A recent article by Forbes contributor Steve Denning reviewed Roger Martin’s new book, Fixing the Game. It was a good review and I plan on reading the book.
The gist of the article is that managers of public companies focus too much on the expectations behind their stock price, and in turn “maximizing shareholder value.”  According to Martin, the causes stem from misaligned incentives and the business culture that has developed over the past 30 years. This focus on shareholders usually comes at the expense of customers and employees. “If you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either.” When managers are working in the expectations market, they’re much more likely to make short term decisions that benefit only themselves and a (vocal) subset of shareholders—traders. This includes seemingly harmless activities like giving quarterly or annual earnings guidance, or for retailers reporting monthly same-store sales figures.
Martin proposes a few remedies to the problem, like improving board governance and eliminating both safe harbor provisions and stock-based compensation. These would go a long way to nudge corporate behavior in the right direction. But for managers who want to take it upon themselves, here’s my proposal: think of your company as a Dynamic Pie.
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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”