Joseph Schumpeter’s “gale of creative destruction” like the ravages of climate change induced cyclones and tornadoes, is visible across the economic landscape. Schumpeter wrote about “the process of industrial mutation that incessantly revolutionises the economic structure from within, incessantly destroying the old one, incessantly creating a new one”. The only thing mutating faster than various technologies today is possibly the COVID-19 virus. The ghost of Schumpeter is surely here today.
Look at the payments industry with an ecosystem undergoing rapid change. The incumbents, such as Visa and Mastercard, are the current keystone species of this landscape, situated as they are, at the centre of banks, merchants and consumers. There are several tailwinds to growth, not the least being the ongoing global shift to a cashless world. Both the players have a strong ‘moat’ in their network effects and the payment flows they currently capture.
The runaway growth, however, is coming from relatively newer players, such as PayPal and Square. COVID-19 has been a catalyst to digital commerce and both the players have their toll booths erected there. Square capitalised on another trend — the rise of the gig economy for which it created the Seller ecosystem, which is a one-stop shop solution largely for small businesses. Its second peer-to-peer ecosystem, Cash App, became a consumer-centric financial services solution, albeit with a large amount of its current revenues from trading in bitcoins. The optionality is on its future products and services, akin to traditional banks, its ability to monetise the convergence of both its ecosystems and the expansion of its geographical footprint. Its moats — economies of scale and switching costs — remain strong.
PayPal, a technology platform and digital payments company, is a facilitator of digital and mobile payments on behalf of consumers and merchants worldwide and is also a large free cash flow generator. Its success as a payments app has allowed it to enter a suite of other services. It has a moat because of its two-sided network approach, that is, it connects over 300 million customers with 25 million merchants, which leads to better data analytics and fraud protection. It has also entered physical retail with the greater implementation of QR codes at point-of-sale transactions and the launch of the Venmo credit card. Growth has also been aided by acquisitions such as iZettle (a European company with a business model like Square’s), Xoom (international money transfers) and Honey (rewards programmes and price-tracking tools to connect consumers and merchants online).
Digital wallets, such as Cash App and Venmo, continue to gain market share from traditional banks. Payments from digital wallets in online transactions are expected to outpace that from cards worldwide, although the incumbents are rolling out digital alternatives to online wallets. And then there are platforms such as Amazon, Alphabet, Apple and Facebook. When disruptions happen, it is easier to identify the losers than pick the winners. In a digital world, an extensive physical branch network could become an expensive, value-destroying luxury.
Survivors’ strengths
While the digital wave could overwhelm many traditional businesses, there are a few that have created their unique and formidable strengths. In retail, a sector disrupted by Amazon, there are some characteristics of competitor-survivors. Costco’s strengths include its high membership base (membership fees account for a major part of its EBIT), its low-frills warehouse shopping experience (traffic drivers’ food and fuel account for 60% of sales; large products size often stacked on pallets to reduce internal distribution cost), procurement strength (a small number of SKUs resulting in purchasing leverage, which allows bulk purchases, reduces capital and contributes to real-estate efficiency).
Or consider Target which has higher margins relative to competition on the back of smaller sales from low-margin grocery; a developed store network, with store renovation done to serve as omnichannel fulfilment centres; and its own brands and some exclusive brands, which contribute about a third of total sales.
Competitive intensity notwithstanding, Dollar General has a wide US store network, with almost three-fourths of the US population listed within five miles of a Dollar General store, important for the target market that Dollar General serves — households with annual income of $40,000 and less. Its focus on concentration of a limited number of items in a wide range of categories gives it cost leverage and convenience value. Competition is limited because of thinly populated areas and small-ticket baskets (80% priced at below $5). Dollar General is also leveraging technology, including its mobile app which gives digital coupons and enables scan-and-go checkout in select areas. Ongoing productivity increases and strict cost controls should help its operating leverage.
The convergence of many technologies could further change the contours of retail as it will for financial services and banking, as has been argued by Peter Diamandis and Steven Kotler in their book The future is faster than you think. The Internet of Things (IoT) could enable ‘frictionless shopping’ and reduce staff requirements. Smart shelf technology employing RFID tags is already in use. But when artificial intelligence is added with voice activation, smart shelves could be capable of conversation. AI could cause the entire supply chain to be more efficiently managed. 3-D printing is already in use in some retail outlets in the US. Expect 3-D printing to have a huge impact on supply chains including the possibility of dis-intermediating manufacturers and distributors. It could enable the rise of user-designed products. And virtual reality (VR) may mean that visits to shopping malls become less frequent or even redundant. What may not change is what creates ‘stickability’ to stores — giving customers an amazing experience.
Lessons from nature
A time invariant lesson from investing in new technologies is that they go through a capital cycle of fasting, feasting and then fasting again — from a position of capital starvation to a surfeit of capital and then back again to capital paucity.
Nature has shown many ways to deal with change and complexity and investors may want to pay heed to those. For one, nature hedges its bets by investing in diversity even at the cost of efficiency. In an uncertain and complex world, portfolio optionality, including investing in companies having high optionality, is useful even at the cost of higher diversification.
Evolution follows a bottom-up strategy. So do many value investors. Confusing the picture with too many predictions about direction of interest rates, trade policies and macro variables detract from the longer term picture that trends sometime reveal.
Dealing with radical uncertainty demands risk management. US army colonel David Hackworth wrote in his memoir About Face what it takes to be a good soldier: “Insight, receptivity and risk management. It takes insight to formulate a battle plan or thesis, receptivity to change the battle plan as the facts and circumstances change and risk management to avoid large losses and/or commit your resources to the most vital parts of the battle — proper risk management is how you become an old soldier.”
(The writer is the co-promoter of Jeetay Investments and Jasmine India Fund.)
