Investment Mistakes Part 6 – No Sustainable Competitive Advantage

I purchased Trek 2000 on January 9, 2006 at a lofty (on hindsight, it was darn lofty !) price of 61 cents, after doing a preliminary research on the company. After months of waiting for “true value” to show, I sold out at a loss of 15% (52 cents) on November 13, 2006. Subsequently, as I discovered more about value investing, I realized that key aspects of Trek’s business had eluded me when I did my analysis in the first place, forcing me to admit that I had made a fundamental error. When I discovered that, I bit the bullet and cut my losses. The counter is now trading at 35 cents as of today.

So what went wrong ? First, an introduction to the company. Trek 2000 is a company which manufactured and patented the thumb drive or flash disk, the small storage device which people carry around to transfer and store data. This device is handy and compact, making it a useful accessory for storage of up to 2 GB of data. This device was much preferred to the portable hard drive as the latter is heavy and cumbersome and prone to damage if dropped. A thumb drive, on the other hand, is light, portable and can withstand some degree of external shocks (of course, don’t step on it lah !). Trek 2000 would earn licensing revenues from these devices and it was also into R&D, designing new thumb drives which had biometric features in order to enhance the security features of each drive.

All in all, it sounds like a good business plan since they are the ones who came up with the technology and are thus earning revenues from it. Unfortunately, several factors come into play which severely diminished their ability to compete effectively and to scale up their business. They are as follows:-

a) Commoditization of Thumb Drive – Their flagship product, the thumb drive, was viciously copied in countries like China and sold under other brands’ names. Trek 2000 went on a legal spree to recover damages relating to the other companies’ selling their products, and they won the lawsuit ! Despite this, many copycats still copy the technology and re-brand the products under their own name. Since the lawsuit only covers certain territories, Trek 2000 would have to take expensive legal action in all relevant jurisdictions in order to recover the “damage” to their brand. This is cost-ineffective and puts a large drain on their resources. Thus, brand and product erosion took place which means their product is rapidly being commoditized.

b) Competition – The usual culprit called competition comes in to eat away at market share and margins for Trek 2000. Although the thumb drive commands quite a good market share and pricing, the technology sector usually moves so quickly that one product soon becomes obsolete. This may well be the case for Trek 2000 in the near future, which is why earnings clarity is not present. This was my first “brush” with the technology sector and I had read that for most technology companies, product life cycle from introduction to decline is very short as compared to conventional products such as toasters and ovens. Though thumb drives may seem to be the portable storage device of the future, you never have the certainty that it will be the dominant product and market leader for many years to come.

c) Poor Investor Relations – Trek 2000 was fined S$75,000 for “selective disclosure” of an interview with Reuters which was not announced through SGXNet. The CEO Mr. Henn Tan personally paid off this fine instead of allowing the company to foot the bill. However, it was not the first gaffe from the company and it shows that they are inept at managing proper disclosure practices.

d) Unable to Maintain Pricing Power for NAND Chips – In Trek’s 1Q 2007 financial review, they said that even though sales volume of their products increased, the prices they commanded were substantially lower. This led to an overall decline in sales revenues and profitability was affected as well. Looking forward, this does not seem to be a temporary “blip” and will probably continue to persist for the company in the long run.

After this experience, I was more careful about choosing companies without wide “moats” around their business to prevent competitors from assailing them. Still, I continued to make errors in judgement (which will be described later on) by choosing to purchase UTAC. Currently, as of this writing, I am also contemplating if Global Voice will become my next investment mistake. Perhaps I should start to write about it now as the feeling is slowly creeping in on me. I hope the numbers from their 1H 2007 financial statements will prove me wrong.