When you make a good product or service more efficient, you are giving your customers time.
Never take any of that time back in the future or customers will never forgive you. New versions of a product should always take less of customers time (or the same time at the very least).
How do you take time from customers?
- Make the product/service less efficient
- Add unnecessary features
- Make things slower
- Leave bugs that confuse and stop flow where it was seamless before
Sure, the newer product may still be better than anything people had before. But you’ve already given them that time, and it’s too late to go back. Charlie Munger calls this “deprival super-reaction syndrome” — another way of saying loss aversion.
Cross-posted on the Atlastory Blog
Large competitive moats play an important roll in determining the current and future success of a business. Moats are barriers to entry that protect the economic castle—from both new entrants, or expansion by current competitors. So the bigger the moat, the better the business, right? For the current and very near future, yes. But huge competitive advantages can become disadvantages when they lead companies to become complacent about their customers and potential alternatives to their product.
On the one hand, you have Wal-Mart and Coca-Cola—companies where consumer preference plays a large role. Wal-Mart has economies of scale that result in lower costs—probably the biggest competitive advantage in all of retail. But as the old saying goes, “retail is detail” and they still have to work hard to get the customer experience right (at least for their price point). If they don’t, competitors like Target and the dollar stores are more than willing to pick up new business.
Coca-Cola also has seemingly large advantages: a powerful brand name due to strong consumer habit and share of mind, plus large economies of scale in global marketing and distribution. Coca-Cola-owned brands account for 3% of every beverage consumed in the world today. But consumer preference still drives this market share, and a single slip-up (like this) can drive customers to the also-dominate #2 in the market, Pepsi.
On the other hand, you have companies with extremely wide moats like Microsoft and Ebay. They essentially have a lock on most of their customers because of high switching costs or strong network effects. Ten years ago, if you used their products and wanted to switch, it would be very difficult. Among other reasons, I think that led them to skimp on product quality and customer experience. There were product updates and improvements, but little innovation compared to alternatives. Why upset the apple cart when people are essentially forced to use your product?
The details matter!
Having a powerful lock on customers can lull companies into complacency. By the time they realize customers have a good alternative or their business model is being disrupted, it may be too late. For companies who have big competitors or have to constantly cater to customers, it’s easier not to fall into that trap. So if you have the luxury of running or investing in a business with a strong lock on its customer base, remember to sweat the details. Customers will always eventually have an alternative.
Arbitrage is “the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.” Once the arbitrage spread closes, the profit is made and the opportunity no longer exists. According to Austrian Economics, entrepreneurs’ profits “derive from the services he performs in detecting and eliminating arbitrage opportunities, thereby allowing supply and demand for a given good to meet.” By recognizing and acting on opportunities, the entrepreneur moves markets toward equilibrium. So entrepreneurial arbitrage is a low-risk way of exploiting gaps between what the market demands and what it’s being supplied until the spread closes.
There is very little “invention” involved—startups imitate or slightly modify someone else’s idea and only introduce breakthrough products or new business models many years later. This is what Peter Drucker calls creative imitation. The technology and market demand already exist, but the creative entrepreneur understands what the innovation represents better than the original innovators. This also includes packaging current technologies into new business models. Paul Graham calls this an idea that’s “a square in the periodic table”—if it didn’t exist now, it would be created shortly.
Continue reading “Entrepreneurial Arbitrage”
In December of last year, I gave a presentation to a group of investors on the mental models of robustness and generalist/specialist species. Below are some of my findings, along with how these models can be applied to business and investing.
Animal species reside on a scale with “generalist” on one end and “specialist” on the other. Specialists can live only in a narrow range of conditions: diet, climate, camouflage, etc. Generalists are able to survive a wide variety of conditions and changes in the environment: food, climate, predators, etc.
Specialists thrive when conditions are just right. They fulfill a niche and are very effective at competing with other organisms. They have good mechanisms for coping with “known” risks. But when the specific conditions change, they are much more likely to go extinct. Generalists respond much better to changes/uncertainty. These species usually survive for very long periods because they deal with unanticipated risks better. They have very coarse behavior: eat any food available, survive in many climates, use a simple mechanism to defend a wide range of predators, etc. But unlike specialists they don’t maximize their current environment, because they don’t fill a niche where they could be more successful. It’s tough being a generalist—there’s more competition.
An environment with more competition breeds more specialists. Rainforests have huge diversity and competition, and therefore many specialist species.
Continue reading “Generalists vs. Specialists (And the Specialist’s Dilemma)”
It’s good for any investor or business person to know where their company fits when it comes to the progression of innovation. Even if a certain company or product isn’t new, at some point in time the business it’s in was. Throughout history, innovations (whether they be technological inventions or innovations in business model) came about that performed a certain “job” better than the status quo. Most of these innovations didn’t arrive spontaneously — they were built upon or evolved from their predecessors.
The following is a simplified chart/timeline of innovations in the computer industry:
Consumers purchase computer systems, with new innovations or shifts in one component (processors or operating systems) driving innovation in computer design and vice versa. Other components like storage and display also drove innovation but were less important in this context. Most of the above innovations are technical, with the exception of the commodity PC makers (Dell, Compaq, etc.) which were an innovation in business model.
After money was transferred from consumers to computer makers, it went primarily to chip makers and OS developers. Because suppliers like Intel and Microsoft had strong competitive advantages, they had strong bargaining power, and therefore received and kept most of the value.
The progression of innovation doesn’t just apply to industries as technical and complex as computers. Below is another timeline (dates are approximate) of the progression of the retail industry: Continue reading “The Progression of Innovation”
Instead of further examining where Apple’s current (and future) products fit in on the “innovation scale,” in Part II I want to talk about Apple as an investment, and where its products fit in in terms of investment value.
Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.
One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.
Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.
Apple and the Red Queen Run the Hedonic Treadmill
“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”
So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year. Continue reading “The Innovations of Apple: Part II”
Insight: When looking at a company, what type of building is it?
Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.
Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.
Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.
Skyscrapers can be turned into pyramids over time. But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.
You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.