Aug 26 2020
Corporate Decision-Making in the Fog of the COVID-19 War, Continued ...
In this installment, I’ll build on issues covered in parts 1 and 2 of this mini-series on market fundamentals. My aim is to keep these as sequential as possible, so you may want to review those previous articles if you haven't read them (Part 1 and Part 2). Today we’ll cover fundamentals 6 and 7, which encompass the relationship between emerging technology & industry life cycles and substitutable products.
Fundamental #6: Thoroughly Investigate the Nuances of Emerging Technologies and an Industry’s Life Cycle
Emerging technologies can foster the birth of industries while reshaping existing ones. New technologies may seem like a genie in a bottle with so many wishes seemingly granted with a snap. They often mesmerize with dreams of yet unimagined products and services, of world-changing applications.
But wait. Your competitors are no doubt on to this, too! So, the race begins.
In the past 40+ years, I have witnessed brilliant, seasoned decision-makers make inglorious decisions under the tantalizing lure of swiftly emerging technologies. And amid pressure from stakeholders, they often acquiesce to the presumed wisdom of the crowd.
The Wisdom of Crowds
In James Surowiecki’s 2004 book “The Wisdom of Crowds” he cautions of situations when the crowd makes poor decisions, arguing that their reasoning or cooperation failed as members were overly conscious of others’ opinions. They began to emulate each other, conforming rather than thinking or behaving independently. Doesn’t the ease and immediate fluidity of information nowadays facilitate this systematic flaw?
There is clearly a grey area between the “Wisdom of Crowds” and the foolishness of bandwagons.
Pro Tip: Beware of hopping blindly on bandwagons
Another metaphor applies here—opening a Pandora’s Box. Once opened, the box of rapid technological innovation can be as perilous as it is seductive.
Here’s a great example. The internet bubble was marked by poorly capitalized, highly leveraged companies funded by zealous investors—including banks. Bankruptcies and defaults were prevalent as the dot-com boom/bust rapidly unfolded. This is a great illustration of a generational technological leap, with, nonetheless disruptive consequences. Consider my last newsletter that looked at retail trade and the “Amazon Effect.”
Beware of Rapid Technological Change
My concern revolves around a potential lack of institutional knowledge as businesses and creditors scurry for a foothold while being ill-equipped to assess opportunities and risks, thus leading to misguided decisions.
The effects of rapid technological change are not limited to tech industries. Technology has structurally transformed most industry groups, including:
Retail (shopping malls/centers)
Manufacturing (robotics/machine learning)
This not a new phenomenon—just think of the industrial revolution.
The high-tech arena can be seductive and present opportunities. Just look at the constant stream of interest in artificial intelligence, cloud development, cybersecurity, bio- and nanotechnology, to name a few. It can also be politically complex—consider TikTok and Huawei.
So, be skeptical of rapidly emerging technologies, as they often portend massive industry restructurings and bankruptcies. Lacking the institutional knowledge and the management skills required to comprehend the ramifications of technological change can be dangerous. In other words, do your homework.
Industry Life Cycles & Technology
A related issue is where an industry resides in its life cycle. Here, the introduction of new technologies plays a key role. There are four basic stages of the life cycle.
Industry Life Cycle Stages
The emerging stage includes industries in their infancy that have developed a new product or service or may be applying a new technology. Often the market is untested or not clearly defined. Vast amounts of capital are needed and, in many cases, government support is in play. Official funding sources include the likes of the UK Research and Innovation, the National Science Foundation in America and the Australian Research Council. Financing is also sourced privately via venture capital or banks.
Information technology and communications industries continue to record high failure rates with many venture-based startups collapsing. For leading examples of the risks inherent in emerging industries, you can again consider the dot-com boom/bust. An interesting case study is the web development company ArsDigita that failed despite abundant VC investment.
Be warned that ample funding and scalability are no guarantees of success when hitching a ride on tech bandwagons.
Having graduated from the emerging stage, industries in the growth phase typically need funds to fuel further growth. Although often considered in the “Goldilocks zone” for investors, these apparent sweet spots live in a turbulent world where consolidations and M&A activity are rampant. Larger, well-capitalized firms gobble up or simply trample smaller players.
Historically, think of the automobile industry just prior to the introduction of mass production. In modern times, industry growth segments like smartphones and tablets have expanding markets and an apparently insatiable craving for new apps and more sophisticated hardware. Other examples of growth industries include software publishing, IT consulting, video games, and a host of online retailers.
Although companies in growth industries present exciting opportunities, there are winners and losers in this tempestuous space so pick your bets wisely.
For companies in the mature industry category, earnings and sales grow much slower than during their growth phase. Though earnings are generally steady, the hopes of accelerating growth prospects are unlikely as remaining companies consolidate market share, practice cost containment, and create barriers designed to stifle the entry of new competitors.
Nonetheless, there is a haven in this category: “cash cows.” Despite slow growth, they have galvanized market shares and, with stable profit, can weather the storm in times of uncertainty. There is a preponderance of these “blue chip” firms in the production and sales of staple goods like common household products, food stuffs, and other nondiscretionary spends (necessities). On the service side, many health care segments fit the bill.
Perhaps this group is not particularly exciting, but stability can be a welcome attribute in today’s dicey environment. The recent sectoral advances in the US stock market seem to bear this out.
Industries in decline are scary. Their withering sales put them on a trajectory of death by attrition. Key examples of industries in decline in advanced economies include hosiery and apparel knitting mills, shoe and footwear manufacturing, camera and film manufacturing, and many brick & mortar retailers. In many economies, some establishments have seemingly been on life support forever—like department stores and newspapers.
Nonetheless, if firms on death row can sell variable assets, opportunities might present themselves.
Fundamental #7: Recognize How Substitute Products and Services Compete
Failure to recognize this subtle but powerful force can lead to a serious underestimation of default risk and misguided calculations of risk appetite. Substitution risk is often amplified during periods of economic stress.
There are three central attributes that dictate the degree of substitutability of a good or service:
The buyer’s switching costs are low,
The substitute product or service is highly price-competitive, and
The substitute product or service is of equal or superior quality and/or its functions, features or performance are equal or superior to the industry’s product.
One example is the competition between recycled paper and virgin pulp, which are substitutable products used in paper production. The process for recycled paper entails more complex production than paper from virgin pulp, which can mean higher costs. Moreover, virgin pulp fibers are longer than the recycled variety, making the latter less suitable for various products. The bottom line in this example is that market conditions are not always equally friendly to virgin pulp and recycled paper.
In my next newsletter, I will consider the increasingly important issue of supply chains as well as concentration risk.
Hope to see you then.
Rick Buczynski, Ph.D.
IBISWorld Chief Economist
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Liked this article? Read Part 4 of this series