Investing Logic in Moore's Gorilla Game.
When you purchase stock, you are buying a proportional share of the company's future stream of cash flows. You want to purchase the stock at price that is less than the net present value of those estimated cash flows. When making the investment, you hope for an excess return, one that is larger than expected, given the degree of risk. Yet, in a free market, economic theory posits that excess returns attract competitors who invariably drive excess returns back down to the cost of capital, down to equilibrium where return equals risk.
A company that creates shareholder value generates an excess return that is measured by the positive spread between its return on invested capital (ROIC) and the weighted average cost of capital (WACC). Only four financial strategies create value: (a) improve the use of existing capital by increasing the spread between ROIC and WACC; (b) deploy more capital in the existing business that is successfully generating excess returns, (c) invest new capital in new projects whose returns exceed their costs; and (d) lower the cost of capital. Because competition is attracted by excess returns, the unusual ability to sustain excess returns, exceeding the cost of capital and its risk adjustment, is especially valuable.
In The Gorilla Game, Moore argued that a company that fulfills a set of selection criteria identifying a gorilla offers investors a superior opportunity to buy a share of a value-creating company's future after tax profits. Moore's (1999, p. 87) classic claim: although a gorilla looks like a very hot company in a very hot category, and its price gets bid up, nonetheless, the market still undervalues just how hot the gorilla actually is. That is, Moore believes that a gap exists between the markets' expectations about the value of the gorilla and the enormous gap that gorilla status, in fact, imparts.
Here is a summary of his argument. The price of a stock is based on the market's expectations of the net present value of its future excess returns. A company's market capitalization (price per share times the number of shares outstanding) is the stock market's best estimate of the net present value of all of its future after-tax operating profits. Investors generate their own individual expectations and purchase stocks in an auction market where equilibrium is created between buyer and seller. Prices tend to rapidly stabilize and are subsequently changed going forward only as investors' expectations change.
Moore used diagrams of market capitalization, graphed along an ordinate of returns and an abscissa of time, to visualize the value of a growth company. To visualize the value of a gorilla he overlays a diagram of the expected market capitalization of a gorilla compared to a normal company (the area representing the gorilla is far larger in both height (returns) and width (time)). The height of the market capitalization diagram is a function of the depth of competitive advantage of a company relative to its competition. Relative competitive advantage represents the potential to generate superior earnings based on a superior offering.
Moore calls this potential for excess returns the Competitive Advantage Gap (GAP). A gorilla has a much higher potential GAP because: (1) its technology is inside the tornado, which means many interested customers; (2) it is the market leader, which attracts pragmatists as buyers; (3) it sets the de facto standard, which increases both its advantage over its competitors and its leverage over its value chain; and (4) it attracts many significant partners into its value chain, which makes the resultant whole product more valuable than the whole product of its competitors. This extraordinary set of competitive advantages creates an extraordinary premium on a gorilla's invested capital.
Moore calls the potential sustainability of competitive advantage, represented by width in a market capitalization diagram, the Competitive Advantage Period (CAP). When a non-gorilla company enjoys excess returns, it attracts competitors who seek to match or exceed its competitive advantages, making any present GAP hard to sustain. It has no moat, no franchise, thus, no expectation of sustainability of its competitive advantage. In contrast, a gorilla company enjoys a long CAP because: (1) the category of technology generating a new tornado has just entered a three- to five-year period of hypergrowth; (2) then the technology goes onto Main Street, where the gorilla will continue to enjoy its competitive advantages that created its market leadership until the end of the category's life; (3) the gorilla's competitive advantages actually increase throughout the lifetime of the technology paradigm, continually reducing the risk of losing its sustaining advantages over time; (4) finally, the remarkable sustainability of the gorilla also flows from its value chain participants who promote and protect the gorilla in the face of competitive threats to preserve their own interests in the technology paradigm.
The curved line shaping the upper boundary in the market capitalization diagram represents the curve of projected future earnings, with the origin point on the ordinate representing the last quarter's earnings. The curved line of projected future earnings degrades in height over time because projected future earnings are discounted by both the net present value effect and the uncertainty effect of predicting the future. The shaded area under the curve represents the net present value of excess returns above the risk-adjusted minimum. Moore believed that the change in the size of this area alone accounts for the overwhelming bulk of changes in a company's market capitalization and its stock's price.
