Transcript
Clay Fink (0:00)
You're listening to tip. On today's episode, we're diving into what I believe is one of the most practical frameworks for understanding business strategy and competitive advantages. And that's Hamilton Helmer's book, Seven Powers. Warren Buffett has long emphasized the importance of owning high quality businesses, and a key trait of these businesses is their ability to sustain high returns on capital over long periods of time. To do that, they need a moat. But what exactly makes up a moat? And what makes a business defensible and keeps competitors at bay? That's exactly what Hamilton Helmer sets out to answer in Seven Powers. After decades of investing and consulting, he distilled his findings into a clear framework that identifies seven distinct sources of enduring competitive advantages. In this episode, we'll walk through each of the seven Powers in depth and explore examples like Netflix, Facebook, SAP, Tiffany Vanguard, and Toyota. Without at least one of the seven Powers, a business is destined to deliver average returns on capital and is vulnerable to disruption. So with that, I hope you enjoy Today's episode on Seven Powers by Hamilton Helmer. Since 2014 and through more than 180 million downloads, we've studied the financial markets and read the books that influence self made billionaires the most keep you informed and prepared for the unexpected. Now for your host play Fink welcome to the Investors Podcast. I'm your host Clay Fink, and today I'll be sharing the key takeaways I learned from reading Seven Powers by Hamilton Helmer, and hopefully you'll pick up a nugget or two to add to your toolkit. As an investor or a business person yourself, Helmer put together the Seven Powers framework. After hundreds of consulting engagements and decades of active equity investing, he argues that a business without at least one of these powers lacks a viable strategy and is vulnerable to disruption. The seven Powers covered in the book include scale economies, network economies, counter positioning, switching costs, branding, cornered resource, and process power. I'll be covering each of these powers in depth during this episode. Now this book was interesting for me to cover because as a stock investor myself, I'm very interested in learning about what gives a business a competitive advantage. I own nine individual stocks in my portfolio at the time of recording, and now that I've read Seven Powers, I'll need to walk through each business and mark down each of the seven powers that each business has, and if I come to find that one of my companies doesn't have a strong case for any of the powers, then that business might be in trouble because they're likely to be disrupted. I also work for a small business myself here at tip, so we're constantly thinking about how we ourselves can leverage the powers we hold and use them to our advantage. The companies in my portfolio lean pretty heavily into the processed power category, which is quite rare and can be difficult to correctly identify, and it's potentially the most difficult power to sustain over a long period of time. A network effect, for example, is one that's pretty durable and able to be sustained for long periods. We recently covered booking holdings on the show, and the power of their network effect is a big reason why I recently purchased shares for my own portfolio. Now when we look at Constellation Software, for example, which is another holding of mine, Mark Leonard has famously said that anyone can pick up a phone and start dialing to try and acquire software businesses. From the holding company's perspective, the core of their competitive advantage, I believe, is process power. On the surface, it might look easy to pick up the phone and go out and try to buy software companies, but to do it in the way that Constellation has done it is not as easy as it might appear on the surface. Helmer illustrates the example of Toyota in the book to illustrate how process power works in more detail. However, Constellation does have a couple of other powers that Helmer outlines for the software companies they own. The companies benefit from high switching costs, which gives these companies a high amount of sticky and recurring revenue. They also have a cornered resource with their proprietary dataset that gives them insights on what types of businesses they should be buying, what irrs they can expect, and where the best opportunities are all around the globe now. Zooming Out Power and competitive advantages are incredibly important to understand. If we look at a company that's growing at around 10% per year, 85% of that company's value is derived from their cash flows after year three. So if you misassess on the durability of a company's cash flows in their competitive moat, then you can be just totally off the mark when judging a company's true underlying value or their intrinsic value. So Helmer defines power as the set of conditions creating the potential for persistent differential returns. So in other words, power is simply the ability to earn high returns on capital. This falls in line with what Poulock Prasad stated in his book what I Learned About Investing from Darwin. If he could define a high quality business with one metric, he would look at the return on capital employed. As Helmer puts it, power is the core concept of strategy and of this book too. It is the holy grail of business. Notoriously difficult to reach, but well worth your attention and study. He then defines strategy as a route to continuing power in significant markets. He explains that power has two necessary and sufficient conditions, a benefit and a barrier. A benefit is a method that improves your business relative to your competitors. Benefits or improvements happen in businesses all the time, practically every single day. Now, a barrier is an improvement that not only improves your business, but it also widens the gap between you and your competitors. And that gap must persist over time, meaning that your benefit isn't accessed by existing and potential competitors. So a power exists when you have both a benefit and a barrier in place. It's not enough just to have a benefit, because your competitors could also have that same benefit, and the excess returns that were generated from that can quickly be arbitraged away by the market. Now, one of the key takeaways for me from this book was that benefits are plentiful, but barriers are not. For example, hiring productive employees is of course a benefit for a company, but that doesn't mean that your competitors can't also hire productive employees or a retailer. Selling items in bulk can be a benefit because the retailer sells more volume and the customer gets a better price per unit. However, the barrier to