Why Understanding a Business’s Ecosystem is Critical for Investing Success?

Warren Buffett has always said that he wants to invest in businesses with Moats.  A moat is a business with a competitive advantage.  The competitive advantage could be lots of different things.  It could be a brand name, it could be that you are a low cost producer, it could be that you have a technological advantage, or it could be that you have a superior workplace culture and therefore offer a greater product or service than your competitors.  This is not an exhaustive list of competitive advantages. One of the things we like to do when we analyze a business is go beyond the concept of a moat, and we look for businesses that are creating a lot of value for their business ecosystem.

Ecosystem Value Creation

Creating Value with the Lock-In Effect

A business ecosystem involves all of the stakeholders that a business deals with.  This includes not only the customers and the shareholders of a company, but could also include the company’s employees, their suppliers, business partners, local communities, etc.  These various stakeholders can be broadly grouped into producers and consumers.  Businesses can and should create value for all of the various different groups in their ecosystem and for producers and consumers alike.  The most value-accretive businesses attract a greater share of the market’s consumers and producers and foster their respective dependencies on the business which creates a “lock-in” effect.  Often this lock in enables a business to create even more value and therefore it can work in a virtuous cycle for the benefit of the business.

Ecosystem Control

A business ecosystem is very complex. Therefore a business must analyze its ecosystem holistically with an emphasis on the needs of participants. After all, the participants are ultimately the driving force in an ecosystem.  The most important participant is the consumers, without the consumers we would have no business. When a business is providing a lot of value to consumers or users, the value to other stakeholders may occur naturally.

Unhealthy Ecosystem

When an ecosystem becomes unhealthy or toxic due to a business taking shortcuts or prioritizing near term fixes of that ecosystem’s long term health, the feedback loops in today’s world can result in cascading negative effects and lost consumers or lost producers.  In addition, the value a business creates may not always flow to all stakeholder groups and this can create an unhealthy ecosystem overall.  Sometimes a business creates a lot of value for consumers at the expense of other participants. This can be sustained in the short term but in the long term it will erode the strength of a business’s ecosystem.

A good example of this is Amazon.  Amazon creates a ton of value for consumers and in recent years it has also created a ton of value for shareholders.  However there have been criticisms more recently that Amazon is not creating value for other participants such as their employees and their third party sellers. In fact there has been accusations that Amazon actually exploits these groups.  If true, this could create an unhealthy ecosystem for Amazon which could erode the value creation of the business.  If employees no longer want to work for Amazon they may need to raise wages or simply suffer a lack of good talented employees.  Similarly if third party sellers no longer wish to list their goods on Amazon, that could materially damage the quality of their marketplace and therefore reduce the value being created for consumers.  It is vital for a business that all ecosystem participants are thriving so they are not incentivized to turn to competitors solutions instead.

In order for a business to make a good investment, the business not only has to provide value, but it has to provide value which is clearly above that of its competition. The way a business can do this is by identifying what the ideal value proposition is, and then constantly trying to improve its own value proposition so that it is as close to the ideal as possible.  A good example of this is in transportation.  In an ideal world, the consumer would be able to instantly teleport to their destination, however outside of science fiction this isn’t currently possible.  Nevertheless transportation companies can work and improve all the time so as to get closer to this ideal.  When Uber created it’s ride sharing service, this was a marked improvement over previous transportation options and therefore Uber has been able to capture a lot of value in the transportation market within its ecosystem.

Amazon and It's Ecosystem

Another attribute of a good ecosystem is that it is difficult for competitors to replicate. For example, Amazon has been able to build its business to such a scale that it can offer services like Amazon Prime or same day shipping which would be very difficult for a new competitor to try and compete with.  This means that the lock0-in that Amazon has with the participants is greater because the value they are offering is greater than what its competitors can offer.

One thing that is not well understood is that a business has stakeholders in its ecosystem which may not be direct participants in its ecosystem.  This could include its local community where it operates in, or it could include the wider industry where it operates, or for things like the natural environment, it could even extend to the whole world.  While I don’t think it’s necessary for a business to create direct value for the whole world, it is important for all businesses to create more value than they destroy. In a world where climate change is a very important issue, I think we can all recognize that a business like oil and gas drilling, which was very profitable before, can now seem less attractive if it is contributing to the destruction of our environment.  That’s why I think it’s important to include good honest analysis on what damage a business does to its wider stakeholder ecosystem, and decide whether the value it creates is high enough that their ecosystem is still healthy and they can maintain that lock-in.   This is another potential risk when we analyze a business but it is also a good filter to run a business through to test whether it is actually creating value or whether it is simply capturing value by destroying value somewhere else.

How Can We Identify If a Business Has a Great Ecosystem?

So if we know that a business with a strong ecosystem makes for a good investment, how can we identify if a business has a great ecosystem?  There are many different ways to do this and it will vary from business to business, however the key is to look for value that is being created for the participants in an ecosystem.  If a business is very popular, meaning it has a lot of users or customers and it is consistently growing the amount of users or customers it has, that is a pretty good indication that value is being created for those customers or users.  If lots of people are trying to get a job with a certain company, that is a pretty good indication that value is being created for employees of that company.  If you can find a business where all of the different participants in the ecosystem are all desperate to be a part of a business’s ecosystem, that is indicative of a very healthy and strong ecosystem and likely means it is an excellent business which can generate a lot of value.  These are the businesses we like to own.

- Craig White, BA, LL.B., CIM®

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.