The Next Game-Changers
Economic moats are dynamic entities that are constantly shifting. As investors, it's crucial to
know whether the competitive advantages of our firms are getting stronger, weaker, or not
changing much. Below are some of the larger trends we are observing that will change the
landscape in the coming years. How these trends play out will determine whether or not
dozens of companies we follow hang on to their moats as well as which companies will
eventually graduate to wide moat.
Fragmentation of Media
It was only a generation ago that media companies of all stripes had some of the widest
moats. In any given city, there might be one or two newspapers, as well as a handful of
television and radio stations, and that was about it. The companies that held the appropriate
licenses controlled the dissemination of information. It was almost impossible to start and
maintain a business without paying the relatively steep price of the few toll-keepers that
managed information exchange.
As an example of just how concentrated media was a few decades ago, back in the 1950s, it
was common for more than half the televisions in the country to be tuned to the typical "I
Love Lucy" show. But today, the world has totally changed, and it will likely only continue to
get worse for the existing media companies. It's safe to say that the shared media experiences
of the past are mostly gone.
The number of options for receiving information via any given medium has exploded. We've
gone from three major television networks to hundreds of available cable channels. In radio,
in recent years we've gone from a couple dozen stations in any given market to hundreds
because of high-definition and satellite services. Each additional channel slices the existing
pie into pieces that are that much smaller.
Not only are we seeing a proliferation of options over media that have existed for some time,
but we are also seeing an explosion of alternatives. For instance, I no longer receive physical
newspapers; I just read everything online, a far superior format in terms of scope and speed.
Plus, why watch "reality television" when Web sites Facebook and YouTube can provide just
as much entertainment? My kids and their friends (as good an indication as any of what the
future will bring) still watch small amounts of TV, but it is a tiny fraction of the amount I
watched growing up in the pre-Internet era. They much prefer (as do I) to spend their
downtime in front of a computer instead of sitting on a couch in front of the TV.
The losers from the trend are the media companies themselves, including conglomerates
Disney and General Electric . In a nutshell, these companies control something that was
once scarce but is now plentiful. There is a big silver lining, however, as there is a group
benefiting from this trend. Namely, the consumer products firms with strong brands, such as
Coca-Cola and Procter & Gamble . In the golden age of media, it was relatively easy to reach
a broad audience to launch a new product. Today, attaining critical mass for a new national
brand is much more difficult, as there is no easy way to advertise to a majority of the
population. As media fragments further, the incumbent brands simply become that much
more entrenched.
Digitization
Not only is the way we receive media fragmenting exponentially, but the information and
entertainment we consume is moving to the digital realm. Examples best tell the story here.
Physical newspapers are closing by the day, as people migrate online to receive the news.
Audio CD sales continue to plunge (now at roughly half the peak reached in 2000), while
download services such as Apple's iTunes continue to explode in popularity. Or, consider
the high growth rates of Netflix , while Blockbuster is nearing bankruptcy. (And even the
traditional Netflix mail service is likely to be supplanted by downloads.)
In a nutshell, in the future, if something is able to be delivered and consumed
electronically, it probably will because this method of distribution is much less expensive.
After all, the value in any given media is not in the cardboard and plastic, but rather in the
information itself. Apple and Amazon's gain will be at the expense of physical retailers such
as Best Buy and Barnes & Noble .
Cloud Computing
It's not just music and movies that are likely to be delivered via the Internet in coming years,
but software, too. The days of buying a physical cardboard box full of software and manuals
are numbered.
Consider "cloud computing" (which is sometimes called "software as a service"). Basically,
instead of having all your software and files installed on your computer, in a cloud
computing world, you would just fire up a Web browser and use services provided remotely
from central locations. In the current way of doing things, I buy Microsoft Word, install it on
my machine, use it, and store my files on my local hard drive. But on the bleeding edge of
technology, I could just fire up a Web browser, visit the Web site of a word processing service
(such as the current Google Docs), and save my documents on the service's central
computers. It's cheaper, and the documents are automatically backed up and available from
anywhere.
