As we write this, Steve Ballmer recently announced that he is stepping down at Microsoft (MSFT). The equity market was encouraged and MSFT saw a quick bump in value. The "smart money" is betting that Microsoft can use its enormous war chest to acquire a stake in the rapidly growing social media, mobile, and big data revolution.
At the other end of the spectrum, BlackBerry's (BBRY) board announced that it was "considering strategic alternatives" for the company. In plain English, they've given up on regaining their competitive position with the BlackBerry and it's time for a fire sale.
FOCUS senior advisor John Mason has recently been exploring the concept of Transient Competitive Advantage. Sixteen years ago in his seminal work, The Innovator's Dilemma, Clayton Christensen introduced us to the concept of disruptive innovations that provide new entrants with such an overwhelming cost or efficiency advantage that entrenched firms cannot compete. While this dynamic enabled upstarts such as Google (GOOG) to win, it still left plenty of room for most existing players to hold their competitive edge with incremental improvements. Mason posits that we are now in a fundamentally different world:
"These companies that achieved a competitive advantage that seemed unassailable now face the reality that what seemed to "permanent" in the past no longer exists. Now, innovation must constantly be created to replace past "legacy" competitive advantages, not try to extend them."
These ideas are not new, they derive from the tenets of classical economic thought. Adam Smith and other early English political philosophers (a.k.a. economists) described an economic system in which competition inexorably created efficiencies that drove out excess profits from the system with one exception. As an example, the income of a brick making factory was divided between three groups of participants: the workers, the business owners or entrepreneurs, and the landowner to whom the facility would revert at the end of the lease. They called the landowner's profits "economic rents", because, unlike the workers and entrepreneurs, the land owner was not personally adding real time value to the productive process.
Eventually the concept of economic rents was extended to include that portion of an enterprise's profits that derived from the ownership of capital rather than from the current value add of those involved in the productive process. Profits in excess of those derived from a market rate of return on capital would presumably be eliminated over time unless some outside force prevented it. Governmental intervention to benefit a privileged class, such as patent holders, could interfere in this process and protect rents for an extended period, but otherwise competition would eventually eliminate profits.
Of course, in the real world, we can identify many cases where profits seem to have been preserved over a long period even in the absence of government granted monopolies. Without taking any credit away from entrepreneurs who struggle to protect their profits and add a great deal of economic value in the process, it seems clear that market friction and inertia have historically been important factors protecting the profitability of many entrenched firms. In the modern world, good examples of such friction are brands such as Coca-Cola (KO), network economies, such as Facebook (FB), and geography specific access to focused skills and industry experience as has been the case in Silicon Valley for IT or Los Angeles for entertainment.
Mason indicates that we may have reached a point where increasingly rapid technological and societal changes threaten to eliminate these frictions so quickly that any competitive advantage should be looked on as purely transient. In this world, there are no unassailable business franchises and change comes too quickly for most firms to react effectively. If you doubt this, just ask the owners of a former "monopoly" local newspaper.
In such a world, the only companies that can prosper are those that continually push the edge with new technologies and products, including technologies that will in the end eliminate the need for their core products and services. Those that don't will soon follow BBRY over the precipice. And where these cycles were once generational, they can now be measured in a matter of years. Kodak took decades to forfeit its once unassailable position in film photography, before ultimately descending into bankruptcy. Today, the road to oblivion is often much shorter, even for the giants of our age.
What's the lesson in this for small cap and middle market private companies? Bottom line: if they have a competitive advantage that supports unusually high profits - whether from technology, geography, government fiat, or otherwise - that favored position will not last long. Those companies that take advantage of their moment in the sun to find a strategic or financial partner willing to recognize their value can count themselves among the fortunate. Those that miss the window … well, they missed the window. And the likelihood of a small cap or middle market private company coming back for a second act is low. IBM (IBM), Microsoft, or Hewlett Packard (HPQ) may have the wherewithal to reinvent themselves - perhaps multiple times. Middle market companies rarely do.
This leads us to inquire about the current state of M&A. As you will see by going to our Mid-Year Middle Market M&A Review, M&A got off to a relatively slow start in 2013, but we have reason to believe that will change in the second half. Q4 2012 was a strong time for M&A closings and it's taken the market a while to digest. As 2013 rolls on, we expect to see investors' appetites whetted again. Even so, this remains a seller's market. Money is plentiful and valuations remain near historical highs. If you've invested in a small cap or middle market business that benefits from a potentially transient competitive advantage, you should consider the possibility that this may be the best time it will ever have to sell.
Click on image to the left to view a video presentation with additional thoughts on the article presented above.