selling in bulk is quite low. Another key insight was that great businesses are built through innovation. When you look at visionaries like Steve Jobs, Elon Musk, or Reed Hastings, they are doing something entirely new. They aren't looking at their competitors and saying, how can I just do things a little bit better? They are looking at an industry and just totally revolutionizing them, which can't be done by just looking at your competitors. So those are some of the key concepts to keep in mind as we walk through these seven powers here. So let's dive into the first power covered, which is scale economies. Scale economies refer to when a business has declining per unit costs as production volume increases. Helmer illustrates the example of scale economies with Netflix. He took the leap and invested in Netflix in the spring of 2003, and at the time, Blockbuster dominated the DVD rental industry with their brick and mortar retail stores. But Helmer saw the potential for Netflix to shake things up. Through their impressive mail to order business, Blockbuster faced the unpleasant choice of losing market share or eliminating late fees, which accounted for around half of their income. Helmer's investment hypothesis was grounded in this uncomfortable dilemma. Blockbuster would drag their feet facing up to the painful existential imperatives that confronted them, and Netflix would continue to cannibalize their customers. However, Netflix also knew that it was only a matter of time that the physical DVD business would would be supplanted by digital streaming distribution. Moore's Law ensured that would be the case once advances in Internet bandwidth and capability allowed this transition to take place. So they strategically set up both business units as they officially started their streaming segment in 2007, they knew that if they didn't make themselves obsolete, then somebody else surely would. Initially, Netflix negotiated with content owners for streaming rights, but in 2012, they made the radical choice of creating their own content that would be exclusive to their platform with the release of the House of Cards series. This move proved to be a total game changer for the industry, because if other streaming services wanted to differentiate their offering, they would also need to spend to create original content in order to effectively compete with Netflix. This industry dynamic would give Netflix a structural cost advantage through scale economies. If Netflix spent, say $100 million on content and they had 30 million subscribers, they would effectively be spending $3 per subscriber. This level of spend would be incredibly difficult for a provider with say 2 million subscribers, as they would be spending $50 per subscriber. As Netflix grew their number of subscribers, they would be able to spread out these fixed costs over a larger subscriber base, which created a flywheel as they could invest more in content than their competitors, which would then attract even more subscribers. Now this competitive advantage was out there for anyone to see. But what would prevent someone from raising a bunch of money, investing in new content in order to attract subscribers, and thereby give Netflix a run for their money and potentially steal market share? Helmer argues that in order for a competitor to effectively steal market share, they would have to provide more value to customers either through differentiated content or lower prices. In an established market, such tactics would be visible to the leader, which in this case is Netflix. If a new player tried to enter the market with lower prices, Netflix could potentially match that price decrease themselves to prevent the new entrant from stealing much market share, which could inevitably destroy shareholder value for the new entrant rather than creating it, establishing a barrier to entry and a strong competitive moat to Netflix. It's not that a competitor can't necessarily enter and try to compete with Netflix, is that entering the market comes with an unattractive payoff or an unattractive risk reward dynamic. Helmer writes here, this situation creates a very difficult position for Netflix's smaller scale streaming competitors. If they offer the same deliverables as Netflix, similar amounts of content for the same price, their P and L will suffer. If they try to remediate this by offering less content or raising prices, customers will abandon their service and they will lose market share. Such a competitive cul de sac is the hallmark of power. So a company like Netflix has the task of trying to balance their power. They of course want to achieve high returns on invested capital, but if they achieve returns that are too high, then that might encourage competition to enter, bringing their returns down over time. On the flip side, if they price their product too low, then they could be leaving a lot of money on the table as customers are receiving a disproportionate share of the value created. So it's this balancing act beyond fixed costs, there are a few other ways in which scale economies can emerge. One is from distributed network density. As the density of a distribution network increases to accommodate more customers per area, delivery costs decline as more economical routes structures can be accommodated. One example of this is Old Dominion Freightline, which is a less than truckload carrier that we covered in depth on episode 652. Another is purchasing economies. A large scale buyer can often elicit better pricing for inputs. Walmart and Costco are prime examples of this since they have the scale and reach that few retailers have. As our listeners know, a competitive advantage is required for a business to earn high returns on capital over long periods of time. In the case of Netflix, the presence of this is obvious as it's one of the best performing stocks in the market since the company went public in 2002. Transitioning here to the second power we have network economies, otherwise known as network effects. Network economies occur when the value of a product to the customer is increased by the use of the product by others. Helmer illustrates network economies with the story of rick Morini. In 2010, Morini launched Branch out, which was a professional networking app similar to Facebook but tailored to professionals. He raised a $6 million Series A round of funding and was off to the races and attracting users. Recruiters want to make the best use of their time, so they typically go to the source with the largest number of active professionals. At the same time, professionals looking for work or who want to keep their options open work wise want their names listed on sites with the most recruiters. This is a critical aspect of a network economy. One side of the