The Fallible Investor

As previously discussed, I have a rule that I will not buy a business unless it is highly likely to still exist in 10 years time.[1] The reason for this rule is simple. If the business does not exist in 10 years time it is likely to be a very poor investment. However, it is hard for me to predict whether a business will be around in 10 years time. Therefore, I simply assume that businesses in industries that change the least have the highest probability of surviving. The industries that change the least are usually low technology product or service industries. However, I do think that some high technology companies with very strong competitive advantages (think Microsoft) are likely to last. 

The graphs below show the low probability that the average business in a fast changing technology industry will still exist in 10 years time. The number of businesses in both of these technology industries rose and fell dramatically over a short period. 

[Click on the image for a better view] 

Source Michael Mauboussin[2] 

There is a lot of other evidence that the failure rate of businesses in technology industries is much greater than other industries.[3] The really interesting question is why. Bronte Capital (an Australian hedge fund) has written what I think is a very good explanation of why this failure rate is so much higher:

In technology the competition is remorseless. In most businesses the competition might be able to do something as well as you – and it will remove your excess profit. People will build hotels for instance until everyone’s returns are inadequate but not until everyone’s returns are sharply negative. Even in a glutted market a hotel tends to have a reason to exist – it still provides useful service. And someday the glut will go away so the hotel will retain some value.[4] In most businesses the game is incremental improvement. If you get slightly better you can make some money for a while. If the competition gets slightly better you will make sub-normal returns until you catch up.

In technology the threat is always that someone will do something massively better than you and it will remove your very reason for existence. Andy Grove – one of the most successful technologists of all time (Intel Corporation) – titled his book “Only the paranoid survive”. He meant it.

If your technology is obsolete the end game is failure – often bankruptcy. Palm will fail because Palm no longer has a reason to exist. If we wait 20 years Palm will be even more obsolete – but the hotel glut will probably have abated. Nothing left in Palm is likely to have any substantial value.

This is a crucial point. In most industries a reasonably efficient business will be able to manage its assets to make a return on its invested capital which is at least close to its cost of capital. That is often not the case in technology industries. Irrespective of how efficiently you run your business if your technology becomes obsolete you will make little or no return on your capital. Moreover, your operating assets will usually have no value to any other business. If your technology becomes obsolete your operating business will usually be worth nothing.  

Bronte Capital point out that the key to survival for technology businesses is keeping out the competition:

Surprisingly, changing the world looks like the easy bit. Plenty of companies do it. The problems are in keeping the competition out. Only a few do that (Microsoft, Google are ones that seem to)…

A simple example is Garmin…Garmin has over a billion dollars cash on the balance sheet – and that cash represents past profits. It has changed the world – and thus far it has been well remunerated.

The only problem is that they can’t keep the competition out. Nokia has purchased a mapping company. Iphone now has a Tom-Tom app, downloadable for $80 in Australia. Soon sat-nav will be an expected application in every decent mobile phone. Google has mapping technology too and will embed it into their android phone. Eventually the maps will be given away because people might book hotels using their sat-nav device whilst they are travelling. [It is darn useful to know where a decent hotel with a spare room is when you are on the road.]

Garmin has a great product. They have improved my world. The only problem is that they can’t sell their product at any price that competes with “free”. Garmin’s business is going the same direction as Palm. Bankruptcy however is only a remote possibility – they have a billion dollars on the balance sheet and unless they do something really stupid on the way down they will remain a profitable avionics business.

This raises the very important question of why do some technology businesses survive (for example Microsoft’s operating system software). Is it because of the strength of their competitive advantage?  Does Microsoft’s economies of scale and customer captivity with its Windows software allow it to spend so much on research and development that it can keep most competitors at bay? Or is it the nature of the technology they are selling? Are some technology products or services likely to only change incrementally and, thus, not become obsolete overnight? (i.e Windows Office software).[5] I think some technology businesses survive because of one, or both, of these reasons.

Nevertheless, the risk of obsolescence with technology businesses remains. I deal with this risk simply. I only invest in them if I think the business is highly likely to still exist in 10 years time. I assume that the only technology businesses which are likely to still exist in 10 years time are those which have a product or service which is likely to change only incrementally, and which have a very strong competitive advantage.

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[1] I make an exception to this rule for businesses that I think are ‘cheap’ compared to the value they will realize in liquidation or in run off. 

[2] P108, ‘More Than You Know: Finding Financial Wisdom in Unconventional Places’, Michael Mauboussin, 2007.

[3] See P108, ‘More Than You Know: Finding Financial Wisdom in Unconventional Places’, Michael Mauboussin, 2007 for references.

[4] “Unfortunately the hotel is usually mortgaged – and the value often reverts to the debt holder.” Footnote from the Bronte Capital Article.

[5] There is obviously the longer term risk from cloud computing systems.