The biggest risk companies face

I’m going to make a (not so bold) prediction – the world will change. In big ways and small. In expected and, especially, in unexpected ways. 

‘Change’, in all its forms, is arguably the biggest risk established businesses face, because it never goes away. The competition never rests, technology never stops advancing and consumer tastes and fashions never stop evolving. This means once dominant businesses can quickly lose relevance. Especially today, where trends move at lightning pace. 

The good news is some businesses tend to be more resilient in the face of change. These are the companies I’m seeking to own. In my experience, they usually share a few characteristics.

The ability to defend against competition

One of the biggest risks any business faces is a change to the competitive landscape. Nowhere is this more evident than in the retail sector. 

Retail has always been fiercely competitive. But in the last two decades the onslaught of online competition has magnified this, spelling the end for many traditional retailers, from Woolworths to Debenhams and Wilkos, and leading many others to lose relevance.

But not all.

Costco and Primark (owned by Associated British Foods) have thrived, despite being slow to develop online propositions. Why?

I believe a key reason is because they both benefit from a competitive ‘moat’. A ‘moat’ can defend from competitive attacks. It can come in many forms – I give examples below. In general, the more ‘moat sources’ a business has, the more protected it is likely to be.

These competitive advantages are mutually reinforcing. Strong distribution networks and scale economies lead to lower costs, which can be passed on to customers in lower prices. This fortifies the brand and value proposition.

It’s a reason why Primark and Costco’s customers have remained loyal despite the ever-changing and fiercely competitive retail landscape. And it should give both businesses a greater chance of retaining relevance in a world that never stops moving.

Resistance to technological disruption

Technological change is a constant risk and can be hugely disruptive, even for companies with a well-recognised brand (just look at Kodak and Nokia). However, the threat isn’t equally critical for all companies. Those operating at the cutting edge of technology or in recently established industries tend to be more at risk. 

I tend to avoid the ‘new and exciting’ in favour of slower-changing industries based on well-established technologies. Many industrial businesses fall into this latter category. O-rings have been critical cogs in industrial machinery for well over a century and it is hard to see that changing. The same goes for many other industrial components, which have changed little over many decades. It’s a key reason why industrials make up around a fifth of my Quality Shares Portfolio.

But just because a company is in the technology sector, it doesn’t necessarily mean it faces a high risk of disruption. Technology is a broad church. Microsoft Office has been around for over four decades, while other technologies have been quickly superseded. So why have some technology businesses proven more resilient to technological change?

Well, probably many reasons. But if I had to pinpoint one it would be high switching costs. 

Switching costs buy companies time to adapt to technological change. It’s why the software sector is a fertile hunting ground for me. It’s often disruptive and costly for companies to change software providers, particularly when it is critical and used daily (the cost and hassle of retraining staff alone often isn’t deemed worth the effort). These switching costs help explain why Microsoft Office has remained dominant, despite operating in a fast-moving industry. 

Protection from changing tastes and fashions 

In 2006, MySpace temporarily surpassed Google as the most visited website in the US. Yet, six years later it had virtually no market share. It’s a similar story for Hi5, Friendster - and Friends Reunited, which closed down in 2016. These once-dominant social media platforms have all but disappeared, because consumer preferences changed.

Consumers can be remarkably fickle and this presents a constant threat to a company’s ongoing relevance. It's why my 60-point investment checklist asks - is the company largely immune from changing tastes and fashions? If the answer is no, I am very unlikely to invest.

In my experience, companies serving other businesses (B2B), rather than consumers, are often less vulnerable to changing tastes and fashions. Partly this is due to differing incentives. Consumer purchasing decisions are often driven by a need for excitement or keeping up with the Joneses. It’s what encourages people to try a new social media app or new retail store.

On the other hand, a compliance officer purchasing anti-money laundering software from RELX (a company held in the Quality Shares Portfolio) primarily wants to know the software does its job. They are mainly concerned with minimising risk – to themselves and the organisation – making them much less willing to entertain an unproven provider.

Avoiding single points of dependency

A business will be more vulnerable to change if it’s reliant on a single industry, customer, supplier or product.

A biotechnology company dependent on one drug is an obvious example. But even the biggest drug companies can become victims of their own success when their top-selling drugs come off patent. AstraZeneca’s statin-drug, Crestor was so successful that it grew to a fifth of group revenues by 2011, achieving ‘Blockbuster’ status. When the patent expired – and generic competition entered the market – Crestor sales started to decline. It took a decade for AstraZeneca’s revenues to recover their previous highs. 

AstraZeneca revenue ($ billion)

It’s one reason I tend to steer clear of pharmaceutical companies and instead look for ‘picks and shovels’ providers. A good example is Danaher, held in the Quality Shares Portfolio, which provides equipment to pharmaceutical and biotechnology companies for drug research and discovery. Its broad product portfolio sold to a range of customers means it can benefit from the launch of new therapies, without dependence on the success – or otherwise – of any one drug. 

The key is to look for companies that are well diversified, preferably with exposure to a range of customer-types and industries. This means if something goes wrong – like a large customer leaves or sales of a certain product start to decline – they are better placed to recover quickly.

An adaptive, innovative culture

Even a business model resistant to change will steadily lose relevance if it doesn’t move with the times. Often, it’s the largest companies that are most at risk, because they grow complacent and don’t feel the need to innovate or adapt.

The vacuum cleaner industry had all these hallmarks. Before James Dyson came along with the invention of the bagless vacuum cleaner, incumbents had become complacent. They were mainly concerned with protecting the highly profitable bag replacement business, meaning the industry was bereft of innovation. This allowed one man and his dog, operating from a rural coach house, to disrupt the industry against all the odds.

No matter how good your business model, the moment you see your company as bulletproof you are in trouble. I try to look for companies run by management teams with a healthy sense of paranoia. They are seeking constant improvement, are vigilant to threats and will adapt course as necessary. 

Summary

‘Change’ in all its guises is an ever-present threat to established businesses. But luckily, some companies tend to be more protected from this risk.

Typically, they possess strong competitive advantages that help insulate them from competition as well as technological disruption and operate in industries less sensitive to shifting tastes and fashions. Combining these characteristics with a well-diversified business model and an adaptive, innovative culture, adds extra layers of protection. 

No company will ever be immune to change – the world is too unpredictable. But find a business with all these traits and they are much more likely to endure and prosper.