Moore (1999, p103) offered two critical takeaways: "1. The premium any company earns in stock market valuation is a function of how much it can be expected to outperform its risk-adjusted rate of return. 2. The ability to outperform the risk-adjusted rate of return is a function of the company's competitive advantage in its primary markets." For Moore (p. 103, his bold emphasis), "Investing is all about understanding competitive advantage. That is the underlying thesis of the gorilla game."
Therefore, we can conclude that the investor's knowledge advantage in investing in a gorilla is a function of the reduction in uncertainty in its future because of its deep and sustainable competitive advantages.
In contrast, Moore assumed that superior execution alone, which raises the GAP without lengthening the CAP, had an inherently modest effect on stock prices. Also, he believed that lengthening a CAP without raising the height of the GAP merely pumps more life into an old gorilla. Instead, Moore concluded that it is the dynamic effect of the tornado market in the new category of a whole product that create a huge increase in economic value added that, in turn, drives a huge increase in stock price and market capitalization. Thus, the dynamics of the tornado generates three beneficial category effects: (1) an increasingly higher excess returns (GAP), (2) an extended CAP, and (3) a lower risk-adjusted rate of return. What the gorilla investor knows that the market does not yet know is that the gorilla has unusually deep and sustainable competitive advantages relative to its competitors within the category.
What are the dynamics of the gorilla's depth and sustainability in the tornado? First, consider the dynamic of depth. Demand for a given category of product outstrips the marketplace's ability to supply it, such that, ramping as fast as it can, it still cannot catch up to the escalating demand. Therefore, growth curves become limited at the point where new invested capital cannot be deployed in an effective or timely way. The state of demand in the tornado continues to outstrip production, and in this state where companies cannot effectively deploy any more investment, "the return on invested capital is the highest imaginable." So, returns increase from the beginning stock price, which was starting point on the ordinate, until the price reaches a maximum based on inefficiencies in deploying more capital in the face of this unrelenting tornado of demand. The gorilla gains a disproportionate share relative to its competitors specifically because it is the de facto standard and market share leader with a value chain that delivers a superior whole product.
Second, consider the dynamic of sustainability. Given a discontinuous innovation in a technology category, the new whole product both adds a huge step up in value (GAP) as it is taking over the market from an older technology category. The market anticipates both the powerful effect of the technology displacement and the continuation of the new paradigm into the future until some unforeseen category of technology displaces it in an indefinite future. Projecting that time into the future estimates that category's CAP. Of course, this projection is subjective, given the unpredictability of the future. No one knows just when in this necessarily indefinite future that a new discontinuous technology will appear or its new whole product will form to ignite another tornado. But everyone knows that a new paradigm is in place and cannot be displaced without a further revolution in technology. The gorilla has a disproportionately long life relative to its competitors specifically because the category's tornado lasts 3-5 years; on Main Street the gorilla as market share leader enjoy its competitive advantages as long as the category lasts; it cannot be shaken out because it continues to increase its relative CA through the law of increasing returns that continually reduce its risk, and, to preserve their own place in the system architecture, the value chain promotes and preserves the gorilla.
Furthermore, any company riding this technology wave will find it benefits from a reduced cost of capital because the technology wave itself reduces the risk that invested capital will be lost. This creates a lower risk-adjusted return, and, hence, more area under the EVA curve. The combination of continually increasing excess returns to the maxima and a projection of an extended competitive advantage period and a lower cost of capital drives stock prices higher.
Moore continued by indicating that the power of the tornado creates a stronger than usual first-mover advantage and, I would add, the law of increasing returns, sorts competitors into a stable hierarchy based on their market-share. The market, and by this I mean everyone, knows that the company left standing atop the hierarchy is the 800 lb gorilla-as-king-of-the-market-share-pyramid. That is, although everyone can recognize the dominant company in a category and call it a "gorilla," not everyone may recognize when that the dominant company is also Moore's gorilla. (The distinctive features of Moore's gorilla, for example, it will maintain its competitive advantages until the end of the category's CAP because it is immune to the risk of shakeout, are in italics above.) There are "gorillas" and GORILLAs. Any dominant company has a set of competitive advantages, but Moore's gorilla's competitive advantages are deep specifically because, hence, it hogs the initial excess returns, and, better yet, it sustains and increases them for the category's life specifically because, hence, its stock price just keeps on ticking upward.
