The Abstracted World: Where Bytes Meet Bricks

If The Investing Meta-Game discussed the competitive interactions between investors in stock markets and an underlying business reality, this essay is about a more fundamental change, the large potential shifts in industry profit pools driven by changes in the technology of distribution.

It seems two worlds exist today: the “physical” world we know and the “abstract” world of the internet, software, and information. This transformation of tangible assets of distribution into digital assets of abstraction is driving the commodification of formerly profitable activities in the value chain towards new areas of emerging opportunity. In an earlier essay I used the concept of emerging scarcity as a leading indicator of where profit pools might move next.

If investment strategies reflect assumptions about the incremental sources of business profitability, then the interaction of technology on competitive dynamics might explain some conundrums of the current investment landscape.

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The Investing Meta-Game

This essay explores, through the metaphor of the water we swim in, why changes in the market environment are changing the investment strategies that may work going forward.

There are five important takeaways:

  • All investors are engaged in a common myth – or narrative;

  • Most investors describe the “quality” of their investment process, but this is only one part of what generates alpha; it is investment process relative to your competition which matters more;

  • A strategy’s ability to generate alpha (or excess return) depends on the eco-system in which it operates. And investment alpha can only be generated relative to another dominant strategy;

  • All investment strategies, even value investing, are information front-running. Widely available information reduces these opportunities;

  • Idiosyncratic risk is likely the last preserve of human investment managers.

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Mapping emerging scarcity

What investors take for granted as investment ‘quality’ reflects both long accepted wisdom about where scarcity exists, such as distribution moats, brand, patents, and an unstated assumption that these points of scarcity remain unchanged. Instead, it seems likely that extreme changes in marginal costs wrought by technology are forcing a reconfiguration of existing business models.

This essay is an attempt to tie those ideas together to identify where the next great businesses might emerge. Amidst a changing investment environment which lacks historical analogues the challenge for investors is identifying profit pools prospectively.

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The investment paradox of software

The period 2014 to the present has been one of soul-searching for value investors as many formerly successful fund managers retire following stagnant performance. Commenters increasingly describe a market rally that is remarkably narrow in breadth led by FANG (Facebook, Amazon, Netflix, and Google) and other software-driven technology stocks which trade at valuations which appear unhinged from traditional cash-flow based valuation metrics. There are several possible explanations for value investors' under-performance: more competitive markets, diminished information asymmetries, a venture capital bubble, or changes in business models, especially in terms of technology and intangible assets. Yet, there is also some historical evidence that our current tech-dominated market indexes may simply reflect the out-sized importance of software in emerging business models

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Why Customer Acquisition Cost (CAC) is the new rent

A few weeks ago Inc. Magazine wrote a fascinating article whose argument could be summed up in one phrase: Customer Acquisition Cost (CAC) is the new rent [1]. For those not reading tech reports for the past two-years, customer acquisition costs represent the cost of acquiring a repeat customer whether through Google AdWords (search advertising), social feeds (Facebook advertising), or even a marketplace such as Amazon or eBay (sellers’ commission). The crucial point is this concept can also be applied to the physical realm: CAC is a useful tool to compare online digital businesses to businesses which exist primarily in the physical world. I suspect these economic concepts can be extended beyond merely explaining the broad disruption of physical retail but also provide a framework for predicting what business configurations might flourish in the future.

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