• Tarpon US Equities

Competition

Most of the time, most of us underestimate the long-term harmful effects of competition. Being naturally programed to focus on the present, we end up like the proverbial boiling frog.


At this point in my career, I have already listened to multiple hundreds, if not thousands, of comments from CEOs, CFOs, and IR executives about competition; they usually go like this:


“Yes, they are a good company, but the market is big and fast growing, we, them, and a few others can all do well concurrently”.


“Our relationship with these big platform companies, like AWS, Google and Apple is coopetition… and we can do well, despite their bundles, because customers want the best-of-breed, or because we can do business cross-platforms.”


“They are a small entrant focusing just on that small piece of the market… We have this big customer base…”


“The next downturn will be different, there is now much more discipline on pricing and discounting amid our peers.”


“We don’t really see them as competitors… we rarely see them in bids. They come to market through that way, and we focus more on this route.”


“We have a differentiated user experience, better content, greater rewards…”


“Private label brands don’t really attract our core customers.”


“Our customers like our high-touch model.”


“We all sell the same product for the same price, but we cater to customers like this, company X to clients like that, and so on…”


“Our LTV/CAC metrics remain stable… We have experts doing performance marketing in-house…”


I have learned to completely distrust these comments. But I keep asking about competition because every once in a while I find a sincere soul, as well as because the more upbeat or dismissive is the answer, the more I have to fear. Interestingly, the reverse is often true: CEOs managing monopolies or oligopolies often outspeak of how competitive their markets are, as if to increase the value of their managerial skills.


Just as (lack of) cash is what kills business, competition is what makes them mediocre. The more management dismisses it, the greater the harm, as the need for ruthless execution cannot be overlooked in competitive markets.


In the short-run things always seem somehow stable, market-shares seldom change quickly, CACs too, but, in the long-run, only the really powerful and unique companies create big shareholder value. We all know which are these companies and their characteristics. I don’t need to go on about network effects, economies of scale, data advantages, technological oligopolies, and powerful brands here – this audience is full of reading about this stuff.


The reality is that we, investors, often let ourselves be fooled by enthusiast management teams. Both sides are acting naturally. Optimism and reality-distortion are usually pre-requisites for great managers, and often a step through which they end up achieving real competitive power. On the other hand, long-only investors somehow need to see the world through bright lens, because otherwise we get paralyzed. But the tigers come at night. There is no sugarcoating a weak competitive position. Financial results will, invariably, reflect it over time. Capitalism works, after all.


For experienced businesspeople, it is possible to, almost intuitively, grade a company’s competitive strength after acquainting oneself to its market and characteristics with good (not extreme) depth. The simpler the thought process and the less variables, the more trustworthy the intuition. I find this intuitive reaction is usually better the more detached we are from the business. Zeca has a great nose to quickly grasp a company’s competitive position and his sincere thoughts are very useful in our partnership as I do the necessary work of going deep into and getting close to companies.


Over these last three years working together, we have learned a lot about competition in the new economy (digital companies, software, etc.), including how it manifests itself, early bad signs and so on. We have created an “uniqueness” score, which is based on that intuitive feeling, for all investable companies in our universe, and, for those of you who observe the evolution of our portfolio with some attention, you may have noticed it trending towards businesses in oligopoly positions protected by strong barriers to entry. Today, the vast majority of our portfolio is in companies we grade eight or higher (out of ten) for uniqueness. We may be wrong in that judgment, and the world is always evolving (with enough time every business power degrades), but experience has thought us (and many others) that this is the place to be to avoid getting boiled.


This was a nice finish, but I will go on for a few more paragraphs with examples so that this text isn’t just abstract. Before that, let me state the obvious: the rarest and most valuable companies are those in monopolies or oligopolies within fast growing markets. Growth is to competition like nectar is to bees.


Was the pandemic good to Netflix? In the short term yes, tremendously good. Demand exploded, many people learned to love streaming rather than traditional TV, and, as expected, most people, including management, dismissed long-term competitive effects, as in the short-term things were more than fine for the company, with big growth and growing margins. However, as the streaming market boomed, a flurry of competitors came in, like Disney+, Apple+, Paramount+, HBO+, Peacock, and so on. Netflix’s growth has slowed to a trickle and margins are suffering. Similarly, was the pandemic good for PayPal? Yes, great in the early days. But digital payments and banking became a focus, not only for a wave of well capitalized startups like Affirm, Klarna and Afterpay, but also for powerful established companies, like American Express, Bank of America, and, most importantly, Apple, all of which are seeing growing success with their digital financial services. Therefore, over the long term, the outsized growth of this market was quite bad for PayPal, as it catalyzed much more competition.


Same question for social media? We saw a big, short-term bump for all players in the sector, from Facebook to Pinterest. But competition for people’s attention grew dramatically, not only from new players like TikTok, but also from growing supplies of great stuff in gaming and streaming. Same for software companies focused on front-end products, like website building, such as WIX. I could on and on, but you got it. We were caught boiling with PayPal and WIX, fortunately we woke-up midways and sold relevant parts of these investments, including most of WIX, before others had awakened. We avoided the other examples. But why did we even enter PayPal and WIX? Because we let our bar down when making these investments – we should have stopped at their low moats. Saying NO is, perhaps, the greatest tool for investors.

Now, let me turn to the positive side.


Was the pandemic good for cloud computing superpowers like Amazon and Microsoft? Yes, extremely so, both short and long term. Scale, network effects, technology and other competitive advantages prevent entrants in this market. Was Covid good for Google? Absolutely. It is basically a monopoly in search and will continue to capture alone most of the growth in this market, with expanding margins. Was it good for Intuit? Yes, because, even though it is a SMB focused software company like WIX, not only its software is extremely more complex to build and mature (ERP, accounting, and tax rules), but also much harder to distribute (you need professional accountants to get used to it) and tougher to replace. We did well with Amazon and Intuit, and have used the recent downturn in all tech stocks to buy Google and Microsoft, enhancing the quality of our portfolio.


Finally, let me talk a bit about our most recent investment – something I don’t usually like to do, but couldn’t resist because the example is just perfect for this piece. Semiconductor manufacturers like Intel, TSMC and Samsung need increasingly complex machinery to keep tying more transistors together. Companies that develop and manufacture these machines, though little known, have become superb businesses as, after decades of consolidation and extremely complex R&D done alongside peers and clients, usually just two, three, or even one of them remain capable of producing the most advanced technologies for a given line of equipment (there are many types of machines in a fab). We have chosen three companies to begin to invest in the space: KLA, Applied Materials and Lam Research. I suggest you go look at their stock charts over the last twenty years. Demand for semiconductors has exploded during this period, growth of the kind that would usually attract many competitors. But the barriers to entry are so great that there are not only no entrants, but also growing power and margins for the incumbents. These stocks are volatile, as their revenues are particularly exposed to the semiconductor cycle, therefore, most investors keep wondering about next year’s profits, missing the point that this is a structurally growing market with great oligopolies. We won’t be able to perfectly time our investments here but hope to build a nice position for the long-term, maybe adding to it with discipline.


Guilherme Partel


Tarpon U.S. Equities


September 2022

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