A “Digital Moats” investment theme focuses on companies in the digital economy that have the ability to sustain an exceptional competitive advantage and generate excess returns for shareholders over time. These companies stand apart from the rest of the industry in terms of long-term visibility, superior return on invested capital and strong cash flows. While enjoying a privileged market position, they still benefit from abundant growth opportunities.
The digital economy – which we define as transactions and businesses based on digital code – is subject to fast change and short innovation cycles. The major drivers and enablers over time have been Moore’s law[i] and the invention of the Internet.
These dynamics make the digital economy creative and destructive at the same time. New companies emerge frequently, taking advantage of new technologies with new ideas. Some will create new markets while others will displace older or obsolete technologies and business models. Many companies will eventually struggle in the face of competition, innovation or shifting consumer demand. Only a few will be consistently successful for long periods of time, becoming the “winners” that compensate shareholders for the risk of investing in this dynamic space.
Since disruption is a creative process we believe that it is virtually impossible to identify future individual winners at an early stage. Visibility increases as markets mature, demand patterns emerge and the competitive landscape settles. While at this stage many successful businesses see their margins and growth erode, a few start displaying the characteristics of an “economic moat” such as pricing power, superior returns on invested capital and resilience over time. Such economic moats are rare, but can be found in both business-to-business and business-to-consumer business models.
We believe that many successful companies in the digital economy benefit from a network effect by which the adoption of a product or service by one customer generates positive externalities for all other customers, thus creating sustainable businesses that are able to maintain the investment needed to stay ahead of the competition. As a consequence, the leading player occupies the most favourable competitive position, enabling it to consolidate the market and creating “winner-takes-all” dynamics. We observed this phenomenon more frequently in the digital space than in the economy at large.
From an investing point of view two approaches may lead to success:
1) Invest early in a portfolio of disruptive businesses on a diversified basis, trusting that the returns generated by the few winners will (over)-compensate for the inherent riskiness of disruptive innovation, or
2) Identify economic moats of a single company and capitalise on the realisation of its potential.
We opt for the second approach while fully accepting the validity of the first. Hence, rather than looking for the “next big thing” we focus on understanding the drivers of the underlying businesses by applying our 4M (Macro, Market, Moat, Management) analysis framework.
As a consequence, our “Digital Moats” investment theme focuses on companies engaged in the digital economy that have the ability to sustain an exceptional competitive advantage and to generate excess returns for shareholders over time. These companies stand apart from the rest of the industry in terms of long-term visibility, superior return on invested capital and strong cash flows. While being in a privileged position in their markets, they still benefit from abundant growth opportunities.
Author: John Kelly, Partner at 2Xideas, Website www.2Xideas.com and contact +353 1 571 9239
[i] Moore’s law is the observation that, over the history of computing hardware, the number of transistors on integrated circuits doubles approximately every two years. The law is named after Intel co-founder Gordon E. Moore, who described this trend in 1965.