The Strategy Tax

One of the more interesting finance stories to come out this week was the $1 billion buyout of the Dollar Shave Club by Unilever. Dollar Shave Club was founded in 2011 with some simple ideas — let’s sell low-cost razors to men by utilize some interesting marketing platforms and cut out all of the usual overhead that causes other razor companies to increase their costs and thus prices. They quickly gained market share. Ben Thompson from Stratechery explains (emphasis mine):

Perhaps the biggest of these second order effects is on value, and that’s where I come back to this purchase price: the tech community is celebrating the massive return for Dollar Shave Club’s investors, but $1 billion for a 16% unit share of a market dominated by a brand that cost $57 billion is startlingly small. Indeed, that’s why buying Dollar Shave Club was never an option for P&G: even if their model is superior P&G’s shareholders would never permit the abandonment of what made the company so successful for so long; a company so intently focused on growing revenue is incapable of slicing one of their most profitable lines by half or more.

For their part, Unilever is fortunate they don’t have a shaving business to protect, because being an incumbent is going to increasingly be the worst place to be. Dollar Shave Club’s motto may be “Shave Money Shave Time,” but just how many shareholders and policy makers are prepared for the shaving of value that this acquisition suggests is coming sooner rather than later?

Razors were thought to be a no-brainer business model with a huge moat. That’s why Buffett was Gillette’s largest shareholder back in the day. It fit his investing style perfectly. Although Gillette still commands a huge share of the market, Dollar Shave Club was able to come in and steal a large share of the market in a relatively quick time frame and ultimately cash out.

On the a16z podcast last week the founders of venture capital firm Andreessen Horowitz, Marc Andreessen and Ben Horowitz, discussed the benefits of being a small or mid-sized firm competing with larger, more established firms. Here’s Horowitz:

In a way they’ve got an interesting advantage in that they’re not tied to the last generation of use interfaces, so that they don’t have to pay the strategy tax.

And Andreessen with a follow-up:

The problem that big, established companies get into which is what he referred to as the strategy tax, which is basically big companies with existing agendas have to sort of fit their next thing into their existing agenda. And they often compromise it in the process. 

These two examples resonated with me this week because I talked to a reporter (stay tuned for the story next week) who asked me why so few small and mid-sized institutional investors utilize simple portfolios comprised mainly of index, quant or smart beta ETFs or mutual funds in lieu of more complicated portfolios. You can now build fairly sophisticated portfolios using simple mutual funds and ETFs that would have been nearly impossible to put together in the past, so why haven’t more large investors gone that route?

I’ve been asked this question a number of times in the past. There are plenty of good theories — inertia, overconfidence, career risk, a lack of understanding, it’s boring, the assumption that complex markets require complex solutions, etc.

But I think this idea of the strategy tax is a huge reason why. It’s difficult for individuals or organizations to change their mind about something after they’ve always done things a certain way. People hate to admit that either (a) they were wrong or (b) there may now be a better way of doing things.

Why do you do things this way?

Well, we’ve always done it this way? Why change now?

You see this all the time with people who manage money (or those who have opinions about how to manage money). They take a hard line stance and then even when the weight of the evidence clearly shows that they’re wrong, instead of admitting error, they dig in and double down on their wrongness. A stubborn conviction of your own ideas can be a terrible thing when you can’t see the error of your ways.

One of the reasons Vanguard now has 5 of the 6 largest mutual funds or ETFs in terms of assets (and 36 of the top 100) is because so many established firms have been paying the strategy tax of sticking with high fee funds. These fund firms can still earn larger revenues for the time being because they charge such high fees, but that game isn’t going to last forever. Investors are wising up. (Also, something most people don’t realize is that Vanguard even has $1 trillion in actively managed — but low cost — funds.)

Established companies rarely want to cannibalize their existing products or ideas. This is something that has always impressed me about Apple — they don’t care if a new product basically puts an old one out of business.

I’m not trying to say that every established firm is toast. Far from it. Some ideas and brands really can stand the test of time. But it seems like the advent of newer and better technologies is making it easier for smaller and mid-sized firms to thrive these days when they approach stale products, services or ideas in a new or interesting way.

The finance industry is ripe for these types of changes. It’s not going to happen over night, but those firms who continue to pay the strategy tax will likely languish or risk being passed by upstarts or those firms will to adapt to the new realities.

Software Programs the World (a16z)
Dollar Shave Club and the Disruption of Everything (Stratechery)

Further Reading:
How Institutional Investors Use ETFs

Now here’s the stuff I’ve been reading lately: