Finding Asymmetry and Convexity
If asymmetry and convexity exist, this investment will have a much greater risk-adjusted return, and those positive returns will increase at an increasing rate. Obviously, these are the most attractive components to the most successful investments. How do we find them?
Closed Loop Businesses
A dynamic that has emerged globally combining industry disruption, technical innovation, customer loyalty, and a worldwide market is the “closed loop” business. This is where a company provides a product or service that is innovative, useful, and generates significant demand. Customer feedback for that product or service provides a “loop” that enables the company to understand its customer better and the attractiveness or negative aspects of the company’s product or service. The customer feedback now enables the company to provide a better product or service and be a more formidable competitor. There is now a loop connecting the company and the customer. If a company is essentially able to close this loop so that the customer values the company’s product or service so highly that the customer will not look for competing products, this will enable the company to grow at an increasing rate. Essentially, this closed loop is a value-generating competitive weapon that improves the product offered, retains customers gets better feedback to make an even better product, retains and attracts even more customers, etc. It enables more effective capital investment, more efficient operations, and improves decision-making from better customer data and responsiveness. This creates a virtuous cycle that spirals the business upward creating a sustainable competitive advantage generating increasing returns. As a result, a company that creates a closed loop with its customers will create the most attractive returns.
Examples include Google, Facebook, Netflix, Amazon, and Apple, among many other companies. Obviously, the FAANG stocks it produced extraordinary returns for the last 10 years, and the closed loop customer relationship is one of the key drivers to those extraordinary returns. While these companies are large competitors, the closed loop positions them to defend against any aspirant or potential competitor. The closed loop business model, fundamentally based on innovative services (mostly based in software that can be modified easily and distributed globally immediately), creates an agile company that delivers its software services in a systematic and industrialized manner. People, processes, and technologies combine to deliver a sustainable competitive advantage and go a long way to explaining these large competitive companies. They are not monopolies by the pure definition (there is significant customer benefit and attractive pricing models that this structure delivers) but they dominate their sectors and seem almost unassailable. For all intents and purposes, they are monopolies and generate monopoly-like returns
The important point here is to understand a sustainable business model and to build investments that are a combination of these companies. The closed loop dynamic delivers businesses with significant upside potential with much less risk. While there is always risk, the sustainable competitive advantages of the companies in this combination will most likely generate a portfolio that outperforms the overall market.
Companies with the best data leading to the best products win. Innovative software and services make the difference, and these new business models will prevail. Essentially, closed loop data create a powerful prediction engine, and it is this prediction engine that drives exceptional value.
The prediction engine is the underlying force that creates this dynamic:
Predicting demand for essential services, predicting customer demand, and coordinating the logistics needed to meet this demand, predicting the services businesses require, and completing the loop for quality and quantity of data, products, and services. This improved decision-making leads to more efficient operations, happier customers, better data, better decisions, more efficient operations, a more powerful prediction engine, and a more valuable company.
Another critical component to identify an attractive investment is when a company provides a product or service essential to all competitors within an attractive market segment. In other words, the “arms dealer” to that industry. Arms dealers typically represent a singularly attractive investment opportunity. Examples of companies that serve an entire sector with their product or service include Taiwan Semiconductor (TSM) – the fabricator of global integrated circuits (other than Intel) – because they represent the integrated circuit manufacturing capacity for the entire circuit industry, except for Intel. They are indifferent as to which “side” or competitor wins because they sell the “bullets” to everyone. This is a sustainable and attractive business as long as integrated circuit manufacturing is an attractive business. It seems something worth betting on for quite some time.
There are other companies, heavily weighted by technology companies such as Qualcomm (despite current political machinations with China, which represents 30% of its revenue) that serve growing and attractive markets and have created a sustainable advantage because of their price-performance. Qualcomm serves the wireless industry with its technology (essentially every mobile phone has a Qualcomm component), and it also serves an emerging 5G market. Other examples include Nvidia, whose integrated circuit technology serves the gaming industry as well as other computational intensive markets such as artificial intelligence – a powerful tool that will permeate all dimensions of software and development tools essential for artificial intelligence represent an extremely high-growth opportunity.
Data has become one of the primary products of any industry. It’s reasonable to say that every company actually has two businesses – one is the product or service they sell, and the other is the data they collect from customers. In many cases, that customer data may ultimately be more valuable than the product or service. Data collection, analysis, processing, and delivery creates one of the most attractive business opportunities for arms dealers. Arms dealers provide the processing, storage, and movement of data. These include companies like ARM (essential to wireless technology in almost every device manufactured globally), Qualcomm and Nvidia, as mentioned earlier (for mobile telephony and data processing), and many other examples of companies supplying essential services for all participants in cloud computing, mobile phones, and networking equipment. Other sectors servicing many competitors where a single source supplier or duopoly thrives include payments processing (Visa and MasterCard), financial services, especially in China (Tencent and Ant Financial), online advertising (Google and Facebook), and many others. These companies capture increasing profitability in a high-growth sector with a sustainable competitive advantage over any potential newcomer or incumbent. The advantage that an arms dealer has is that it is indifferent as to who the winners are, everyone has to buy from them. So long as the sector is growing, these companies will thrive.
