Addressable Markets

One of the central topics that interests this blog is what factors create opportunities for disruptive marketplaces.  This blog post from a few months ago by David Haber of Spark Capital is a nice contribution to that thinking in listing some of these factors.  I quote:

As I look at this list as well as all marketplace companies that we get pitched at Spark, I keep coming back to a few salient points which I believe dictate the potential value of these companies:

• Size of the Market  – Don’t be fooled by the incumbent market, think about the one that may be created or unlocked. While the initial focus might be small, what does the potentially broader market look like for this company (i.e. from couchsurfing to travel lodging industry in its entirety)?

• Excess Capacity– Some call it an asymptotic market, but it’s simply the fact that a good portion of a given industry is sitting idle or under-monetized.  Why is that? Can it be changed by a new business?

• Friction / Opacity– Are there middlemen in this market that shouldn’t exist?  The larger or more considered the transaction, the more likely there are intermediaries (i.e. buying a bike vs. buying a company).  Intermediaries benefit from (and often perpetuate) opaque markets.  They withhold information in order to make margin.  Value is created when these intermediaries can be dis-intermediated.

• Fragmentation – Is this market highly fragmented, or are there a few dominant players?  There isn’t much opportunity in a market where there is concentration on one side or the other.

• Customer Experience – Whether you become the transaction processor that eliminates an awkward in-person cash transaction or simply provide a more compelling user interface to a staid business (i.e. like Uber has done with the livery business), a better customer experience can be the differentiating factor for your success (and one that keeps transactions within your platform).

The Divorce of Investment From Profits

One economic trend of recent years, more than any, begs the question of whether we as an economy have lost our edge.  As the FT reports:

Profits in the US are at an all-time high but, perversely, investment is stagnant.

According to GMO, the asset manager, profits and overall net investment in the US tracked each other closely until the late 1980s, with both about 9 per cent of gross domestic product. Then the relationship began to break down. After the recession, from 2009, it went haywire. Pre-tax corporate profits are now at record highs – more than 12 per cent of GDP – while net investment is barely 4 per cent of output. The pattern is similar, although less stark, when looking at corporate investment specifically.

This change is profoundly odd. Economic theory says investment is driven by profitable opportunities on one side and the cost of capital on the other. High profits suggest there are decent opportunities to make money; historic lows in interest rates and highs in the stock market mean that capital is dirt cheap. Yet investment does not follow.

“We have this strange thing that the return on capital really does seem to be high, the cost of equity capital is low, and yet we’re getting a lot of share buybacks and not much investment,” says Ben Inker, co-head of asset allocation at GMO. “It just feels a bit weird.”

Simply put, big corporations are no longer investing in innovation, despite having the money to do so.  The breakage of the link presents a new economic puzzle based on economic history and theory.

Two potential explanations for this are that 1) there are no innovative projects to invest in; and 2) there are such projects, but big companies do not have the incentive or access to invest in them.

For the purposes of this blog, we will assume the first is just not true:  Startup tech activity suggests that people are more entrepreneurial than ever.

We will explore the second explanation in several subsequent posts.

Poetry and the Mobile Form

The joy of poetry lies in the distillation of an emotion into a tight, condensed, intense form.  As someone said, “poetry might be defined as the clear expression of mixed feelings.”

Design has also been enhanced by the tight time, bandwidth, and screen space limitations of the mobile experience.  This is Bill Gurley in his latest essay:

Users favor mobile applications that are crisp, clean, and quickly responsive. My partner Matt Cohler has written that the smartphone is a “remote control for your life.” This is a clever metaphor that succinctly specifies the objectives for an ideal mobile application. Like a remote control, it should be quickly responsive, and do what you want with very few button clicks. The Uber* experience is a great example. Press a button, receive a ride, and everything else disappears – even payment is automated. Websites do not always have this same “one-click” usability expectation, and as a result web designers can easily come up short by building mobile applications that are overly complex. The limited screen real estate , and limited user-attention on the smartphone forces better design decisions. Lastly, lower mobile bandwidth (versus the desktop) increases the consumer benefit of pre-cached content and UI.

The Fire-In-The-Belly Cycle

Growing up as a sports fan, you learned that players enter the league, playing for the love of the game, and some, after a few flush years, stop caring as much, feeling entitled, distracted by their lifestyles and their paycheck.

Growing up, you realize this works in many professions,  You encounter those partners, a decade when they last gave good advice, much too worried about the size of their paycheck and their mortgage for their upstate log mansion and Jackson Hole ranch to care about their clients or show up on calls.  As one hedge fund GC recently told me, he never hires the senior partner, because he knows that person does not care, but the hungry junior partner might care.

