If one thing scares us more than staring at the P/E multiples of low quality companies it is investing in companies with low/no barriers to entry. The inability to stay away from “hot sectors” is a common challenge for investors across the world. Two years ago setting up NBFCs was all the rage in India. Until last year investing in co-working spaces was seen as cool thing to do. Right now investing in pharma is all the rage because apparently due to Covid more pharma manufacturing will shift from China to India.
The reason trend based investing usually ends in tears is that without barriers to entry, a company can’t make money regardless of how popular the product is. This is why Indian telecom providers and India’s airlines have perpetually struggled to generate an ROCE above their cost of capital. The following colourful story from the Politico describes how the world’s hottest/coolest/hippest marijuana provider imploded because it could not erect barriers to entry: “MedMen was faring worse than most, but the rest of industry was also coming down hard from its high. There were too many entrepreneurs trying to blaze the same path as Bierman, competing for a pool of legal sales that was not growing fast enough, with too much regulatory uncertainty hanging over them. In the year leading up to March 21, the United States Marijuana Index, which tracks top cannabis stocks, fell by more than four-fifths.”
The story is told in the format of a Hollywood movie and is super entertaining. MedMan was founded by Adam Bierman and Andrew Modlin in California around 2013. Inspite of burning through hundreds of millions of dollars of funding, the company could not build barriers to entry because:
  1. Barriers to entry do not come from spending money on the personal security & lifestyle of the promoters: “The (class action) suit alleged excessive spending on security—including installing a panic room in Bierman’s home—as well as using company funds on the likes of a custom Tesla SUV, “pearl-white” Cadillac Escalades, and a salary for Bierman’s personal marriage counselor….Bierman bought a $4.7 million home on the water in Marina Del Rey. Around the same time, Modlin purchased a house in West Hollywood for $3.9 million. The modernist structure came with a swimming pool, a cabana and an outdoor fireplace.”
  2. Barriers to entry do not come from spending heavily on lobbyists, fixers, PR, advertising, branding, etc: “It hired lobbyists, shaped legislation and funded legalization campaigns. It had the backing of powerful politicians. It had a partnership with Gwyneth Paltrow’s chi-chi lifestyle brand, Goop, and an award-winning ad directed by Spike Jonze. It had a marketing campaign dedicated to ending the “stoner” stigma, part of its plan to make cannabis inviting to affluent “Chardonnay Moms” from coast to coast. And for those who still embraced the stoner ethos, it acquired the rights to the Woodstock brand, too.”
  3. Barriers to entry do not come from hiring expensive staff from well known firms: “It hired executives from the ranks of corporate American icons like Walmart and Apple, as well as edgy tech firms like Grindr, the gay hookup app.”
  4. Barriers to entry do not come from raising loads of money from marque investors: “From there, MedMen was on its way to the big time. Chris Leavy, a former executive at BlackRock, the world’s largest asset manager, came on as co-chairman of the firm’s private-equity funds, and MedMen announced it was setting out to raise $500 million from private-equity investors. Leavy, who has since left the board, declined to comment…. In early 2018, Toronto-based Captor Capital invested $30 million for a 3 percent stake, implying that MedMen was among the first, if not the first, U.S. cannabis firm with a ten-figure value.”
  5. Barriers to entry do not come from rapid growth: “At its height, MedMen seemed to be everywhere. It snapped up a retail location in Manhattan’s Meatpacking District and secured preliminary approvals to open a shop near Boston’s Fenway Park. It opened a store in Beverly Hills and acquired a pot business in Arizona. In Nevada, it opened a cultivation facility in Reno, opened stores in Vegas, and started a delivery service.”
Barriers to entry arise from patient hard work done over several years, often decades, by focused, skilful professionals. It is boring, high intensity work something that most people are not cut for: “They wanted to be in control of their own manufacturing and cultivation,” recalled a former MedMen executive, who said the founders’ ambitions to grow high-quality marijuana, a skill that takes decades to hone, outmatched their capabilities. “They couldn’t grow a fucking tomato plant.””

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