The GG-Investor's Advantage
What is Moore's thesis for investors? If investors are to beat the market, at some point in time, they have to know something the market does not know. In the gorilla game, Moore assumes the stock market underestimates the returns of a gorilla in a tornado market because the GAP and the CAP are so deviant from other market leaders. The stock market will only correct its misperceptions in fits and starts, never adequately pricing the stock of gorillas in tornadoes or on Main Street, according to Moore (199, p. 121) because "in both cases, the correct valuation appears drastically overvalued," and "This double dose of persistent underpricing provides the foundation of the gorilla game." Moore might also have said, this is specifically because the gorilla's competitive advantages are a distinctive conjunction that, when combined, creates exponential competitive power.
The GG is a conservative approach to investing in high technology stocks because it reduces risk. How is risk reduced specifically? Risk is reduced by knowing something that the market does not yet know, specifically by the investor's superior ability to recognize a gorilla using the criteria promulgated by Moore, a stock selection that takes full advantage of the market's underestimation of its GAP and CAP. None of this is to say that if you buy the stock of a gorilla at a lower price early in the category's lifetime or when the market as a whole is down, that this is not an advantaged purchase.
It is worth noting that the key strategy for reducing an investor's risk is: wait for the commencement of the tornado. Mike Buckley's insistence on this in regards to BEA (or other stocks) is one of the significant takeaways of that discussion. Mike's insistence follows logically from Moore's argument summarized above. The tornado is a necessary condition for anointing the gorilla because it is the dynamic driving stock prices higher and leads to the consolidation around the whole product of the value chain that keeps stock prices continuing higher for longer. Although all other criteria may be in place, they are not sufficient because no tornado means no gorilla.
However, growing or accelerating market share are significant considerations in recognizing who is the potential gorilla. The leader has the best shot if the tornado develops. Taking market share or an acceleration in the growth of the category's market share are early warnings of gorilla or tornado statuses. Investors with a higher tolerance for risk or desire (greed?) for reward may jump in early if they choose not to follow Moore's advice.
As Moore noted, after the pyramidal shakeout of the dominant company from the pretenders, the market itself can recognize the competitor who is left standing, the so-called 800 lb gorilla-as-dominant-market-share-leader. This "gorilla" may or may not be Moore's gorilla. On the one hand, if it is not, then its competitive advantage will be less deep and long lived. On the other hand, if it is, then the distinctive combinatorial and exponential power of its competitive advantages still may not be recognized.
Of course, the more the market relies on gorilla game criteria, the less the advantage. The over reaction of the stock market to the bursting of the technology bubble has provided protective cover for gg-investors for the immediate future anyway.
Nonetheless, if you wait to invest until everyone knows what you know, even if it is only a partially correlated insight, there is a decrease in the gg-investor's advantage. That is, at least, some of the advantage of knowing what the market does not know has a time window. Part of the GG investor's advantage is limited to the time between the onset of the tornado and the market's recognition of the gorilla as the strongest company left standing.
However, this can be true only when the gg-investor is using criteria that the market does not recognize; the call must be that this is not just a dominant-King but a Moore's gorilla because its value chain has anointed its proprietary open architecture with high switching costs as the de facto standard that permitted the tornado for the whole product (system) to begin.
At the point where market share dominance is achieved, what the market yet may not recognize is the second dose: the gorilla's CAP that will last the lifetime of the paradigm because Moore believes its leadership cannot be shaken out because its increasing returns build further competitive advantage and because of its value chain's investment in maintaining the status quo.
