leaders in mass fashion leveraged large scale, good designers and strong marketing capabilities
through both media campaigns and capilar store fronts to offer affordable fashion to the masses.
With the advent of fast communication networks and large data processing capacity, large scale was no
longer critical to lower production costs: fast fashion players lowered costs by significantly reducing costly
mark-downs through virtually eliminating fashion risk. This new model shifted the basis of competition
from scale to responsiveness of supply chain. Challengers like Boohoo and Missguided succeeded by
offering consumers a significant upgrade to the value offered:
– More adequate and appealing designs in touch with current trends
– Lower prices (funded by lower markdown and marketing costs)
– Wider assortment
– Convenient home delivery
– Stronger community engagement through social media interaction with like-minded customers
This was possible by designing a different supply chain and distribution strategy
– Reducing lead times from 3 months to 2 weeks
– Making small initial runs, testing them online (for only a few hours) and producing larger batches
of the products the consumers liked
– Using customer and celebrity endorsement on social media to generate buzz and demand
– Home delivery from central warehouse with larger inventory and deeper size offer

DJIA Components on March 4, 1939
Allied Chemical and Dye Corporation General Electric Company The Procter & Gamble Company
American Can Company General Foods Corporation Sears Roebuck & Company
American Smelting & Refining Company General Motors Corporation Standard Oil Co. of California
American Telephone and Telegraph Goodyear Tire and Rubber Company Standard Oil Co. of New Jersey
American Tobacco Company (B shares) International Harvester Company The Texas Company
Bethlehem Steel Corporation International Nickel Company, Ltd. Union Carbide Corporation
Chrysler Corporation Johns-Manville Corporation United Aircraft Corporation
Corn Products Refining Company Loew’s Theatres Incorporated United States Steel Corporation
E.I. du Pont de Nemours & Company National Distillers Products Corporation Westinghouse Electric Corporation
Eastman Kodak Company National Steel Corporation F. W. Woolworth Company

For years, incumbents like The Gap Inc or H&M relied on their large scale and numerous store network as
a competitive weapon to keep expanding and taking market share against smaller mom and pop chains.
Today, however, these stores and large scale are a hindrance to their ability to move online faster and
efficiently and to move to a fast-fashion production schedule. This change of the source of competitive
advantage in the fashion industry has opened several short opportunities for Somar.
Somar believes that the process of disruption today is evolving faster for two reasons:
– Customers have instant and convenient access to information through the internet and their
smartphones. Therefore, they are quicker to find superior offers when available
– Easier access to capital through both venture capital and public markets, allows disrupters to scale
faster and mount a more robust challenge to incumbents3
With many disruption processes in place and faster scalability of challengers, Somar believes there are
plenty of attractive short opportunities in the markets today. Your team at Somar is heads down focused in
finding them and making them work for you. We will continue to report to you on our progress.

 

Source: Wikipedia; Somar Analysis

1 Chicago & North Western Railway Company; Delaware, Lackawanna & Western Railroad Company; Lake Shore Railway Company; Louisville & Nashville Railroad Company; Missouri Pacific Railroad Company; New York Central Railroad Company; Northern Pacific Railroad Company; Pacific Mail Steamship Company; Chicago, Milwaukee & St. Paul Rail Road Company; Union Pacific Railroad Company; The Western Union Telegraph Company.
2 Amalgamated Copper Mining Company; American Car and Foundry Company; American Smelting & Refining Company; The American Sugar Refining Company; Colorado Fuel and Iron Company; National Lead Company; The Peoples Gas Light and Coke Company; Tenessee Coal, Iron and Railroad Company; United States Rubber Company; United States Steel Corporation.