While the term speaks to a specific legal standard, essentially, monopolies are constructed within industry sectors constantly. A valuable product or service, while perhaps initially part of a fragmented industry, ultimately consolidates into a few, and sometimes a single source supplier. One example that stands out as both a monopoly and an arms dealer is Microsoft. Its operating system was essential for any PC manufacturer (other than Apple), and, within this explosively growing sector, commanded tremendous profits with a truly sustainable competitive advantage. All software needed to function on a common platform for PC manufacturers have a viable market position. All participants needed to have the common Microsoft operating system. Once Microsoft captured this advantage, the company then developed a more value-added product, their Office software (Word, Excel, and PowerPoint) that became essential for every PC. Now, there was a suite of high margin software running both the operating system and all the productivity tools. PC manufacturers became commodity suppliers, and Microsoft became the value-added component to the PC industry. Their software was essential, and they commanded a monopoly because there really was no “second-best” operating system or productivity software that any business or even individual would own.
There are many other examples, mostly driven by disruption from technological innovation. Many innovative platforms were created to run on the Internet, and because of these innovations, a monopoly can be created and sustained. Examples include eBay – who would want their product to be sold on the second most popular auction site? – and Google – who would want to search on the second most popular and effective search engine? Technology enables the natural formation of monopolies because the network effect enhances the value of the market leader significantly while leaving no real room for any other player to be significant. This concept, “no room for second best” make these industry leaders extremely attractive investments. If you want to be connected on social media, Facebook is the dominant (and in reality, your only real) option. Markets have essentially enabled the network effect to give a company with even a slight advantage a monopoly. Once that slight advantage is exploited, it is almost impossible to overcome by any new entrant or other competitor.
One specific example where a monopoly is essentially legally granted is biotechnology. In this sector, companies are given what essentially amounts to a monopoly through intellectual property and patent protection. A company’s product can be protected from competition for the duration of the patent, enabling monopoly profits for the duration of their patent protection. Often, even beyond the point of patent protection, biotechnology and pharmaceutical companies create brand names for their products, and even though generic alternatives may be available at lower pricing, many times, customers still choose the higher-margin brand. Often, even the generics keep a pricing umbrella high enough to allow significant profitability for everyone. On top of that, patent holders have a strategy of modifying a product (sometimes only slightly) and getting extended patent protection. This can mean that high-margin pharmaceuticals may enjoy monopoly-like protection for many years. Every major pharmaceutical company employs this strategy. Some products have had patent protection for two or three times the normal patent duration – and have generated extremely high profits as a result.
Another attractive component to biotechnology is the certainty of the addressable market. Unlike other technology companies where the total addressable market is still uncertain, even through most of the development process. The product will most likely work, by it. Predicting demand for new technology products is uncertain and volatile. In biotechnology, we are uncertain whether or not the product will work, and there is tremendous risk to product development. From inception in a lab to final approved product, the odds are more than 99% against you. But, if the product works, the total addressable market is well known and usually quite large. Some products have a monopoly position in applications that generate billions of dollars a year. Development costs can be high, but ongoing manufacturing costs are extremely low. There is a saying that “the first pill costs $1 billion, everyone after that costs $0.05 each.”
Some technology companies’ addressable markets diminish, increase, or flatten, and sometimes it is challenging to predict this. Think of Nokia and the mobile phone Its leadership position was completely usurped by Apple and the smartphone. This is not the case with pharmaceuticals. Not only does the patent protection prevent loss of the market, but the market is well known and is not fickle among new and better offerings. If we are addressing a liver disease, and we have developed the standard of care for that disease, we know the size of that market and other competitors are essentially prevented from entering. While there are complexities to this industry that we will not go into here, including insurance reimbursement, pricing legislation, and adaptation from doctors along with formalizing a selling and distribution chain, the market size has little risk versus technology, where markets can be risky, dynamic, and unpredictable.
Combine Them All
As you can probably see, the arms dealers and monopolies are essentially closed-loop businesses. By far, the most attractive companies are those that combine all three elements. We discussed how Microsoft does this. Also, within the Apple ecosystem, there is a closed-loop with its customer base, combined with a monopoly for Apple’s attractive products and services, (including the app store) and their app store platform is essentially the bullets needed for competitors to access Apple’s customer base. The same is true for other valuable companies such as Amazon, where constant customer feedback, Amazon Prime subscriptions, and business model revision combined with access to products and world beating logistics create an unassailable business model combining the best attributes of a monopoly, an arms dealer, and a closed-loop business.
The X Factor
Often unmentioned, yet the most important component to an investment’s story is the team managing the business, especially the CEO. We have discussed businesses that build slight competitive advantages and the network effect built monopolistic positions or understood how to play a role as the provider of an essential product to all competitors in a growing industry. But without doubt the most important component of all of this is the people managing the business. Extraordinary companies are built by extraordinary people. There are many choices that can be made, and most decisions are typically the riskiest and least predictable. It takes a special combination of qualities to make these decisions and, more importantly, implement them effectively. It is the quality of the management who make these choices that can determine whether a company is average or extraordinary. Think of the trajectory of Microsoft. While it had its operating system, it chose to license this system to all industry participants. Once it had this position, it was the keen insight of senior managers to develop the Office suite, as we discussed earlier, ultimately leading to exceptional profits. Another obvious example is Apple where Steve Jobs provided unpredictable innovative insight to develop products that changed the world and led to incredible profitability and ultimately led to the creation of the world’s most valuable company.
Every outstanding company, whether Amazon, Netflix, Google, etc. has its X factor. The X Factor is not sufficient, since many other factors including the strength of the industry sector, the strength of competitors, available resources, etc. can make a substantial difference. But no company is successful without it. It is necessary for an investment’s outperformance.