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As competitive advantages go, the ability to run faster than the competition seems like a good starting point, particularly if you are an animal in the African bush. You might think it would follow that the fastest land animal, the cheetah – which is able to reach speeds close to 60mph and to accelerate at a rate four times that of Usain Bolt – would always catch its prey. Not so: the predator is successful only 40–50 per cent of the time. Its prey, the impala has the advantage because its slower speed enables it to make sudden turns at the last second, out-manoeuvring the cheetah. The moral of the story: never assume you know, at first glance, who or what has the advantage.
This is equally applicable to investing in equities, where it is easy to make lazy assumptions regarding competitive edges and their likely duration. Companies with a strong and sustainable competitive edge tend to generate superior returns for shareholders over long periods of time. That’s why identifying companies with a durable edge is a vital part of our stock-picking process and an indispensable element within our Radar framework.
Ascertaining exactly what a company’s competitive edge is, however, seldom straightforward. We hope this paper will give you some insight into how we think about the topic and why we believe we can add a lot of value to the research process by approaching it in fresh ways.
At its simplest, a competitive edge is an attribute that allows a company to outperform its competitors. Michael Porter, the celebrated Harvard Business School academic and a widely-recognised authority on this subject, suggests that a company can build a competitive edge in one of two ways: either by being the lowest-cost player in an industry or by making itself stand out from its peers, either through superior products/services or a unique business model.
We don’t think it is that simple. In our experience, competitive edge is seldom down to a single attribute. Often, it is the result of several key attributes coming together over time. In most cases, these attributes are intangible, softer factors, such as what motivates management or the company’s ability to develop brands or take customers in new directions. This is not something that traditional investment managers are good at identifying.
Conventional research nowadays emphasises quantifying every possible aspect of a company. As a result, for many, investment has been reduced to counting the sum of parts. For us, this seems counter intuitive. Not only is it inherently backward looking and reductionist, but it does not cope well in the era of disruption and rapid change in which we live.
We prefer to take a more holistic approach, by which we mean that we believe the whole is greater than the sum of parts. The magic happens when the key attributes come together and create sparks. Discovering these attributes requires imagination and creativity, not just the ability to read accounts, annual reports or even sell-side reports. This is an area where we believe we can add a lot of value through our research process, which emphasises creativity and looking for the unseen connection points that will drive a company’s competitive edge over time. In practice, this might mean fostering connections with non-financial sources, including academics, authors and those attending industry conferences – anyone with a considered view on the world that can expand our thinking and keep us curious.
Retaining our curiosity helps us to be open-minded about the various elements that might come together to give a company an edge over its peers. It helps us to remain future-orientated and look beyond the immediate and obvious when developing a view on the likely future course of the company and the industry it operates in.
The magic happens when the key attributes come together and create sparks.
This is particularly important because, in most cases, we see companies being successful over long periods of time despite not having any ‘apparent’ competitive edge. IRISO Electronics is one such example. It makes connectors that are used to link various electronic components within cars.
On the face of it, there’s nothing exciting about making connectors and there are numerous companies globally operating in this space. Despite this, IRISO has built an impressive long-term track record of success. We think this has been possible due to the company’s intense focus on its core business (unlike its more diversified peers), as well as management’s ability to re-orient the business towards emerging growth areas. IRISO historically generated the bulk of its sales by selling to manufacturers of in-car entertainment equipment. As this area matured, they seized the opportunity afforded by the advent of autonomous cars and have since turned this market into a significant part of their overall business. But it hasn’t stopped there. The company is currently developing connectors that go into robots, another sign of management’s ability to identify and exploit growth opportunities in new areas as they arise.
Investors who are steered by short-term considerations are susceptible to taking a company’s prospects as read because they tend to extrapolate past performance into the future. As a result, change often blindsides them.
Noritsu Koki is a classic example that illustrates the perils of relying solely on history and ignoring change. Established in 1951, Noritsu was a global leader in paper-based photo processing equipment called minilabs. Over the next five decades, the company was run by its traditionally-minded founder who ignored the fundamental shift towards digital photography and hence the company fell victim to disruption. Following his death in 2005, the founder’s young and dynamic son-in-law took over the business. He sold every vestige of the legacy business, including the land on which their factory was located. He re-invested the proceeds in building a portfolio of potentially exciting and high-growth healthcare-related businesses.
Incredibly, and despite such dramatic change, the market and the sell-side still harbour an outdated view of Noritsu Koki and hence struggle to articulate its competitive edge. However, we think a combination of softer factors such as dynamic management, an adaptable business model and being an early investor in emerging healthcare technology companies gives Noritsu its competitive edge over peers.
We believe that sustainability of an edge is inextricably linked with how adaptable a company is.
In the context of our research framework, we openly acknowledge and embrace the fact that change is the only constant in a world of rapid technological advances. This also means that the concept of a ‘sustainable competitive edge’ needs refinement. We believe that sustainability of an edge is inextricably linked with how adaptable a company is. By focusing on identifying and investing in companies that have the ability to ride out changes, we are able to unearth the small subset within our investable universe of smaller companies that will be able to extend and solidify their competitive edge over long periods of time.