Here is how this works

One chief investment officer at a $5 billion institution breaks down the typical hedge fund life cycle into four evolutionary stages. During the early period, when a fund is starting out, its managers are hungry, motivated, and often humble enough to know what they don’t know. This tends to be the best time to put money in, but also the hardest, as the funds tend to be very small. Stage two occurs once the fund has achieved some success, when those making the decisions have gained some confidence but they aren’t yet so well-known that the fund is too big or impossible to get into.

Then comes stage three—the sort of plateau before the fall—when the fund gets “hot” and suddenly has to beat back investors, who tend to be drawn to flashy success stories like lightning bugs to an electric fence. Stage four occurs when the fund manager’s name is spotted as a bidder for baseball teams or buyer of zillion-dollar Hamptons mansions. Most funds stop generating the returns they once did by this stage, as the manager becomes overconfident in his abilities and the fund too large to make anything that could be described as a nimble investing move.

You maximize your chance at success by understanding where folks fall in that cycle.

Data Karma

My wife and I were raised Hindu and Jain respectively, both religions that have karma as a central element.  One part of the notion of karma is that you get what you give.

That may be an useful way to think about the cold start problem that one encounters when trying to create data network effects.  One company that has done it well is Markit in various financial markets.  The simple insight is that in order to benefit from the valuable data output, you need to input your own data: i.e, you give, then you get.  Its story has it all: opaque markets, prices all over the place, and a benefit from aggregation and transparency.

This is from the Economist:

Mr Uggla’s big insight, as a former bond trader, was that opaque market structures made it tricky for banks accurately to price some of the complex financial instruments they were dealing in. Only by pooling their proprietary data could they get reliable marks. The trick was first applied to credit default swaps (CDSs), a sort of insurance policy against borrowers going bust. Unlike shares, CDSs are not traded on exchanges with transparent prices. They are bilateral contracts that give rise to a jumble of erratic price quotes. Only those banks that fed their prices into the Markit system got access to the aggregate data. They also got a majority stake in the company: Markit’s owners include the likes of Goldman Sachs, JPMorgan Chase and UBS. Staff own 30%, a handful of other investors the rest.

What came next distinguishes Mr Uggla’s approach from that of Michael Bloomberg, another former bond trader with a successful data franchise. Markit has moved into a broader role as a partner for banks that want to pool or outsource costly non-core activities.

At a facility in Dallas, for example, it receives and processes 7m faxes a year on behalf of customers. Few are of any interest to the recipients—they are mainly updates on the progress of loan repayments—but regulations require that they must be kept on file regardless. Another Markit product helps make sure that complex deals devised by hotshots on trading floors are recorded and processed accurately. Yet another ensures all sides to a transaction are using the same formula when calculating collateral payments. Last year it acquired a company central to securities lending, a practice that enables short-sellers to borrow the shares they want to bet against.

Virtual Webvan

In 2000, Sequoia and others lost hundreds of millions as Webvan’s national distribution business fell apart; I lost $1000 investing in its IPO.

Today, FreshDirect does locally what Webvan endeavoured to do nationally.  Yet, over the course of a week, we still choose to shop for groceries through a mix and match combination of five sources: Western Beef, Trader’s Joe, a local “farmer’s market,” Whole Foods, and Amazon.

That makes Instacart such an interesting idea: no large costs to build warehouses and a distribution network, and perhaps better matching customer shopping behavior.  It is not clear what the business model is other than delivery charges, but my guess is that the arbitrage opportunity in prices at local supermarkets — price differences which are surprisingly high – may provide an interesting arbitrage opportunity.

This is how BusinessWeek describes the business:

Its 10 full-time employees, mostly engineers, work from a small office in San Francisco’s South Park neighborhood. The company’s app sends customer orders to about 200 independent Bay Area personal shoppers, who receive commissions based on the number of items and orders they deliver in their own vehicles. The app features detailed maps of local supermarkets and can direct the personal shoppers to specific aisles. Founder Apoorva Mehta says Instacart’s “secret sauce” is its fulfillment software, which allows the online retailer to combine orders placed at different times and fill them from different stores—supplementing frozen food from Trader Joe’s with fresh fruit from Whole Foods and cereal from Costco. Customers assemble their orders with lengthy drop-down menus on Instacart’s website or app.

The A16Z Aha

If this is how they roll, who wouldn’t want to work with Andreessen Horowitz?  This is Scott Weiss, a General Partner there:

All great pitches have a few things in common: the founder/team is wicked smart, the idea is big and a breakthrough, and the market is potentially enormous.

But the best pitches are also usually non-obvious and unique to the particular entrepreneur’s story and background. “Founder/market fit” is important. Does the founder’s life story, educational background, personal struggles, Ph.D thesis, or prior work experience somehow qualify them to unfairly prosecute the opportunity they are pursuing? At our firm we always start off our meetings with a deep dive into the entrepreneur’s background, and the most convincing pitches literally pour out of them with some deep connection or “aha” that led them into the business they are explaining.  By doing so, the idea is unique/original and is presented authentically versus a canned sales presentation.