Allow me a short analogy using electricity. Think of how the world would look if each of us
had our personal electricity generator in our backyards. Although silly and inefficient, this
is essentially what we have with computers today. Eventually, it looks as though the
computing world will move to the electricity model, where power is generated efficiently at a
handful of central locations and then distributed via a robust transmission system.
Another emerging example of this trend comes from console gaming. A new firm named
OnLive will soon be offering a service that--according to early reviews--will offer games
comparable to what is available today from Microsoft's Xbox or Sony's PlayStation. But with
OnLive, there is no big box under the television or physical games required, just a controller
and a simple device that connects to the Internet.
The winners are the companies that can provide the large central servers such an
infrastructure would require. This means numerous firms, such as IBM (NYSE:IBM - News),
Oracle (NasdaqGS:ORCL - News), Cisco , and Google, could see their moats widen a tad
and/or their growth rates tick up. Those with narrowing moats are those that benefit from the
old way of doing things. Dell does a great job selling powerful desktop boxes, but the amount
of computing power sitting on a desktop is becoming much less relevant. Moreover, Microsoft
has a stranglehold on desktop software, but once software becomes provided as a service, the
desktop loses relevance. (We still think Microsoft has a wide moat as it will no doubt be a
major player in cloud computing, but its moat is definitely narrowing from its previous
"superwide" status.)
Cloud computing is perhaps the most revolutionary trend in this article, as opposed to the
other trends that are more evolutionary. Simply put, software is no longer married to
hardware. Or, just think of it as the trend toward having the majority of computing power no
longer distributed on millions of desktop boxes, but rather provided by central servers in
thousands of locations and distributed via the Internet.
Health-Care Reform
Health-care spending growth has outpaced overall economic growth for several decades now,
and this is not a sustainable situation. This means we will have to limit care (no more "all
you can eat" health care), or we will have to reduce the cost of care, or both. Reform could
potentially take several paths, and in the most drastic scenarios, nearly every health-care
company we follow would have its moat destroyed. But we think milder, incremental
changes are most likely to occur.
One thing that seems to be obviously coming down the pike (because it was mentioned in
President Obama's budget) are generic versions of biologic drugs. Biologics are drugs
composed of proteins that tend to be quite large chemically (thousands of atoms) and made
via biological processes. These differ from most pharmaceuticals, which are small molecules
with only a couple dozen atoms, easily manufactured in bulk. Whenever a biologic drug goes
off-patent in the United States, the drugs essentially maintain a monopoly because a biologic
drug's form and function depend on its manufacturing method. Much like how a wine from
France tastes different than a wine from Ohio; the differences are subtle but important. With
biologics, creating a precisely exact copy of a drug is nearly impossible, so at the moment, a
generic manufacturer cannot simply say "me too" concerning the safety and efficacy studies.
Right now, there is no meaningful approval pathway for generic biologics.
But that is changing. In order to generate greater competition (and lower prices) the
government wants to create relatively easy pathways for generic biologics to make it to
market by relaxing and streamlining testing restrictions. Should this happen, the losers
would be those companies currently selling biologics, such as Amgen and Johnson &
Johnson . Winners would be generic manufacturers, such as the Sandoz unit at Novartis
(NYSE:NVS - News). (This trend could move the needle a lot at Amgen, but not so much at
J&J and Novartis, given their diversity of operations.) Either way, the broader trend is that the
government will be doing everything in its power to lower its costs (reduced pricing power in
the industry across the board), offset mildly by an increase in volumes as the currently
uninsured receive more care.
As you can see, some companies will see the competitive advantages weaken a tad over time,
while others will get stronger. It's simply the way of the world to have comers and goers.
We've got eyes on the changes and are incorporating all the shifts in the landscape into our
ratings and analyses.
A version of this article originally appeared in the May issue of Morningstar StockInvestor.