Assessing competitive edge is especially tricky for young companies that may not have a track record for us to rely on. An extreme example would be biotech companies that make little or no profit for several years and where the probability of long-term success is small. Various studies have shown that the success rate of drug programmes that make it from Phase 1 through to approval is as low as five to ten per cent. Even for the drugs that do make it to market, it takes years to get there. So how do we even begin to define the competitive edge of a biotech company with the odds stacked against it right from the outset?
In such circumstances, we think that it is important to focus on identifying the building blocks of a future competitive edge rather than adopt a static approach that places a lot of emphasis on the current state of such businesses. Healios is one of Japan’s leading biotech companies. It is working with induced pluripotent stem cells (IPSC) to develop a cure for age-related blindness (AMD). There are few expert practitioners of IPSC globally and Healios is among the more advanced players in this area. At present, there is no cure for AMD and there are many patients who could benefit from a breakthrough treatment such as the one that Healios is developing. It is also an area that, unlike oncology for instance, is not crowded with competing medical solutions.
In essence, Healios is developing an actual cure for an unmet medical need rather than a clone of existing therapies that only serve to delay the onset of the condition. It is run by its young and dynamic founder, who is also an ophthalmologist and has prior experience of developing successful treatments for optical ailments. So, despite the low probability of success for its novel therapy, the above-mentioned attributes could form the building blocks of an edge for Healios in the future should its drug program be successful.
One trend that we are observing is the rise in small, entrepreneurial companies established by their founders to solve a big problem that they may have encountered personally.
One trend that we are observing is the rise in small, entrepreneurial companies established by their founders to solve a big problem that they may have encountered personally. The result of this is an increasing number of fast-growing businesses that are creating new markets. While this is an exciting development for us as long-term growth investors, it also makes the task of determining the competitive edge of such companies challenging. Because of the relative immaturity of such businesses, we believe it is important to focus on the intangible sources that, when taken together, give rise to a meaningful competitive edge.
Bengo4.com is an example of a young company that was set up by its founder following a difficult personal experience. This is Japan’s only online portal that connects lawyers with people looking for legal advice. Following a road accident, the founder found it extremely difficult to hire an experienced lawyer to deal with his case and hence decided to start Bengo4.com to make navigating Japan’s inefficient services sector easier. Since 2005, the company has successfully created a new market in Japan for online legal advice and has begun to monetise this in recent years.
We think the company’s competitive edge stems from a combination of being run by a visionary founder/CEO and a unique business model built around a compelling product offering. These are qualitative factors and hence difficult to ‘model’ for conventional analysts. With just over one-third of all lawyers in Japan already members, we believe that the company should eventually build a strong and ultimately quantifiable scale advantage over potential competitors.
For an analyst, clearly articulating the competitive edge of a company is perhaps the most challenging task. As the examples above illustrate, there isn’t a ‘one-size-fits-all’ approach that we can take when assessing a company’s edge, simply because no two companies are the same. In most cases, businesses derive their competitive edge from a collection of seemingly mundane and intangible characteristics that are downplayed by conventional analysis, mostly due to intellectual laziness. We believe that it is vital to have the mental flexibility to think creatively about competitive advantage and focus on the building blocks of what might constitute a strong and sustainable edge in the future rather than anchor to the present.
This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.
Any stock examples, or images, used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
As with all mutual funds, the value of an investment in the fund could decline, so you could lose money. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty and greater volatility. These risks are even greater when investing in emerging markets. Security prices in emerging markets can be significantly more volatile than in the more developed nations of the world, reflecting the greater uncertainties of investing in less established markets and economies.
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The most significant risks of an investment in the Baillie Gifford International Smaller Companies Fund are Investment Style Risk, Growth Stock Risk, Long-Term Investment Strategy Risk, Geographic Focus Risk, Small-and Medium-Capitalization Securities Risk, Asia Risk, China Risk, Conflicts of Interest Risk, Currency and Currency Hedging Risk, Emerging Markets Risk, Equity Securities Risk, Focused Investment Risk, Information Technology Risk, IPO Risk, Japan Risk, Liquidity Risk, Market Disruption and Geopolitical Risk, Market Risk, New and Smaller-Sized Funds Risk, Non-U.S. Investment Risk, Service Provider Risk, Settlement Risk. For more information about these and other risks of an investment in the fund, see ‘Principal Investment Risks’ and ‘Additional Investment Strategies’ in the prospectus. The Baillie Gifford International Smaller Companies Fund seeks capital appreciation. There can be no assurance, however, that the fund will achieve its investment objective.
The fund is distributed by Baillie Gifford Funds Services LLC. Baillie Gifford Funds Services LLC is registered as a broker-dealer with the SEC, a member of FINRA and is an affiliate of Baillie Gifford Overseas Limited.
Top Ten Holdings as at 31 December 2019
|2.||Douzone Bizon Co||3.37|
|9.||AirTac International Group||2.41|
It should not be assumed that recommendations/transactions made in the future will be profitable or will equal performance of the securities mentioned. A full list of holdings is available on request. The composition of the fund’s holdings is subject to change. Percentages are based on securities at market value.
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Praveen graduated BEng in Computer Science from Bangalore University in 2001, and an MBA from the University of Cambridge in 2008. He previously worked for FKI Logistex before joining Baillie Gifford in 2008. After completing the investment graduate trainee programme Praveen joined the Japanese Equities team as an Investment Manager in 2011. Praveen is a member of the Portfolio Construction Group for the International Smaller Companies Strategy, a strategy dedicated to investing in the most exceptional smaller companies internationally.