A lack of originality and authenticity is probably the biggest turnoff. Stereotypically, this can be a couple of MBAs that have been churning through different business ideas in order to find something that might make them rich. Or it could be a hired gun/former sales VP as the CEO adopting or explaining someone else’s idea. In both cases, they typically have done a superficial, McKinsey-esque market analysis but have no passion or connection to the business.

Another important quality of a “perfect” pitch is when a founder exudes in many different ways, the confidence and courage to go the distance, against improbable odds, to make an enduring or lasting business. They come off as expertly informed, determined and unflappable during the hard questions. And they usually lay out a series of chess moves that reveal an even bigger ambition: “If we do this, then we can do that…”

A lack of confidence is also a huge turnoff – usually typified by a single slide in the deck entitled, “Exit Strategy or Exit Options.” This is the kiss of death for our firm.

The Governance Layer

From Perry Chen as interviewed by Walter Isaacson in Aspen.

“I think governance is key for every user-generated website…Sites like Wikipedia found a way to have this kind of body of core members, most other sites have their internal teams but it’s potentially becoming the most important layer of the web.  It’s not like new chips anymore, it’s not about the speed now, it’s about identity, about the personality of the company, about how your regulate and govern your community.”

Education Is Not The Answer

Yesterday was catching up on Krugman day:

The McKinsey Global Institute recently released a report on a dozen major new technologies that it considers likely to be “disruptive,” upsetting existing market and social arrangements. Even a quick scan of the report’s list suggests that some of the victims of disruption will be workers who are currently considered highly skilled, and who invested a lot of time and money in acquiring those skills. For example, the report suggests that we’re going to be seeing a lot of “automation of knowledge work,” with software doing things that used to require college graduates. Advanced robotics could further diminish employment in manufacturing, but it could also replace some medical professionals.

So should workers simply be prepared to acquire new skills? The woolworkers of 18th-century Leeds addressed this issue back in 1786: “Who will maintain our families, whilst we undertake the arduous task” of learning a new trade? Also, they asked, what will happen if the new trade, in turn, gets devalued by further technological advance?

And the modern counterparts of those woolworkers might well ask further, what will happen to us if, like so many students, we go deep into debt to acquire the skills we’re told we need, only to learn that the economy no longer wants those skills?

Education, then, is no longer the answer to rising inequality, if it ever was (which I doubt).

Profits in the Intangible Economy

Not clear where Krugman is going in his blog today, and neither is he, but it looks to be somewhere interesting.

But there is at least one important respect in which the 21st-century economy is different in a way that ought to have a significant effect on macroeconomics: the much larger role of rents on intangible assets. This isn’t an original insight, but I haven’t been finding systematic analyses of the point.

What do I mean by the role of rents? Consider the changing identity of the most valuable company in America. For a long time, it was GM, then Exxon, then IBM. These were companies with huge visible production activities: GM had more than 400,000 employees, which was amazing when you consider that the overall national work force was much smaller than the one we have today, Exxon had oil refineries. IBM was an information technology company, but it still had many of the attributes of an old-style manufacturing giant, with many factories and a large, well-paid work force.

But now it’s Apple, which has hardly any employees and does hardly any manufacturing. The company tries, through fairly desperate PR efforts, to claim that it is indirectly responsible for lots of US jobs, but never mind. The reality is that the company is basically built around technology, design, and a brand identity.

There was an old Dilbert in which the pointy-haired boss explained that the company had discovered that despite its slogan, people weren’t its most important asset — money was, and people only came in at #8 or something. Actually, in Apple’s case market position is its most important asset.

There are a couple of obvious implications from this change in the nature of corporate success. One is that profits are no longer anything remotely resembling a “natural” aspect of the economy; they’re very much an artifact of antitrust policy or the lack thereof, intellectual property policy, etc. Another is that a lot of what we consider output is “produced” at low or zero marginal cost.

This jumps out at me.  When an economy moves toward where “intangible” assets are the economic driver, the level of reward is tied immensely to the regulatory rules of the reward which limit or allow competition.  So, for Apple, most would probably disagree that anyone could completely copy the iPhone from design to software to icon to Apple logo.  We might call that theft, and from an economic perspective, it would drive profits to zero and would reduce any incentive to come up with iPhone.

On the other end of the spectrum, many would probably disagree that by coming up with the iPhone, no one else was allowed to see a smartphone with a touchscreen, apps, etc.  From an economic perspective, this would make Apple’s profits even larger.

The current situation lies somewhere in between. The rules of the road that govern this are antitrust and intellectual property, as well as some other legal rules.  The push and pull determines where we end up in the wide spectrum between those poles.

One question that follows then from Krugman’s question and my analysis is whether it make sense for the same antitrust and IP rules that governed when tangible assets were the key driver to today’s world of intangible assets.

Maybe, maybe not.