“If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn't.” -- Alice in Wonderland
"The single biggest factor that differentiates multi-billion dollar companies is a scalable advantage in customer acquisition costs" -- @benthompson
The vast dislocation of value-chains by new technologies is changing existing business and requires new narrative maps of where great businesses are likely to emerge.
Emerging scarcity is a useful framework to think about great businesses: scarcity creates a lack of substitute goods / services which allow above-average profit margin opportunities.
Diagramming the economic value-chain might be a good way of visualizing the factors that create the competitive moats of the future.
During the last six-months I’ve written haphazardly (about) how new technology is changing the economics of business. The 18th Century Post Office discussed why internet platforms might be analogous to a post office: common infrastructure for many sellers to reach customers. Why modularized distribution costs matter considered why unit-variable costs might disrupt large-scale distribution, a common competitive moat. The investment paradox of software proposed one theory of why increasing returns to scale enabled by software might justify higher market valuation multiples.
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 (see Prediction Machines, Chapter 2) [i].
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.
Investors are really searching for emerging scarcity
Competitive moats such as cost advantages (production technology, resource access), customer captivity (habit, switching costs, search costs), scale advantages or government intervention (patents, regulatory, licenses) create scarcity and describe a product or service with few or no close substitutes.
A “one newspaper town” was a content-distribution monopoly. For an advertiser, a newspaper was a singularly effective medium to reach a broad audience.
Companies with valuable patents have been granted ‘scarcity’ by regulators, limiting competitors.
Economy of scale businesses, such as TSMC, are scarce because few companies can afford the significant capital investment needed to invest in the next-generation of chip foundries [ii].
Technology radically changes some of these historic points of scarcity. For instance, Amazon third-party logistics (3PL) transformed a large fixed-cost activity into a low unit-variable cost activity, opening distribution to SMEs; while shifts in price-transparency via the web have vastly reduced opportunities for price-premiums across retail channels. Some inspiration for the idea of technology-driven scarcity came from Alex Danco / Social Capital here and here [iii]:
“There are some kinds of technologies which increase access to a scarce resource to the point where that resource is no longer scarce at all. The identity of the scarce resource changes: something new emerges as valuable, somewhere else, and it often isn’t obvious what or where for some time. This is the “paradigm shift” we’ve talked about. Until recently, these shifts were somewhat uncommon: the identity of scarce resources changed only occasionally, and when they did they were quite monumental (the advent of modern farming, the printing press, the industrial revolution, and so forth). But something new and different is happening because of software and the internet: these paradigm shifts, where the identity of the scarce resource changes, are happening much more frequently.”
– Paradigm Shift Machine, Part 1: Technology increases access to what is scarce. Social Capital, 2016.
These developments are not inconsistent with past technological shifts. The Industrial Revolution was about harnessing chemical energy and factory automation to remove the constraints of human and domesticated animal production (see Energy and Civilization: A History, Vaclav Smil) [iv]. Once again, what was scarce (human and animal labor) changed, with disastrous short-term implications for human labor.
What is scarce today?
Consumer engagement is scarce, we are bombarded with information we cannot possibly consume ranging from entertainment, communications to news. Major internet behemoths are an example of continual consumer engagement within a specific medium of content.
Proprietary data is scarce, as the training data that enables machine learning can be cost-prohibitive to accumulate except for large vendors.
Social interaction is scarce, as the conversation shifts from the town square to the online square in Facebook or WeChat , where many people meet simultaneously.
In a sense, each of these things is scarce because they are costly to replace. Try to start another social network – how many billions of dollars would a new entrant have to spend “acquiring” new customers through keyword search ads, viral marketing, advertisements or affiliate payments? First-movers spend comparatively little on acquiring customers, instead relying on what is new, novel, or has radically improved their customers’ lives. Changing ingrained habits for incremental gain is vastly more expensive.
The irony is this customer investment is almost completely absent from the balance sheet: 1,000 physical stores to reach customers are defined as an accounting asset but 1,000,000 repeat customers online carries no accounting value. Yet this “customer asset” creates significant economies of scale for its owners.
While the above may be self-evident, generalizing profitability to points of scarcity allows one to think creatively of where these sources of value might emerge next.
Three points of emerging scarcity
Fifty years ago, in an economy of bricks, solutions that bridged the frictional costs of distance and geographic fragmentation were important solutions to scarcity: salesmen visiting customers, supply chains shifting goods, and serving customers near their homes. In a digital economy of bytes, most solutions to physical distance are no longer scarce.
There may be more, but broadly we’ve identified three points of emerging scarcity:
Where bytes (software) collide with scarce bricks (hardware / location / real estate): data-consumption is exploding, and growth in data is enabled by Moore’s Law where costs scale down exponentially. Traditionally hard drives, flash memory, and tech hardware are all price-deflationary: capacity & supply grow faster than demand. Yet, fiber connections to the home are characterized by the frictional costs of the physical world: people who dig the trenches, wires to be connected, or customers to be signed up. Where pipelines of abundance intersect with the limitations of dirt, bricks and trenches, scarcity can prevail.
