Aaron Edelheit of Mindset Capital wrote a post about a talk he had with my friend and fellow investor Fred Liu. One of the concepts discussed was the Power Law Distribution. Applied to the market, this means most of the value created comes from a small minority of companies. This is the 80/20 Rule. Baseball geeks like me reference the term slugging percentage.
End of Mean Reversion?
Aaron’s main point in his post is that the Power Law appears to be impacting one of the most reliable laws of capitalism: mean reversion.
After 10.1% Return In 2020, Mohnish Pabrai Changes Strategy [2020 Letter]
Mohnish Pabrai's flagship hedge fund, the Pabrai Investment Fund II, returned 29.6% in the second half of 2020. Following this performance, the fund returned 10.1% net for the year, underperforming the S&P 500 but outperforming the Dow Jones Industrial Average, which returned just 9.7%. According to a copy of the investment manager's year-end letter to Read More
I’ve been tinkering with this idea for years, trying to better understand why so many great companies seem to defy the laws of gravity when it comes to returns on capital, profitability, and size generally.
On one hand, the internet has lowered barriers to entry, which is good for competition. Starting a business has never been easier. Big tech companies collect a tax on this burgeoning small business ecosystem, but in return they provide valuable services. Instagram, YouTube and TikTok help you build an audience, Shopify might provide the backend infrastructure to help you sell online, Stripe handles payments, AWS lets you scale computing power and storage needs without big capital investments, and Google and Facebook help you find new customers. If you’re in retail, you might deal with just one tax collector and have Amazon handle all of the above. These services can become costly as your business grows, but none require a big up front investment.
A few years ago I wrote about how digital upstarts are able to leverage social media and self-serve advertising on Google and Facebook to build businesses that can make even the largest incumbents vulnerable. The fact that Coca-Cola and Proctor & Gamble are seeing cracks in their once-impenetrable moats is a testament to the competition that big tech has ironically helped foster (given the antitrust scrutiny they are under).
But while competition has never been fiercer, the internet has created certain business models that — once a certain tipping point is reached in size — get more dominant as they grow.
Why is the Power Law so strong in the economy today? Why do excess returns in some businesses seem more likely to expand than to mean-revert?
There are many reasons, but I wrote down four to share here:
Digital vs Physical Stuff
I once read that all the electrons that make up the internet weigh less than a single strawberry, or about 50 grams. In a way, this is a one reason why mean reversion has lost part of its bite.
When compared to digital stuff, physical stuff is heavier, it takes up more space, it’s harder to transport, and it takes longer to create. Weight, space, shipping, and time all tie up capital.
Digital stuff can be created instantly and can be scaled rapidly. Each new customer can be served immediately for virtually no cost outside of the payments processing fee. Facebook has spent billions on computing power to support the foundation of its business, but 2020’s demand for 300 million new users across its networks can be met almost immediately with an infinite amount of digital supply.
Zoom is a great case study. Needless to say, demand for Zoom skyrocketed this year. Physical investments were required to meet that growth (Oracle and Amazon needed to provide more server capacity, Zoom needed more employees, and had to make various security investments), but despite the growing pains, the massive new demand was accommodated with newly created supply. Zoom’s business grew 4-fold. On the other hand, masks, toilet paper, milk, lumber, and any other physical good that saw demand spikes ended up in a shortage, which puts a ceiling on providers’ sales growth potential.
When growth requires bits instead of atoms, there is no such ceiling. Demand can scale very fast, but supply can also scale in lock step, and those two conditions working in concert is what allows certain businesses grow so fast and become so valuable.
Buffett noticed this early when he discovered that every time someone clicked on a Geico ad, Google got paid. The toll road Google built cost a huge amount of money in data centers and engineering talent, but every additional click above that fixed cost base was pure profit.
"Data Economics Shared"
I believe it was Nick Sleep who coined the term “scale economics shared”. As Costco grew, it decided to forego higher profit margins that could have been achieved from its growing sales over a fixed cost base. Costco instead kept margins stable and lowered prices. In other words, Costco chose to give customers the value that accrued from economies of scale, instead of keeping the value for itself… a short term investment for long-term gain. This was great strategy, and it created more growth, which gave Costco more economies of scale that could be passed down to customers in the form of better prices still… a classic feedback loop.
Many of today’s great companies operate in a similar way. But today, the value shared with customers often comes not in the form of better prices but in better products.
The more people use Stripe, the more data they collect, and the better their product gets, which brings in still more users, more data, better products, and so on. Stripe’s customers benefit from these “data economies of scale” because each new customer helps Stripe create new and better products for all existing customers.
Packy McCormick had a great post describing these data feedback loops that Stripe and many other “API First Companies“ possess. The more customers Stripe gets, the more it can spread R&D costs over a larger customer base, resulting in a payments product that is much better (as well as much cheaper) than any customer could build themselves. Like Costco, Stripe’s “data economics shared” will likely strengthen its moat as the business grows, extending any early lead over competing products.
Google’s algorithm famously worked this way. Many now have a cynical view of advertising business models, but in the early days Google was very much a “data economics shared” business. Google search is free, so the benefit of scale came not in the form of lower prices but in terms of a better search experience: each search gave Google data they used to improve the product, which brought in more users, more improvements, etc… Google used the insights it got from its ever growing volume of data to create better products, sharing those innovations with users.
