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Wednesday 28 July 2010

Moats, Unbundled

From Wheelwrights to Press Barons

Imagine yourself as a fourteenth century European knight: safely tucked up in our crenulated castle, defended by our deep filled moat, we’re the confident lord and master of all we can see. Yet we’re on the cusp of a technological revolution that will overturn our beliefs and destroy our way of life. Cannon are coming and our moats are about to become prisons, not protection.

Technological advances beget market dislocations, as old business models are overturned and new ones tentatively created. English surnames tell of such changes – Wrights and Smiths now far outnumber wheelwrights and blacksmiths, vocations long in vogue and now irrelevant. Now a new generation of knights stand watching their battlements blown apart as newspaper barons and music moguls desperately try to shore up their crumbling estates. They’re on a hiding to nothing, of course; the invisible hand is unbundling their once impregnable moats through the medium of the internet.

Moats in Decline

From the mid- fourteenth century onwards the Hundred Years War pitted various noble houses against each other for mastery of France. One of the predictable effects of this conflict was an arms race, ending in the last battle of the war, at Castillon, the first time a battle was decided not by force of arms but by artillery. The development of gunpowder and the creation of cannon changed the face of warfare forever.

Out of this foment arose the science of chemistry and the engineering processes of metallurgy; the re-imagining of gunpowder for weaponry and the development of cannon capable of withstanding the forces generated by exploding projectiles. Overnight the intrinsic value of large defensive castles surrounded by moats collapsed. Often along with the buildings themselves.

When a Moat becomes a Prison

This, of course, is the other side of the investor’s dream business: a company with a natural moat that protects it from competition. Sometimes the moat becomes less a defence and more a prison. Technical innovation has destroyed countless businesses that once seemed impregnable and it’s surprisingly hard for a corporation steeped in a particular way of doing business to modify its behaviour. Dismantling decades of corporate practice and starting afresh is all too often too difficult.

In living memory we’ve seen market leaders like Xerox and IBM usurped as they were undone by unpredicted changes, before re-inventing themselves. They didn’t so much lose their market leading positions as wake up one morning to discover that their markets were no longer worth leading. This has happened far, far more often than we fondly imagine and, as we track back through the decades we find countless examples of apparently superb and untouchable investments failing to survive unexpected environmental changes.

According to Leslie Hannah in 1900 44% of the world’s stockmarket capitalization was accounted for by railroads. An Egyptian company was the world’s largest non-railroad corporation, although mainly for geographic reasons, on account of it being quite hard to move the Suez Canal. This is the vicious Darwinian nature of the markets: today you’re a T. Rex, king of all you survey, tomorrow you’re a bag of bones presenting an embarrassing puzzle for Biblical scholars.

Bundling in Reverse

The rise of the internet, search engines and a range of new intermediaries is a direct threat to those businesses whose business moats rely on the creation of digitally distributable content and, in particular, those that rely on bundling different types of content to create a package with a single price. As any decent procurement person can tell you, the art to knocking down the cost of your suppliers is to slice and dice their content into different pieces so you can price compare with competitors. Only those suppliers of bundled products with enough muscle and moat to prevent this can truly protect their businesses.

Two types of businesses are now in a desperate rearguard action to defend their collapsing defences – music producers and newspapers. Both of these are finding that their pricing models are being pulled apart by the gravitational pull of the internet. Music producers have long profited by bundling individual tracks which people want with those that they don’t really care about; the CD album is the classic piece of bundled media, oft justified on artistic grounds: an album is a complete work in its own right, not a set of separable tracks is the claim.

Such a position may be defensible by those rare bands that don’t release singles but otherwise is simply an attempt to maintain the pricing premium that bundling great and not-so-great content together brings. iTunes offers the market people want, not the one the suppliers want to provide. Anita Elberse points out:
"... that providing consistent levels of quality in a (mixed) bundle is paramount to stimulating full bundle sales. All else equal, having a set of songs that are relatively even in their appeal may lead to a higher overall willingness to pay for the bundle"
The fight against illegal copying is a sideline to trying to figure out a new business model that works: the moats are already breached, the barbarians are through the gate, the battle’s lost.

Advertising for News

Newspaper proprietors face a different problem. As this excerpt from Nicolas Carr’s The Big Switch outlines most newspapers are, if you study them closely enough, simply vehicles for advertising, bundled up with a bunch of stuff that has a variable relationship with actual news. If you can unbundle these different pieces of content, extract the newsworthy stories from the rubbish and throw away the advertising – aka use internet search engines – then the business model collapses. The news that the moats once associated with newspapers are no longer working is hardly current – it’s an established fact and the struggles of old media to come to terms with the new are another fascinating sideshow in this story.

So we see the battle lines being joined by the newspaper moguls against the search engines, as they set up paywalls to try to defend their positions. Unfortunately this is also largely a battle that’s been lost unless they can find new ways of attracting interest. Most news stories only need a single internet outlet to satisfy most readers, the value added by the majority of media spinners is negligible. It’s no surprise that attacks by media groups on the privileged position of the taxpayer funded BBC have increased: paywalls aren’t likely to work while the Beeb continues to publish for free.

Who’s the Journalist, Now?

Worse than this, though, the Fourth Estate’s position as the ultimate check on government abuses is also failing. Many of the bigger news stories are now broken by insiders over the net, through blogs and other outlets. How government deals with this development will be interesting and revealing. In most jurisdictions the status of bloggers as journalists with the protection that that status provides is uncertain. The recent police raid on Jason Chen, the editor of the Gizmodo blog who managed to get hold of an early version of the iPhone 4 suggests that this is true, even in the United States where journalistic privilege has long been a shining example to the rest of the world.

Here in the UK our libel laws are roughly equivalent to those of third-world dictatorships, such that re-publishing of fair comment outside of this country via the internet in a form viewable in the UK has been sufficient to allow corporations to use our libel laws to stifle comment under threat of huge financial sanctions. Yet even here the cracks are showing as the science commentator Simon Singh has recently managed to fight off an attempt by the British Chiropractic Society to legally gag him. As the New Zealand Medical Journal said of a similar attempt: “...let’s hear your evidence not your legal muscle”.

The world is changing, the castle walls are crumbling and the moats are filling up with broken masonry. The best investors can do is get clear of the falling debris, fleeing like rats from a foundering vessel. Of course, this rodent behaviour is always presented as a bad thing, but remember: rats leave a sinking ship for a damn good reason.

Related Articles: Reality 2.0 - Interactive Porn and Crumbling Moats, Is Intrinsic Value Real?, Investing Like Berkshire Hathaway


  1. You can't build new things up without also tearing old things down. The genius of the free market is that it provides a means by which to tear old things down.

    The rub is that there are always lots of people hurt when old things are torn down. If you don't help those people make the transition, the entire project will no longer enjoy the confidence of the public.

    We are going through a time of big change today. There's huge potential growth in our future. But do we have the leadership needed to manage the transition? The answer today is so obvious that it is not necessary to say it (I do NOT mean that as a dig at any one political party). The drama is whether the stress of what is coming will force better, braver, smarter, more life-affirming people (from both parties!) to the top.


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