Patiently changing consumer habits / acquiring customers: people are creatures of habit and Customer Acquisition Costs (CACs) are the cost of changing behavior. For instance, regular use of a mobile app or consumption of social feeds. These costs are global in nature with each large tech platform harnessing a different medium of engagement: Facebook (socializing), WeChat (messaging), Apple (hardware), Amazon (e-commerce), Netflix (entertainment). If 20-years ago economies of scale operated over a city, a country, or a continent, today those cost-curves are global, scaling across millions or billions of people. It is this exploitation of low CACs and entry of product adjacencies (Facebook purchasing Instagram) which are an area of potential antitrust regulation [v].
CAC can be visualized as a global cost-curve. Low-cost operators are likely to touch billions of customers.
Network effects or areas of proprietary data or interactions: where the accumulation of data (Google Search), enabling the interactions between data-silos (Box.net), or better productivity solutions (Microsoft) is expensive to duplicate or mutually exclusive.
Mapping emerging scarcity
One approach to visually describing this borrows from The Color Wheel of Tech [vi]. The circular diagram can be an effective map of the value-chain from User / Customer (at center) to providers, illustrating the relationship between providers and the threat of competitive adjacencies where these platforms / services overlap. Two examples suffice.
Shifting scarcity in Direct-to-Consumer
Why modularized distribution costs matter discussed how unit-variable distribution costs created abundant access to distribution allowing new upstarts to compete with entrenched consumer brands (P&G). The below wheel is an illustration of that concept. The width of the different layers reflects their approximate share of the economic value-add as the business shifts from bricks-to-bytes. The chain begins with the customer (lower-left):
Investors should notice a few features. First, scarcity now exists where bytes collide with bricks (software-driven logistics of Amazon and Alibaba). Second, Shopify software now manages sales & logistics functions, instead of a large vertically-integrated corporation (see Unscaled: How AI and a New Generation of Upstarts are Creating the Economy of the Future) [vii]. Third, changing marginal costs and e-commerce platforms allowed the emergence of the entrepreneur who could capture greater value [viii].
The bigger point is the shift in marginal costs has re-oriented the economic value-chain around consumer acquisition / engagement, creating new economic bundles. In bricks, the high cost of distribution was bundled with marketing, financing, strategy and the product itself. In bytes, the variable-cost services provided by Instagram and Amazon 3P logistics potentially allows other bundles to emerge. Amazon is entering groceries through its control of a last-mile logistics network. Interactive Brokers enters banking by extending its financial products beyond securities trading.
The color wheel of scarcity
Another way to visualize scarcity is in terms of technology-stacks and product-adjacencies. The figure below depicts three value-chains: yoga studios, SaaS software, and ride-sharing, which exist in both bytes and bricks.
Five observations of emerging scarcity can be seen here:
Scarcity is being created in differentiated niches and physical locations where customer captivity, network effects, or government regulatory monopolies exist (top): Google Adwords is scarce because of network effects around search and centralization of the town square. Yoga studios can be scarce in a city block. Yoga studio software (Mindbody) can benefit from integrations with third-party providers of accounting, legal, HR and payroll services.
Areas in-between are likely to be marginalized: Mailchimp is unlikely to be a great business if its customers become large software-vendors, like Mindbody, which plug into its infrastructure.
These maps illustrate how a situation might evolve over time (middle): Twilio exists as middleware, squeezed between AWS (scale effects) and niche SaaS developers who own the scarce relationship with the customer. Twilio’s move into contact center SaaS is an attempt to leverage its platform into areas where it can integrate its services more firmly into the customer’s organization.
Competitive advantage can also be described in terms of adjacencies (bottom): Amazon can enter online advertising colliding with Google Adwords. Uber / Lyft can enter banking (payments) based on an existing financial relationship with the customer.
Software can quickly morph into new functions: Amazon e-commerce can enter online advertising in a way that a team of advertisers at WPP could not enter retail groceries.
Navigating in the dark
The current investment environment presents several unique challenges for investors. Many listed companies exhibit extreme growth yet operate with no accounting profits and limited financial history, making it impossible to infer steady-state profitability. And many incumbents operate businesses oriented around economic bundles which are no longer scarce. This can lead to some (historically) counter-intuitive outcomes:
While music labels appear to be dominant oligopolies through control of valuable copyrights, its not clear if (good) musicians are scarce, or whether it was the financial resources and distribution to back emerging artists which popularized albums. Spotify’s leverage distributing podcasts suggests that in the next iteration, economic value may emerge elsewhere.
Reliance Jio in India is a dominant (cash-burning) EM mobile telecom provider based on its fiber-optic network and high quality 4G connections. Mobile telecom companies in developed markets are marginally profitable, but does the emergence of scarcity (fiber optic cables) allows new bundles of content + connectivity + lack of net neutrality to drive profitability which hasn’t emerged elsewhere?
In China, emergence of a mobile-first internet drove the popularity of messaging, and its bundling with payments (TenPay), provided profitable monetization. This bundle of messaging + payments has not emerged in developed markets where ubiquitous credit cards networks already existed.
With financial statements inherently backward looking, viewing the investment universe through the concept of scarcity, instead of the pattern-matching of historical experience, might help predict where future profits could next emerge.
Special thanks to N.L., K.P., B.K. and H.M. for feedback on some of these ideas.