Welcome to Bookworm, my new column that explores a single idea from an insightful book or investor letter each week. My aim is to give older ideas new life through modern day examples, apply insights from abroad to Australian cases, and provide food for thought.

Today’s insight

Today’s insight comes from Hamilton Helmer’s 2017 book 7 Powers, which outlines seven different flavours of competitive edge in modern business.

Of the seven, I have chosen to explore Helmer’s concept of “counterpositioning”. Not only is this Helmer’s self-confessed favourite of the Powers. I also think that one of the ASX’s most dominant niche winners embodies it perfectly.

Counterpositioning explained

Helmer refers to counterpositioning as “an avenue for defeating an incumbent who appears unassailable by conventional wisdom”.

Here is how he explains this concept in a sentence:

“A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business”.

Rather than a lack of vision or business acumen, the incumbent’s failure or delay to respond is often a completely rational response.

As Helmer puts it, “the incumbent observes the upstart’s new model, and asks, 'Am I better off staying the course, or adopting the new model?'. Counterpositioning applies when the expected damage to the existing business elicits a “no” answer from the incumbent”.

Helmer uses the rise of Vanguard's passive investing business and the lack of response by America’s biggest active fund managers, like Fidelity, as an example.

“Fidelity possessed all the capabilities to develop and distribute passive funds” he writes. “However, active funds carry radically higher expense charges and many even had upfront sales commissions. For the assets [an entry in to passive] would have cannibalised, the revenue decline would have been dramatic”.

Taking such a hit to short-term revenue or profits, even if it leads to much more value being created down the line, may be especially unfathomable for managers incentivised on what sales or profits will look like in the nearer future.

Switching costs for potential competitors

Like Helmer, at Morningstar we are also very interested in sources of competitive advantage. Our moat framework points to five main sources of sustainable edge: cost advantage, network effects, efficient scale, intangible assets and switching costs.

When Morningstar analysts talk about switching costs, it is usually in the context of customers being unlikely to leave their existing supplier because of the time, costs, effort or risks that would involve.

Counterpositioning, on the other hand, can be viewed as switching costs for the bigger company who's 'old way of doing things' is being challenged by an upstart. Which brings us to a great example from Australia.

King of the second hand jungle

When it comes to preowned vehicle listings, Carsales.com.au is Australia’s undisputed king of the jungle. You may remember my car salesman friend, who I tapped for an earlier article, calling it “a tollbooth you cannot get over, under, or around”.

Our CAR Group analyst Roy Van Keulen says that the company’s ascent to this dominant position was highly unlikely.

“To win, it had to fight off Australia’s largest corporations” his research report says. “This included Australia’s largest media companies like Fairfax and News Corp, who not only had tremendous financial resources but vast distribution capabilities through their media assets.”

One of the two main reasons Roy gives for Car's triumph included what he calls “competitor switching costs” in the early days – or in other words, counterpositioning. The Fairfaxes and NewsCorps of the world did not see it as attractive to move their existing classified businesses online.

The money needed to build these new media assets online wasn’t the issue. After all, the established firms had plenty more cash than Carsales. Unlike Car, though, they had an existing business’s profits to think about. Online listing fees were far below offline ones at the time, so it held little appeal.

Playing catch-up can be hard

In 7 Powers, Helmer talks about how the attraction of investing in the new business model increases as uncertainty over the new model’s viability falls and the challenger eats further and further into the incumbent’s market share.

Even in a relatively short period of time, though, the challenger can build formidable advantages and expertise that make it hard to chase down. Here is how Roy describes this in the case of Car Group:

“By the time the traditional media companies caught on to the secular shift online, Car Group had not only spent more money developing its marketplace than its competitors. Crucially, it had spent more time, something the traditional media companies could not buy.”

The result? An increasingly feature-rich and harder to copy marketplace, and a first mover advantage that eventually morphed into the network effect that underpins CAR’s Narrow Moat rating from Morningstar today.

The idea that 1) being first to solve a new business model’s unique problems and 2) “stacking” these solutions and expertise on top of each other can result in a solid advantage is a key premise of Jim McKelvey’s book the Innovation Stack.

Roy included The Innovation Stack in our summer reading list for Morningstar readers and it will no doubt appear in a future Bookworm.

Aiming directly at cash cows

The more profitable an incumbent’s operations in a certain business, Helmer says, the more chance an upstart can benefit from counter-positioning. 

An example that I encounter frequently, and have benefitted massively from over the years, is the rise of cross-border payment apps like Wise.

The other day I used Wise to send $2000 to the UK for what I hope is my final tax bill there. According to Wise, using their service saved me forty dollars versus doing the transfer through my big-four bank.

With savings like that, I am guessing that a meaningful chunk of international money transfers have moved to services like Wise. I’d also bet on banks being slower than expected to mimic these offerings. Even though they could easily do it.

Why? I'm guessing that fleecing customers on FX rates probably remains a high-margin and not insignifcant source of profits.

I am not suggesting here that CommBank will get Blockbustered. I am just saying that Wise targetting international transfers, an area where the main incumbents were making far too much money to change course, was rather clever.

How can investors use this insight?

Many public companies are either trying to disrupt an industry or market with a new business model or are an incumbent facing this potential threat themselves.

As a result, weighing up whether a company could gain or lose from counter-positioning could help you assess its long-term competitive position.

On the upside, evidence that incumbents are being held back by these dynamics might boost your confidence that the challenger will be successful in winning the market.

On the downside, it could lead you to pay more attention to a competitive threat that others may be dismissing. In some cases, the latter could increase the amount of business risk you see in a potential investment.

To learn more about assessing business risk, try this article by my colleague Mark LaMonica.

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