Originally published by Cuffelinks
When explaining science to my children, I often remind them that everything humanity learns builds on previous knowledge.
Except in finance.
The ability to frequently forget that which repeats seems unique to the investor subspecies of the human race.
Forces beyond their control
Businesses and industries don’t operate in vacuums, they are subject to forces beyond their control. Those forces might be social, technological, climatic, competitive, or legislative and those forces all represent changes that can be beyond the ability of company boards to even anticipate, let alone respond.
Companies may be met with different challenges in different jurisdictions, dramatically changing the economics of the enterprise. Change in business appears to follow the expansion and contraction of the bellows of a piano accordion. Expand the accordion: fragmentation. Contract the bellows: consolidation. Fragmentation, consolidation, fragmentation, repeat.
Take, for example, the newspaper business. How different today are our newspapers from only 30 years ago? I can remember delivering the paper, whose weight could be measured in kilograms, on Saturday, to homes that received a morning and afternoon edition.
The classified revenue rivers of gold were not enough to shield publishers from the emergence of more convenient searchable and sortable online versions who would continue to appear and fight until they won. Fragmentation.
Eventually of course, consumers will become impatient with separate apps for real estate, cars, jobs, and the news. Through no fault of their own – perhaps asset prices slump generally, amid a failure of record levels of triple CCC-rated junk bond debt to be refinanced – a new and more exciting offering emerges. Perhaps it’s an integrated newspaper with compelling user-directed news and classifieds with the bonus of fully interactive ads and Amazon (NASDAQ:AMZN) Prime delivering anything you touch to your door before you’ve finished reading. Consolidation.
But perhaps we don’t even have to be as far-fetched to see the piano accordion in action.
The here and now: Ubers and taxis
Witness the evolution of the personal transport industry. Through legislation and or acquisitions, a handful of taxi companies became regional monopolies. So dominant and unassailable were their legislated moats that customer service was irrelevant. Heck, in some cities, every single taxi changed shifts at the same time. If you were in a rush to the airport – walk! Consolidation.
Then the gig economy emerged, along with ride sharing and transit lanes. With customer service a priority, social momentum drove Uber’s expansion. So emboldened by its social imprimatur was the company that it expanded in some countries in the face of government opposition. Fragmentation.
But gig economies, and the companies that monetise them, rely on part-time workers willing to operate without employment contracts and their protections. Concurrently, operators are not required to comply with licencing systems and processes such as insurances and regular mechanical checks designed to protect the public.
In Sydney, a taxi operator is required to submit their vehicle to frequent and costly safety checks. In London, a cab driver is required to sit ‘The Knowledge’ test and demonstrate that more than 25,000 streets have been committed to memory. Uber vehicle owners have no such requirements.
In 2018, Europe will decide whether Uber should be regulated as a taxi service, bringing its labour-hire practices under the same terms as any other transport system operator and dramatically changing its economics.
But it’s not a stretch to imagine the deeper-pocketed Uber surviving the change, and the new regulatory costs dissuading new entrants. Consolidation.
Under another scenario, benevolent Uber shareholders could grow impatient with the lack of return on their capital and cease filling the hat with cash every time it is passed around. Fragmentation? Consolidation?
The piano accordion
Tech stocks have commanded the lion’s share of investor attention in the past 12 months and a significant proportion of the market’s return can be attributed to their gains. But investors are mistakenly projecting their growth to continue into the distant future, uninterrupted and unimpeded.
He didn’t have Airbnb, Uber, Google (NASDAQ:GOOGL), or Facebook (NASDAQ:FB) in mind when he gave his famous Farewell Address but perhaps George Washington had a piano accordion in mind when he said,
“It is in the very nature of power that it will expand until it is checked by an opposite power.”
When consolidation of media power, personal data, or plain old return on capital is concentrated among a few, society repels and rejects. And whether through populist governments or by their direct anointing, consumers cause the piano accordion to expand and the industry in question to fragment again.
All the profits of the disruption will not accrue to the disrupter. Throughout history, when new technology emerged to change the world – think cars, air travel, and television – it was neither the innovator nor the industry that earned large profits. In many cases, the consumer benefited the most.
Extrapolating current conditions into the future, and assuming that the rapidly changing forces that birthed the new player will not then challenge it, is a mistake many investors repeat.
Many investors unrealistically assume current circumstances to continue without interruption. It’s the basis for our divergent expectations framework in our long/short portfolios.
Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management.