Economic moats — competitive advantages that typically protect a company’s market share and earnings — help stocks perform. But do they last?
An incredible proportion of stock market winners of the last 20 years are companies that provide “X”-as-a-Service (XaaS). X can be software, platforms, mobility. The list goes on. Try Googling XaaS, and you will come across words like, “New Era,” “Holy Grail,” “The future of business.” I can understand the excitement, and the model, of course, has a plethora of benefits for all stakeholders. Companies get high-margin, regular, and predictable subscription revenues. They also get a direct relationship with customers that provides insights on how users are interacting, which enables companies to improve the product. For customers, the model reduces upfront costs, increases flexibility, provides better products, and lets them share in the benefits of scale economies. Investors love these companies because they have predictable subscription revenues and deep, deep moats.
But as Harry S. Truman, 33rd President of the United States, once said, “There is nothing new in the world except the history you do not know.”
A forerunner in Paris
Let’s go back in time to the early 1880s. Someone visiting Paris then would have been very impressed by numerous beautiful clocks standing on iron pillars in the squares, at the corners of the streets, and in subways, all keeping accurate time. So accurate that Parisians would set their time by these public clocks. These clocks operated pneumatically, linked to a central station, which would send a 20-second pulse of compressed air every minute. The air would travel through an intricate system of wrought-iron pipes, then into lead pipes or rubber tubes, then into each clock to activate small bellows inside. Each pulse moved each clock hand by one minute. On some clocks, a second bellows would ring a chime.
"Present-day investors, transported back in time, would have loved this Time-as-a-Service business."
If you agreed to subscribe to this service (time-as-a-service), it would have meant allowing the provider to dig a pipe in your floor running from the clock to this pneumatic system. Hotel Le Meurice, an elegant, refined, and expensive Paris hotel, in 1880 installed 148 pneumatic clocks as a status symbol of accuracy. The hotel paid the equivalent of £56 sterling a year for this Time-as-a-Service, the same as its annual bill for water supply, knowing accurate time was valuable intellectual property in that era.
The provider was Compagnie Générale Des Horloges Pneumatiques. It owned a 50-year monopoly (1881–1931) to roll out pneumatic clocks across the entire city of Paris. In other words, it was responsible for “distributing” time through a pneumatic system of 32 km of pipes to 4,000 clocks. Present-day investors, transported back in time, would have loved this business and would have paid a high multiple for it. Just look at the characteristics — the total addressable market (Paris) was huge. Who wouldn’t like accurate time? Significant productivity gains for society could be unleashed as people would have accurate time to set up meetings and make other arrangements.
A temporal and temporary monopoly
This business was a natural monopoly: Once you installed the air distribution network, it’s game over; your leadership was established for a long time. It wouldn’t have made sense for a competitor to replicate the network. It had “scale,” because once you set up a coal-fired engine that powered the air-compressors, profitability improved as you added more clocks to the same compressor. Think about the "switching costs" of this business: Would anyone dare to rip up the floor again to get a new provider, given the redecoration involved?
Of course, we know, or can easily guess, how the business of distributing time ended. Compagnie Générale Des Horloges Pneumatiques was finally discontinued in 1927, well before the monopoly period ended. They were disrupted. Improving accuracy of mechanical watches (and later, quartz) meant that they didn’t need to be set every day. Better distribution of time signals also became available through telegraph, and later radio, and now through the Internet.
Despite some familiarity of Paris’ Time-as-a-Service business with modern-day XaaS, there are some critical differences that make the modern-day version better. Today, many businesses offer digital products (software, music, video) that are non-rivalrous intangibles They can be endlessly replicated at near-zero cost, producing high incremental margins. Also, due to connectivity, there is a feedback loop from customers, allowing a provider to continuously improve the product and overall experience for the customer.
Active investors look for change
Nevertheless, the experience of Compagnie Générale Des Horloges Pneumatiques is a good reminder for companies and investors that moats do not last forever, no matter how deep they appear to be. Things change, disruption happens, and moats can become completely irrelevant or inconsequential. To quote another U.S. President, John F. Kennedy — “Change is the law of life.” As active investors, we remind ourselves to devote attention to what could change. Those who spend too much time looking at the past or present are certain to miss the future.