Be cautious of Blue Ocean multiples

• Global
• Airbnb, Blue Ocean Strategy, Company strategy, Electric vehicles, Growth, Growth investing, Growth strategy, Growth strategy, Tesla, Zoom
• December 31, 2020

You may well recognise the term Blue Ocean Strategy. It’s the redacted name of an iconic strategy book written by W Chan Kim and Renée Mauborgne: Blue Ocean Strategy – How to Create Uncontested Market Space and Make the Competition Irrelevant.

I know what you’re thinking. It sounds like the stuff your annoying mate doing his MBA tries to tell you about at every opportunity. If you have to listen to one more case study …

But, you would be doing yourself a disservice. Even though the book gets off to a slow start, it’s an incredibly worthwhile read for business owners and investors. It’s not a book that you would read cover-to-cover in a short space of time, because there’s a lot to take in and think about. I did it over a week, with a few hours between reading sessions to let the content sink in properly.

If you feel up for the challenge, I recommend that you give it a go.

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Why should you read strategy books?

We live in an age of extreme knowledge sharing – never before has expertise been so widely available and willingly shared. For those wise enough to invest time and a bit of money in personal growth and development, the library of global knowledge is extraordinary.

As a Finance Ghost reader, you are clearly interested in investing and business in general. In analysing opportunities in both these spheres, it really helps to think in a clear and structured way.

Strategy, at its core, is the art of structured thinking. By managing your bias, remaining curious and applying logic to everything you do, your answers to critical questions will be of higher quality.

I also see strategy as a longer-term concept, with tactical moves along the way to react to short-term opportunities. This might be why I’ve historically preferred long-term investing to trading, which I see as being more tactical in nature. Strategic thinking is about looking for long-term patterns and trends and organising those thoughts in a way that spits out a logical outcome.

Of course, if you can master strategy and tactics in the financial markets, then you stand an excellent chance of being able to choose what colour stitching you want on your Porsche’s seats.

What is Blue Ocean Strategy?

I’ve attended enough corporate strategy days to know that most companies don’t have a clue what strategy is. For too many businesses, “strategy” is something that happens once a year, starts with muffins and coffee and ends with a SWOT analysis on a PowerPoint slide.

The day is usually depressing and utterly useless.

The concept of Blue Ocean Strategy asks managers (and therefore investors) to look at growth in a new way. Instead of being obsessed with the competition and what they might be doing, Blue Ocean Strategy asks you to break down barriers in pursuit of new customers and reshaped industries.

Instead of building another me-too business, the book focuses on companies that totally change the game. These businesses innovate to attract an entirely new type of customer, pulling themselves out of a “red ocean” (bloody with competition and pressure on pricing etc.) and into a “blue ocean” where they can swim freely and profitably.

If the book had been written more recently, I suspect the word “disruptor” would’ve been used frequently. Although not all disruptors follow a true Blue Ocean Strategy, some certainly do.

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Interplay with valuation

One of the current debates in the investment community relates to valuation multiples and whether we have seen a structural reset in the market.

Specifically, are companies genuinely expensive, or do we need to change the way we think about valuations in this modern world where global juggernauts can be built in a decade rather than a century?

A valuation is nothing more than an expectation of future value that a company will generate, typically measured by cash flows that can be distributed to shareholders.

As usual, there is craziness at both ends of the spectrum. There are companies caught in a “value trap” that trade at stubbornly low valuations for a long time despite having decent fundamental attributes. Then there are companies that people speak of as bubbles waiting to pop, where the share price has been driven into the stratosphere for reasons that seem difficult to justify.

If you understand how companies strategically compete in their markets, you’ll stand a better chance of getting the valuation right. I believe there is a strong interplay between the concepts of Blue Ocean Strategy and some of the growth multiples we are seeing in the market, particularly in global stocks.

A practical example of where Blue Ocean Strategy meets valuation: Tesla

I find myself referring to Tesla often on this platform, but it’s a topical company and remains a bone of contention in the market.

Until quite recently, Tesla followed a Blue Ocean Strategy by focusing on electric vehicles (EVs) at a time when other manufacturers weren’t putting too many resources into the segment. In my view, this wasn’t because executives at Volkswagen and Mercedes-Benz were asleep at the wheel, but rather because EVs were incredibly unprofitable and Tesla was being kept afloat by an army of Musk cultist investors and regulatory credits.

In defence of Tesla, the company seems to have a product that people want and has recently managed to swing into profitability. The numbers still suck but they suck a lot less than they used to.

Unfortunately for Tesla, the blue ocean is turning bright red. The world’s leading automobile manufacturers are releasing excellent EV products into the market. Already, Tesla’s Model X is being given a hard time by Audi’s e-Tron.

How long can the all-important Tesla Model 3 stay ahead of key European models in important markets?

The ace up Tesla’s sleeve is China, thanks to a clever strategy of local manufacturing and winning support from government. As Jack Ma will tell you though, Chinese regulatory support can be fickle.

My point is that the hyped-up Tesla share price reflects a world where Tesla becomes the dominant car manufacturer. To achieve that, Tesla needs to defeat brand loyalty and reputations of companies that go back over a century.

I think this will be impossible. Tesla will achieve respectable market share and will earn a seat at the table of the world’s finest automobile houses, but to assume that everyone will have a Tesla in the garage just doesn’t make sense to me.

I would caution against applying a “Blue Ocean” multiple to a company that is being circled by sharks. Tesla will have to do truly amazing things over the next few years to come close to justifying the current share price.

The same applies to companies like Zoom and Airbnb, trading on colossal multiples that demand perfection from their management teams and ongoing innovation into Blue Oceans. The true value is in identifying these companies before they become over-hyped monsters. That’s how the big money is made.

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