Click here to learn more:
http://msi.morningstar.com/Purchase.aspx?pgid=msispec
Economic moats are dynamic entities that are constantly shifting. As investors, it's crucial to
know whether the competitive advantages of our firms are getting stronger, weaker, or not
changing much. Below are some of the larger trends we are observing that will change the
landscape in the coming years. How these trends play out will determine whether or not
dozens of companies we follow hang on to their moats as well as which companies will
eventually graduate to wide moat.
Fragmentation of Media
It was only a generation ago that media companies of all stripes had some of the widest
moats. In any given city, there might be one or two newspapers, as well as a handful of
television and radio stations, and that was about it. The companies that held the appropriate
licenses controlled the dissemination of information. It was almost impossible to start and
maintain a business without paying the relatively steep price of the few toll-keepers that
managed information exchange.
As an example of just how concentrated media was a few decades ago, back in the 1950s, it
was common for more than half the televisions in the country to be tuned to the typical "I
Love Lucy" show. But today, the world has totally changed, and it will likely only continue to
get worse for the existing media companies. It's safe to say that the shared media experiences
of the past are mostly gone.
The number of options for receiving information via any given medium has exploded. We've
gone from three major television networks to hundreds of available cable channels. In radio,
in recent years we've gone from a couple dozen stations in any given market to hundreds
because of high-definition and satellite services. Each additional channel slices the existing
pie into pieces that are that much smaller.
Not only are we seeing a proliferation of options over media that have existed for some time,
but we are also seeing an explosion of alternatives. For instance, I no longer receive physical
newspapers; I just read everything online, a far superior format in terms of scope and speed.
Plus, why watch "reality television" when Web sites Facebook and YouTube can provide just
as much entertainment? My kids and their friends (as good an indication as any of what the
future will bring) still watch small amounts of TV, but it is a tiny fraction of the amount I
watched growing up in the pre-Internet era. They much prefer (as do I) to spend their
downtime in front of a computer instead of sitting on a couch in front of the TV.
The losers from the trend are the media companies themselves, including conglomerates
Disney and General Electric . In a nutshell, these companies control something that was
once scarce but is now plentiful. There is a big silver lining, however, as there is a group
benefiting from this trend. Namely, the consumer products firms with strong brands, such as
Coca-Cola and Procter & Gamble . In the golden age of media, it was relatively easy to reach
a broad audience to launch a new product. Today, attaining critical mass for a new national
brand is much more difficult, as there is no easy way to advertise to a majority of the
population. As media fragments further, the incumbent brands simply become that much
more entrenched.
Digitization
Not only is the way we receive media fragmenting exponentially, but the information and
entertainment we consume is moving to the digital realm. Examples best tell the story here.
Physical newspapers are closing by the day, as people migrate online to receive the news.
Audio CD sales continue to plunge (now at roughly half the peak reached in 2000), while
download services such as Apple's iTunes continue to explode in popularity. Or, consider
the high growth rates of Netflix , while Blockbuster is nearing bankruptcy. (And even the
traditional Netflix mail service is likely to be supplanted by downloads.)
In a nutshell, in the future, if something is able to be delivered and consumed
electronically, it probably will because this method of distribution is much less expensive.
After all, the value in any given media is not in the cardboard and plastic, but rather in the
information itself. Apple and Amazon's gain will be at the expense of physical retailers such
as Best Buy and Barnes & Noble .
Cloud Computing
It's not just music and movies that are likely to be delivered via the Internet in coming years,
but software, too. The days of buying a physical cardboard box full of software and manuals
are numbered.
Consider "cloud computing" (which is sometimes called "software as a service"). Basically,
instead of having all your software and files installed on your computer, in a cloud
computing world, you would just fire up a Web browser and use services provided remotely
from central locations. In the current way of doing things, I buy Microsoft Word, install it on
my machine, use it, and store my files on my local hard drive. But on the bleeding edge of
technology, I could just fire up a Web browser, visit the Web site of a word processing service
(such as the current Google Docs), and save my documents on the service's central
computers. It's cheaper, and the documents are automatically backed up and available from
anywhere.
Allow me a short analogy using electricity. Think of how the world would look if each of us
had our personal electricity generator in our backyards. Although silly and inefficient, this
is essentially what we have with computers today. Eventually, it looks as though the
computing world will move to the electricity model, where power is generated efficiently at a
handful of central locations and then distributed via a robust transmission system.
Another emerging example of this trend comes from console gaming. A new firm named
OnLive will soon be offering a service that--according to early reviews--will offer games
comparable to what is available today from Microsoft's Xbox or Sony's PlayStation. But with
OnLive, there is no big box under the television or physical games required, just a controller
and a simple device that connects to the Internet.
The winners are the companies that can provide the large central servers such an
infrastructure would require. This means numerous firms, such as IBM (NYSE:IBM - News),
Oracle (NasdaqGS:ORCL - News), Cisco , and Google, could see their moats widen a tad
and/or their growth rates tick up. Those with narrowing moats are those that benefit from the
old way of doing things. Dell does a great job selling powerful desktop boxes, but the amount
of computing power sitting on a desktop is becoming much less relevant. Moreover, Microsoft
has a stranglehold on desktop software, but once software becomes provided as a service, the
desktop loses relevance. (We still think Microsoft has a wide moat as it will no doubt be a
major player in cloud computing, but its moat is definitely narrowing from its previous
"superwide" status.)
Cloud computing is perhaps the most revolutionary trend in this article, as opposed to the
other trends that are more evolutionary. Simply put, software is no longer married to
hardware. Or, just think of it as the trend toward having the majority of computing power no
longer distributed on millions of desktop boxes, but rather provided by central servers in
thousands of locations and distributed via the Internet.
Health-Care Reform
Health-care spending growth has outpaced overall economic growth for several decades now,
and this is not a sustainable situation. This means we will have to limit care (no more "all
you can eat" health care), or we will have to reduce the cost of care, or both. Reform could
potentially take several paths, and in the most drastic scenarios, nearly every health-care
company we follow would have its moat destroyed. But we think milder, incremental
changes are most likely to occur.
One thing that seems to be obviously coming down the pike (because it was mentioned in
President Obama's budget) are generic versions of biologic drugs. Biologics are drugs
composed of proteins that tend to be quite large chemically (thousands of atoms) and made
via biological processes. These differ from most pharmaceuticals, which are small molecules
with only a couple dozen atoms, easily manufactured in bulk. Whenever a biologic drug goes
off-patent in the United States, the drugs essentially maintain a monopoly because a biologic
drug's form and function depend on its manufacturing method. Much like how a wine from
France tastes different than a wine from Ohio; the differences are subtle but important. With
biologics, creating a precisely exact copy of a drug is nearly impossible, so at the moment, a
generic manufacturer cannot simply say "me too" concerning the safety and efficacy studies.
Right now, there is no meaningful approval pathway for generic biologics.
But that is changing. In order to generate greater competition (and lower prices) the
government wants to create relatively easy pathways for generic biologics to make it to
market by relaxing and streamlining testing restrictions. Should this happen, the losers
would be those companies currently selling biologics, such as Amgen and Johnson &
Johnson . Winners would be generic manufacturers, such as the Sandoz unit at Novartis
(NYSE:NVS - News). (This trend could move the needle a lot at Amgen, but not so much at
J&J and Novartis, given their diversity of operations.) Either way, the broader trend is that the
government will be doing everything in its power to lower its costs (reduced pricing power in
the industry across the board), offset mildly by an increase in volumes as the currently
uninsured receive more care.
As you can see, some companies will see the competitive advantages weaken a tad over time,
while others will get stronger. It's simply the way of the world to have comers and goers.
We've got eyes on the changes and are incorporating all the shifts in the landscape into our
ratings and analyses.
A version of this article originally appeared in the May issue of Morningstar StockInvestor.
Click here to learn more:
http://msi.morningstar.com/Purchase.aspx?pgid=msispec
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