Stripe and Google didn’t lower prices like Costco did; but they used the benefits of scale to give their customers better value like Costco did.
All three of these companies had feedback loops, but technology speeds the rate at which the feedback loop spins.
Technology has Enhanced the Power of the Network Effect
Some of the best businesses in the world are two-sided marketplaces with strong network effects. They are so valuable because they are the only business model I’ve seen where the customer acquisition cost actually declines as the business grows. The larger the network, the more value there is to the next new user, and thus the easier it is to acquire that next user, at least up to a point.
Facebook is the poster child here. Each new user adds more value to the network overall.
But the strongest moats I’ve seen created over the past decade have combined physical investments with the zero-marginal cost economics of the internet.
Copart owns a large percentage of the auto salvage auction market. If you total your car in an accident, the insurance company sends the car to one of Copart’s lots to be sold in an online auction.
Copart’s network effect is very strong. Insurance companies send their totaled vehicles to Copart because they know Copart has the largest network of dismantlers, dealers, and other buyers; and those buyers all come because Copart has the largest selection of cars for sale. This liquid market provides the highest selection for buyers and ensures the sellers they’ll get fair market value.
Copart invested a lot of money over the years to own land which it uses to store these vehicles until they are sold, but Copart doesn’t own the inventory; it just takes a commission connecting buyers and sellers. The auctions are all done online, so each new sale on its network is very high margin.
It would be very hard to recreate the combination of land assets, technology IP, and industry expertise that Copart has developed over the years. Those fixed costs do present a barrier to entry. But Copart’s growth is so valuable because each new sale above a certain fixed cost level doesn’t cost anything, thanks to the zero-marginal cost nature of online commerce.
Etsy’s CEO Josh Silverman says that two-sided marketplaces have low barriers to entry, but high barriers to success. They’re very hard to get off the ground, but once established they’re very hard to kill.
The result is a business with returns on capital that defy capitalism’s law of gravity:
Copart Returns on Capital (source: Tikr)
Copart also reinvests its earnings into new land to support a larger supply of vehicles, which attracts still more buyers, which means Copart’s network effect only gets stronger as it grows.
Growth from Others’ Capex
A recent article on Ebay and Adyen got to thinking about the payments business. Merchants pay to make stuff and have to fund their own inventory, shippers build the distribution networks and buy the trucks, but the companies processing the payments earn most of the profits that come from that aggregate invested capital. Adyen is now larger than Spotify, a big early customer, which is itself more valuable than many of the labels which own the content that Spotify distributes. You can see who reaps most of the value in that ecosystem, and who is funding the ecosystem’s growth. The returns on invested capital are not distributed proportionately. Similarly, PayPal was once a minnow in the Ebay’s ocean, but PYPL now has a market cap nearly 8x the size of its former parent.
A big reason why PayPal became so valuable is it could grow using other people’s money. I wrote about this point last year when I highlighted an old email that Warren Buffett sent to a Microsoft executive.
Microsoft’s growth was funded by IBM’s investments. Facebook’s growth was funded in part by telecoms’ broadband investments.
I’ve also noticed a pattern emerging where the current big tech companies (which all were early beneficiaries of the investments made by others) are using their huge free cash flows to reinvest back into their businesses, creating a new crop of companies that are benefiting from someone else’s capex. Like Facebook, Apple has earned enormous returns on the capex budgets of Verizon and AT&T, but Twilio is now benefiting from Apple’s R&D and Facebook’s investments in data centers that were needed to make WhatsApp a global communication platform (smart phone usage generally has fueled Twilio, and WhatsApp is a large customer).
Twilio is basically collecting a royalty on messaging between businesses and their customers; and thanks to their recent acquisition of Segment; it’s also now benefiting from the growing amounts of data, stored in someone else’s servers that were paid for with someone else’s capital. Twilio also benefits from the “data economics shared” concept, as more customers create more data which leads to product improvements and better value for customers.
Twilio is not in Saber’s portfolio but it is on Saber’s shopping list, and it is one of a number of companies I’m following that can grow largely on the capital investments made by other companies before their time, which means that if demand is there, growth can happen extremely fast. And if growth is combined with one or two of the other advantages outlined above such as network effects or data feedback loops, an early lead can end up being lethal to competitors, and hugely valuable for shareholders.
As Buffett says; the best business is a royalty on the growth of others.
Kodak is Toast
The Power Law is getting stronger, and if you’re a stock picker, it’s imperative to think critically about how this will impact your investments.
In 1991, more than a decade before Kodak became an obvious value trap, it looked like a good old-fashioned value stock, and Bill Ruane was pitching it to a group that included Warren Buffett and Bill Gates. Gates told Ruane: “Kodak is toast”, which seems obvious at this point but was prescient in 1991.
Investing is a balancing act of picking winners and avoiding losers. Both are hard, but I think understanding the reasons behind the strengthening Power Law will help us avoid businesses that are “toast”, while being more open-minded about the upside potential for certain companies that a prior paradigm would not have predicted.
I wrote in June why I think this is a Stock Picker’s Market. This does not mean most stocks are cheap. Most are not, although a few are very undervalued. But the Power Law has created lots of interesting opportunities to study. Curious minds should find the next decade a lot of fun.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at [email protected]