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.
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 theydon’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.
Specialist examples: Orchid mantis (colorful mantis with appendages like leaves, thrives only on orchids and in tropics), sword-billed hummingbird (beak longer than body, co-evolved with flowers having very long corollas and difficult getting food elsewhere), koala (lives almost entirely on eucalyptus filling a niche that is toxic to most animals).
Generalist examples: Cockroach (survives in most climates, only needs water/moisture and a food source, only defense is responding to puffs of air), raccoon (wide diet, omnivore, lives in any area with trees, brush, or structures), rat (found everywhere in the world but the Artic, not picky eaters), horseshoe crab (wide diet on floor of sea bed, tolerates wide range of water temperature, can survive in low oxygen waters and out of water for extended periods; species over 360MYO).
Specialists & Generalists in Investing
This model can be applied to many different areas.
Investors themselves can be put on the specialist/generalist scale. The most specialized investors focus only on narrow segments of the market or certain types of securities. They can be very successful during certain time periods but in the long run are usually disrupted by a changing investment landscape or black-swan-like event. The most generalized investors use very coarse, unchanging rules and are truly “go anywhere”, willing to buy or sell any type of security around the world. They may underperform or lag behind their specialized brethren in the short term but will likely do well in the long run when averaged out over many different environments. Most investors (including Warren Buffett) lie somewhere in between these two extremes. Specialists include investors in certain industries like Sam Zell (real estate) and Ron Burkle (retail), or in certain situations like Jim Chanos (shorting) and David Tepper (distressed). True generalists are more rare, but include great investors like Ben Graham and Seth Klarman.
Specialists & Generalists in Business
A more interesting application is to the competitive business world. Like in the animal kingdom, generalists are rare and are usually much bigger than the specialists. They include big multinationals like Johnson & Johnson, Wal-Mart, Coca-Cola, and Proctor & Gamble. Also included are conglomerates that may hold many diversified specialists like General Electric or Berkshire Hathaway. Specialists are businesses that focus on a local niche whether in geography or product space. Because many specialists can dominate their niche, they’re usually protected by moats and thus have high returns.
This is what I call the Specialist’s Dilemma. The stronger your competitive position in a market niche, the more vulnerable you are to eventually being disrupted by changes in the business environment.
Let me explain further. Out of the universe of companies that have strong competitive moats, many of them have advantages originating from the niches they occupy. (Which can lead to barriers like economies of scale, brand attachment driven by habit, and being ahead on the learning curve.) These advantages are durable only as long as the niche itself remains viable. In other words, the more specialized a company’s dominance is, the stronger its advantages are — but the higher the odds of the niche itself eventually disappearing. Not disappearing due to competitors within the industry, but due to the niche being completely destroyed and replaced by something else. The timing of when this happens partially depends on the “clockspeed” of innovation within the industry (more on that in my last post).
Just something to think about if you’re a long term investor or business manager.
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.
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.
The presentation above compliments my previous post on the systemic causes of the financial crisis. Some of the illustrations didn’t translate well on SlideShare, so to download the original in PDF format click here (6.4MB).
(The following is an excerpt from the most recent letter to the partners of Braewick Holdings LP. I’ll be posting a presentation that goes along with this commentary shortly.)
There have been many explanations thrown around of how we got ourselves into this mess. However, I have a slightly different take on what really caused the problem—and what hasn’t been fixed yet.
The public always enjoys finding someone to burn at the stake. Who is to blame for the current mess? Many culprits have been named: greedy executives, The Fed, short sellers, Democrats, Republicans, CDO’s, CDS’s, real estate speculators, and so on. However, the real issues are more systemic. Derivatives and bad mortgages may be where the problem started, but in and of themselves, did not cause this mess.
In my view, there were three problems that led to the collapse of financial markets: misaligned incentives, poor risk management, and needless complexity. All three problems are not specific to the current crisis, but are widespread and must be addressed to avoid future dilemmas.
If You Give A Mouse a Cookie…
He’s going to want some milk. And if you give a Wall Street executive a $30 million bonus, he’s going to want a bigger one (and he’ll use the same methods to get it—after all, it worked the first time, didn’t it?).
Misaligned incentives were pervasive. And because incentives drive behavior, things are eventually not going to turn out as desired.
This occurred on almost every level. Executives were being rewarded for taking risks with only short-term payoffs. Mortgage originators made money based on the volume of mortgages given, not on their quality. Rating agencies getting paid by the companies they have to subjectively rate (causing a huge conflict of interest). Home buyers were incentivized to buy a house they couldn’t afford with low down payments, teaser rates, no-documentation Adjustable Rate Mortgages, and 0% interest.
Many of the asset managers (including banks, hedge funds, and insurance companies) were given incentives to take huge risks with the firm’s capital only because they produced outsized short-term gains. They were given very large bonuses or a cut of the profits with no downside risk (other than a pink slip and severance payment). There was no link between immediate actions and their future consequences.
Business managers and decision makers need to constantly look at how their incentives are structured. People will naturally do things in their own self-interest, and managers need to react accordingly. Some incentives aren’t so obvious—giving a trader a cut of the profits may not sound bad at all. But even if it’s not their intent, people usually end up gaming the incentive in their favor. If traders aren’t punished for taking long-term risks in pursuit of profit, then guess what—that’s what they’ll do. Continue reading “The Real Causes of the Financial Crisis”→
An interesting article on a contest held at University of Virginia’s Darden School of Business. The contest split 269 students into two groups:
1. The first chooses one of two unmarked briefcases. One has a check for $18,750, and the other has nothing. Before opening the case, they are offered a chance to receive a fixed amount of cash in its place. It’s their choice.
2. The second group is given the cash upfront, and then offered the chance to buy one of the briefcases. For the student mentioned in the article, he was given $3,000. He could have walked away with the $3k, or bought the right to choose one of the cases.
The research showed that “buyers” (the second group) were more likely to keep the cash. Of course that isn’t rational, because the expected value of the case selection is $9,375 (a 50% chance of getting the $18,750 check).
The students admitted the decision is easier on paper, and more difficult when you have a handful of cash.
Overall, I’m glad Darden is doing research like this and teaching the students about decision making in the face of uncertainty. More schools should be doing the same.