However, the market may know that investing in any market leader is often a sound and profitable investment strategy-for example, O'Neil's "choose leaders, not laggards." Investing in the market leader who has a predominant market share may attract a larger following of investors in the market than just GG adherents alone. Also, the momentum in stock price fostered by the tornado may attract "momentum" investors who have no fundamental knowledge of or interest in the intrinsic GAP and CAP of the gorilla. The momentum investors may surf the stock-price wave itself, selecting either a basket of competitors in the category or in its leader because the category's stock prices are going up. (In contrast, GG-investors would be surfing a the technology wave rather than the stock-price wave and would be hunting or capturing its gorilla now.)
If stock attracts traders or momentum investors drive up the price of the stock, then it can become overvalued. Even a gorilla can become temporarily overvalued; although from a longer-term perspective it might not be valued above its future intrinsic value, given its CAP. In fact, a gorilla's high GAP in itself seems likely to send its price up in spurts whenever it reports surprising, exceptional earnings. This characteristic alone might attract some traders or momentum investors.
The GG-Investors Dilemma.
What is the gorilla-game-investor's dilemma? If I pull the trigger too early (before the Tornado begins), I may not have a gorilla. If I wait too long to pull the trigger (after either the tornado itself or the market-share-dominator is widely recognized), I may not beat other investors to the quarry. This dilemma is the age-old tradeoff between risk and reward placed in the context of the gorilla game.
On the one hand, the sting of that dilemma is abated by the second dose of underestimation of any gorilla's CAP. On the other hand, Mauboussin, who is following Shumpeter's logic of cycles of creative destruction, believes that high technology GAPs are becoming steeper and its CAPs shorter. If Mauboussin is correct, then an investor's timely entry into a Gorilla's stock becomes ever more significant in reaping a maximal excess return.
As an aside, we might envisage other threats to the CAP model. For example, given the popularity of Christensen's Innovator's Dilemma on the thread, some of us may recognize that disruptive technologies pose a second threat to a Main Street Gorilla's CAP that is distinct from that of a new discontinuous innovation in how it overthrows the paradigm. Whereas a discontinuous innovation creates a totally new market and whole product, ending the life of the technology paradigm, a disruptive technology dislodges the main-street gorilla who overshoots the technology that the market demands by undercutting it with a simpler, cheaper product, less functional product that expands its functionality over time until it encroaches on the same market from below. Others of us may believe that such a threat is limited to Kings. What does the thread think?
The attack on a Main Street gorilla from below provides a second potential threat, in addition to the threat of a discontinuous innovation, to the value of a gorilla by undermining the duration of its competitive advantage. If you will, it is an attack on the second dose of under pricing: the duration of the CAP. This argument advances the possibility that a market-share leader, even one with increasing returns, can be shaken out. The high margins of the gorilla contributing to the GAP are seductive to any management who listens to their high-end customers (and does not recognize the advantages of cannibalizing its products or platforms), reducing their foresight of the extent of the threat from an inferior product that initially targets a small and less profitable market before working its way upstream.
Valuation of the gorilla matters because its intrinsic value is a function of your estimates of the size of the double dose of under pricing. And this valuation is likely to be qualitative because increasing returns and leverage innovation often extends beyond our foresight and ability to quantify. Still, it is likely that using inexact measures is better than using no measures at all because we may be able to bootstrap these initial efforts. Still, the gg-investors advantage is a function of the gap between its present value and its intrinsic value given your knowledge of its double-dose of underpricing and your skill in selecting a Moore's Gorilla at an opportune time. Also, you must continually assess the risk of discontinuous (and disruptive) threats to your estimates of its GAP and CAP.
Timing matters because there is a trade-off between risk and reward. To invest you must act upon uncertain facts using uncertain skills. The less skillful you are, the more mistakes. The longer you wait to become certain, the less reward because other investors may correctly identify the gorilla or use partially correlated hypotheses to drive up the share price.
Hardest of all, you must act on what you believe in the face of uncertainty in spite of your own fear and excitement and in spite of the contagious nature of affect. Discipline is the art of not letting the market's mood become so contagious that it overwhelms your reasoned investment philosophy. You investing cycle needs to run counter cyclic to the markets' manias and panics. When the market panics, buy. When the market is ecstatic, sell. (Now, if only I could do this.)
Finally, given the market's mood and its evisceration of stock prices, we can be pretty sure that some time close to now may be a good time to invest in Gorillas and Kings.
I hope this helps.
Don |