network growing increases the value for the other side and vice versa, creating a self reinforcing upward spiral. Morini knew the fiercely competitive realm he was entering, which was rapidly scale or die. Catching up to an established network economy is usually impossible and at this point LinkedIn already had 70 million members. But Morini was betting that the race wasn't over yet, and that he could build off of Facebook's user base of 700 million users by tying their platform in with Facebook. Since most people wanted to keep their personal and professional life separate, Branch out would quickly grow from 10,000 users to 500,000. Showing early promise as he went to raise another $18 million monthly. Active users then exploded, hitting 14 million in the spring of 2012, just two years after the launch of the platform. But the party ended about as quickly as it started. As Churn outpaced growth and few users were truly engaged, the site would shut down in September of 2014. The central feature of network economies is that the value of the service depends on the presence of others. Morini was well aware of this characteristic and aggressively pushed out tactics to encourage use of the platform and but clearly LinkedIn and Facebook were much more successful with their own strategies. Building network economies are notoriously difficult. Even Facebook launched Facebook at Work only to learn that users wanted a clear distinction between social platforms for work and their personal life. When we dive deeper into the characteristics of network economies, we find that once it's established, the company with a leadership position has the ability to charge higher prices than their competitors because of the higher value provided, which is a result of the larger user base. For example, LinkedIn's HR Solutions Suite comes with more LinkedIn users, so they can charge more than a competitor can. Or Facebook can charge advertisers more than another social network can because they have targeted ads that deliver a higher ROI per advertising dollar spent. The barrier for network economies is the unattractive cost benefit of gaining share. This can be extremely high. Try and think about what you would have to offer someone to use Branch out instead of LinkedIn. Once LinkedIn has already been the established user base, there's very little incentive for people to switch. The amount of capital it would take to convert a significant portion of LinkedIn's user base is an unthinkable amount, so it just wouldn't be worth a new player trying to enter the market. And if they do, they would essentially just be throwing money down the drain. As a result, network economies tend to be a winner take all industry. Once the leader has crossed some sort of tipping point, once the leader achieves a certain scale, then the other firms are just forced to throw in the towel. For example, Google launched Google in 2011 to compete directly with Facebook, and they spent hundreds of millions of dollars investing in this platform, yet they still ended up shutting it totally down in 2019. In my view, network economies have brought us some of the best businesses in the world because their moats are just so difficult to disrupt and they're extraordinarily profitable. Just to keep on the topic of Facebook here, since it's one of the most obvious network effects when looking at Facebook Blue and Instagram. Facebook, now known as Meta, had 1.4 billion global users in 2014. This grew to 3 billion in 2024. Revenue over that time period grew from 12 billion to an astounding 164 billion. More than a 10x over that 10 year time period. And the return on invested capital today is around 35% showcasing the strength of their moat. What's also interesting to me about these spectacular network effect businesses is that they oftentimes aren't directly offering the product or service that users are going to the platform for. For example, Airbnb helps travelers find a place to stay, but Airbnb does not offer any of these accommodations. Uber helps people catch rides, but they themselves aren't providing their ride sharing service. Additionally, I think with these big tech companies, they benefit from both scale economies and network economies. So meta, they have more capital than any social media company to invest in their platform. And you know, they're putting X amount of dollars into their platform. That's likely to be much more than all of their competitors. But if you look at it on a per user basis, it's likely that they're spending less than their competitors. So they're getting more bang for their buck in terms of maintenance capex despite them in aggregate spending more than say Snapchat or X. The reason for this is that a new incremental Facebook user, or a new user of Airbnb, for example, adds practically no incremental cost to these platforms. So whatever revenue these new users generate practically flows straight through to the bottom line. With that, let's turn to discuss the third power, which is counter positioning, which is Helmer's favorite form of power because it's so contrarian. Helmer defines counter positioning as a newcomer that adopts a new superior business model that the incumbent does not mimic due to anticipated damage to their existing business. So the incumbent might see that they're being disrupted by the new player and and just sort of throw their hands up, saying that there's no way that they can step in and do what the newcomer is doing because that would mean that they need to disrupt themselves. Let's outline counter positioning by sharing the example of Vanguard and its assault on the world of active equity management. John Bogle started Vanguard in 1975 and took the radical approach of starting an equity mutual fund that simply tracked the market, doing away with the manager, actively selecting the holdings and trading in and out of certain stocks. Not only that, it would also operate at cost, paying all returns back to shareholders. Eventually, a third innovation would be put in place as well. Vanguard became a no load fund, meaning that there would be no sales commissions. The fund finally launched in 1976 and saw less than $20 million of inflows over the year that followed. For brokers who were so used to selling actively managed strategies to their clients, Vanguard's passively managed fund was quite off putting. Helmer writes here, swimming against the riptide of self interest in the investment business is not for the faint of heart. End quote. For many of these brokers, I'm sure that selling in an active strategy meant that it would help them pay their mortgage and feed their family. So a fund with no sales commission was likely of little interest to them, even if it showed promise of delivering more value to their clients.