Why I like to invest in businesses with high barriers to entry

The startup mania is upon us, and whether this is a lasting phenomenon or another bubble remains to be seen. Don’t get me wrong: I love technology and startups! Technology, with an increase in computing power and a reduction in cost, has democratized and rendered accessible a lot of industries. Nowadays, it is possible to write a novel on one’s computer, upload it, sell it online, print it in just-in-time, and send it to the purchaser, all this with just a couple of clicks. Musicians and film creators have access to professional tools at a reasonable cost that creators of 20 years ago could only have dreamed of… And in the software industry, it is now possible to bootstrap a company with a couple thousand dollars and a few months of programming from an individual or a small team. Anyone with a great (or not so great!) idea can take the plunge. This is really cool.

But from an investment perspective, there may be better risk-adjusted returns out there. Barriers to entry are obstacles that make it difficult to enter a given market. And the factors at the center of this democratization movement make for low barriers to entry. This results in increased competition. Just think of the struggles to entice buyers in a sea of competition on the App or Play Store. There are high probabilities that your app will simply never be seen by anyone… There are more than 850 new apps submitted daily on the App Store[1]. Thus those kind of ‘’web 2.0’’ products are thus more often than not marketing plays rather than technology plays. They need to get traction. They need to get users. So even though you can get a product out with limited investment, very soon you will need a large digital marketing budget… Yes, there are cases out there of products that are so good that they will spread like wildfire simply by word of mouth. But how many are there?

The barriers to entry can also potentially hinder a more mature company. Facebook could lose its coolness factor to a new entrant quite rapidly. It happened to Friendster[2] and Myspace. In the case of Myspace, the traffic has declined steadily since 2009 despite numerous redesigns. The fact that Facebook has recently seen a decline in teenagers’ activity[3] to the likes of Instagram, Snapchat, Vine, and Flickr, although somewhat overblown, is a warning sign of what could happen. To me, the teenagers segment is the canary in the coal mine. Could it be that ‘’web 2.0’’ companies have shorter lifespans? Will we still use Facebook and Twitter in a hundred years like we still use Dupont’s and General Electric’s products today? The time investment that users have put into Facebook (uploading all those cute cat photos!) does constitute a somewhat high(er) switching cost or high barrier to exit for users. Could it be possible for a new incumbent to offer a one-click solution to upload all of a user’s Facebook content to a new site with her permission? The network effect can have perverse repercussions and amplify the fall when users start deserting en masse…

This is why I like barriers to entry. They can for example result from access to data, high switching costs, intellectual property and know-how, brand and goodwill, and economies of scale and scope. When you have a unique and breakthrough technology secured by intellectual property you can usually enjoy some prosperity without too much competition. Sometimes those technologies are complex and have taken years to develop. Examples of such public companies that I can think of are Nuance and Nvidia. Nuance offers voice recognition solutions and Nvidia manufactures graphics chips. They both have very strong research and development and a long history of product development. Both enjoy very limited competition. It would just be very hard for me (or anyone for that matter) to start a new voice recognition company tomorrow. It would take years of work by high-level scientists and massive amounts of money. It also shows that barriers to entry can be software-based, not just hardware. Microsoft had a monopoly for ages because, well, it’s kind of hard to build an operating system. This market dominance has now been eroded by iOS and Android, two platforms based on Linux, which for a long time has lain in the sidelines as a niche OS. Barriers to entry don’t just exist for large and mature companies. In the startup world, I can think of Hexoskin[4] and Neptune Pine[5], two Montreal-based companies, which have very decent barriers to entry.

Of course, barrier to entry is just one parameter to examine when considering starting a business or investing in one. But they are usually easy to assess and can be the source of great competitive advantage. Of course it is not a panacea since you need barriers to entry for a product or service that customers actually want… What do you think? Do you have examples where companies having high barriers to entry failed?

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s