#164 - Small Businesses, Moats, & Execution

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.” - Sun Tzu

I've been reading 'Competition Demystified' by Bruce Greenwald recently and it is one of the best books I've read on strategy and the various sources of moats in business. Greenwald offers a simple framework for establishing where a business's competitive advantage comes from and illustrates the framework in action with several case studies. I recommend it for anyone who is interested in strategy and moats - both existing and emerging in nature. It can be usefully applied to large and small enterprises alike. The framework is simple as there are only four sources of moats:

Economies of Scale

- low cost producer (Geico, Intel)

- geographic density (Coors, XPO Logistics, Amazon)

Ownership of Supply

- network effects (Zillow, Google)

- vertical integration (Amazon)

- proprietary knowledge / brand (Coke, patented drugs, etc.)

Ownership of Demand

- network effects (Facebook, Google)

- switching costs (Saas businesses)

- search costs

Regulatory Based

- patents

- industry regulation (e.g. healthcare / insurance)

Tangentially, this week I had the chance to spend several hours asking questions about topics ranging from investing to moats to strategy to general leadership principles with Connor Leonard, John Huber, Ryan Connor, and Dustin Gross. Connor is the President of Arbour National, an insurance holding company based out of Raleigh, NC. John is the founder of Saber Capital, a public equities fund management business based out of Raleigh, NC. Dustin is Co-CEO of Mollenhour Gross, a holding company based out of Knoxville, TN and Ryan serves as President of MG.

Dustin asked me a thoughtful question that seemed simple at first but required a much more nuanced answer than I realized - specifically, he asked what is the source of competitive advantage in my property management and services business and in any property management business more generally?

I could intuitively grasp that both businesses are steady in nature (property management = recurring revenues and home services business = re-occurring revenues) and meet critical needs for their respective customers. But I struggled to pinpoint what the exact source of our competitive advantage (if we have one) actually is. I decided to approach the question using Greenwald's framework, and after thinking about it more, here's what I came up with.

At the core, we don't do anything different from any other property management business. Sure, I believe we are the best in our market, have the nicest and most competent team, and will go the extra mile for our landlords, vendors, residents, and customers. However, we don't have a 'secret sauce' per se. So what is the basis of our moat, if any?

I believe the proper answer to why our property management business has a moat involves a bit of all three parts of Greenwald's framework.

First off, we don't necessarily 'own the demand' in the market full stop. But property management is similar to a saas revenue model - highly recurring in nature and somewhat sticky as the size of the owner's portfolio grows. The owner sits back and collects mailbox money each month while we handle her property for a fee (the resident's issues, collections, evictions, enforcing leases, etc.). It's not a sexy business at all and can be a thankless job, but it is incredibly steady as long as your systems are stable and your team is competent. The best part is, it's capital light and your cost structure is relatively fixed in nature so as you add units to your portfolio, most of the fee stream hits the bottom line. So the 'stickiness' of the service is fairly high as owners grow more comfortable with your ability to handle their property and as they grow their portfolio held within the management company. Of course there will always be churn through property sales and the occasional unhappy landlord, but the churn shouldn't be more than 5-10% annually or else something is off. I would grade this part of our moat (switching costs) as modest to strong depending on the owner. The bigger the owner, the harder it is to switch service providers (and more risky to their bank account). So long as we provide a good service, the revenues will continue to be steady.

Second, we certainly don't 'own the supply' of rental homes in our market, but at over 1,000 doors under management and over 10,000 unique visits to our website each month looking for housing, it's safe to say we have mindshare in the rental housing business in our market. Thus, we have been able to rent our vacant units fairly quickly over the years and have maintained a 95%+ occupancy level over the past 5+ years. While the property management business is fragmented in pretty much every market, when your business has been around for 100 years and you have a top 3 position as a rental housing provider, you become a known name in the market. I would grade this part of our moat (brand) as modest as we have become known as a local leader in rental housing.

Finally, there is a component of economies of scale through geographic density involved in our business. For example, it wouldn't make any sense for us to take a management contract of a single family property 2 hours away from our business, because someone local to that market could operate it cheaper than we could based on their density in that market. Said another way, we could not pass our additional costs in time and travel and other administrative expenses on to the landlord without being priced out of the market by a more local operator. But if this property is within our geographic market, it would be an extremely light lift to fold it into our current operations with very little additional overhead besides the additional phone calls for service requests and prospective leasing calls. So most larger property management companies have a component of economies of scale through geographic density as a source of their local moat. I would grade this part of our moat as strong and growing given the fact that if someone started a property management company from scratch today, their cost structure per door would be far above mine and yet they would have no ability to pass additional costs on to the customer without pricing themselves out of the market. This feature of economies of scale only grows stronger as your geographic density increases within your market.

In reality, one could start a property management business tomorrow with just a real estate license. But the blood, sweat, and tears required to actually build a sizable business in the space is a big enough deterrent that most won't try it. The fees are so low from each individual managed unit that getting to a point of sustainability will take years. There are easier ways to make a buck.

Despite all of the spilt ink on moats, an MBA-level strategy isn't necessarily needed to successfully run a small service business and do well. There is a world of difference between the loftiness of Porter's Five Forces and the every day 'knife fight' of small business. In small business, I firmly believe that EXECUTION is most important, closely followed by strategy and moats. Indeed, in many small businesses, there are fundamentally no moats that protect entrants and execution is all that matters. As Brent Beshore has pointed out time and time again, sometimes just picking up the phone, being courteous, following through with your commitments, and offering friendly service can be enough to crush the competition - no moat required.

Don't get me wrong - in smaller service enterprises, moats certainly matter. You have to be able to have a differentiated product or service that is defensible in the marketplace. But the leadership, culture, and execution matter more than simply possessing a 'moat'. I am tempted to believe that the smaller the business, the more that execution matters whereas the larger the enterprise, the more that the moat matters because the average person generates far less value relative to the value created by the overall system.

Moats are important in small business. But no moat can protect against bad execution. Likewise, no amount of strategy or execution can create barriers to entry in an industry with none.

Links:

The difference between disciples of Musk and disciples of Buffett (Joshe Wolfe)

Moses Kagan on building a real estate private equity business in LA (Chris Powers)

The revival of distressed debt and special situations (ARP Investments)

The 7 powers of competitive advantage with Hamilton Helmer (Acquired)

What I told the students of Princeton (Abigail Shrier)

What is the metaverse (Wired)

Benedict Evans' annual presentation