Growth potential is key when selecting your next investment.
Continuing my first article where I mentioned that management skills are the ones that will tip the scales in favor of choosing the team in which to invest, I continue a new one that reviews another critical dimension in investment decisions by savvy investors. Enjoy and be a smart investor!
So we have a winning team, what next ?! Another attribute of companies I look for is the maximization of nonzero sumness (NZS). In a complex world with increasing interdependence, the best outcome for all players is to make decisions that create positive nonzerosum scenarios. An NZS interaction leaves both parties better off than if they had not transacted in the first. I also call it the ultimate mutual growth effect or the GRX.
A company that operates a platform focused on creating value for all participants, including itself, is creating large amounts of NZS. Specifically, when companies create significantly more value for their ecosystem than for their own treasury, the win-win positive spiral is optimal. The relative level of NZS between customers and companies is generally more important than the absolute level – it will vary by industry.
As transparency and the velocity of information sharing increase in the world, it will become increasingly challenging for companies to extract positive sums from their customers. While traditional investors seek businesses with “high barriers” and “wide moats,” I believe this practice is misinformed. A barrier or moat today becomes a vulnerability tomorrow.
Long term thinking is crucial for creating NZS because shorter-term sacrifices are often required. Significant ongoing, long term investments are also required to continue innovation and nonzero value creation.
Companies that are disrupting large, established markets often do so with a value proposition that offers more opportunity for NZS. Often these companies are attacking an industry with large existing switching barriers, which allows the challenger to grow slowly (small position in a very large addressable market with the negative feedback loop of high switching costs) and invest for the long term with a disruptive model that creates more NZS for the ecosystem constituents. A good example of this would be e-commerce companies which offer more selection, lower price and in some cases more convenience to consumers – these companies have created a lot of value and steadily taken share from offline retailers.
NZS strategies often involve pricing a product or service at or below the Pareto efficient price. In a Pareto efficient scenario, a business is charging up to the point where customers would receive zero or negative return on investment, i.e., charging another dollar would mean the customer would go look for a cheaper or more effective solution. There are many externalities to take into account when thinking about pricing – for example, there is the cost of a software license, but there are also the people and infrastructure costs along with long term maintenance fees. Another example is fast food – it is quite cheap and appears to offer an NZS scenario, but when you take into account the long term healthcare costs and burden to society, it is not Pareto optimal.
Another way to think about NZS is the Nash Equilibrium of Game Theory, where no player has anything to gain by changing their strategies (i.e., the maximum amount of Pareto efficient NZS is being created for all parties). However, in a complex world, disruptions to equilibrium are the norm. Recall from Power Law math – lack of equilibrium is the “equilibrium” state! Therefore, when companies create new products and services with increased levels of NZS, essentially, they are changing the rules of the Game (or even the game being played). Thus, in a complex world, companies need to defend against the risk of the game-changing – i.e., they need to be highly adaptable and capable of evolving.
There are three types of network effects that combine to maximize NZS – price, quality, and speed. Many companies grow through lower-priced products, while other companies grow with very high-quality solutions. When you can combine a very high-quality product or service with a low price (could be relatively low), you have the Nirvana of network effects and NZS. This is very common for Internet companies to accomplish – the best quality for the lowest price has the potential to cause significant disruption of established markets and create customer loyalty.
It might have been simple but quality price theory is not enough today. The dimension of speed must be given to it. Today more than ever companies that manage to create infrastructures that allow them to progress quickly to reach customers and users while constantly improving the quality of their offer, are the ones who leverage their network power.
Along with balancing Resilience and Optionality, a company can achieve this type of winning strategy by pricing their products and services well below the point of Pareto efficiency and well of what would create a Nash equilibrium – in other words, create so much value for their customers over the long term itis very hard for a competitor to come in and change the game. Many companies can get away with obfuscating and extracting more value from their customers in the short term, but, in the long run, evolution and information sharing win and new disruptive forces emerge. Michael Porter’s famous “Five Forces” of competitive advantage need to be re-applied and re-examined in this framework. Companies want to create win-win scenarios for suppliers and customers – not extract too much value from either.
Google is another great example of creating NZS. The primary driver of Google’s business is Adwords, which is an auction-based system where advertisers bid up to their maximum point of positive returns on ads, but no higher – Google prices their business as a Pareto efficient auction. Further, Adwords works because of transparency and information. As transparency and the velocity of information rise in the world, it will become increasingly challenging for companies to extract too much value from their customers. Google actually keeps pricing low and innovation high in order to make sure companies and suppliers have no reason to join someone else’s competitive platform.
For optimal NZS, pricing well below the point of maximum value extraction combined with long term focus and a big, addressable market with relatively high switching costs (negative feedback loop) creates very long duration growth. Short term thinking (losing sight of the big picture) or lack of innovation and adaptability will be the primary reason a company creates fewer NZS markets and ultimately becomes a victim of disruption.
Negative Feedback Loops.
In investing and life there’s no such thing as a free lunch. Or, in the terms of physics, nothing cheats entropy over time. There is a price for growth. There is a high price for fast growth. We see this in nature – animals quick to mature live relatively short lives and animals slow to mature live relatively long lives. Imagine, for example, the two-week life of a fruit fly contrasted with the 80-year lifespan of a sea turtle. We often visualize lifecycle through an S-curve – quicker growth through the mid-point of a lifecycle and slower growth and decline later in the lifecycle.
For investors, understanding S-curves can be critical to the ability to make money. As a general rule, most money tends to be made in stock when the curve is convex and most money tends to be lost when the curve turns concave.
The duration of the S-curve, or the S-curve’s slope through time, gives us some indication of the life cycle of a product or a company. To take an extreme example, the S-curves of Groupon is more like a fruit fly while Procter and Gamble is more like a sea turtle.
Ironically, it’s the hyper-growth, compressed S-curves that often get the most attention from investors. However, quick, unchecked growth is extremely dangerous to a company’s long-term health. These stocks offer plenty of allure but usually end in investor tears.
While nothing cheats entropy, some companies appear to do so because their growth is relatively slow and steady over a very long period of time. Because the period of convexity is so long, an investor can buy a stock at any number of times and still make a wise purchase in retrospect. While fast growth is certainly sexy, it’s slow growth over a long time that the market serially undervalues. We argue that slow, long-duration growth stocks represent the ultimate value investment. In this equation, the period of time acts as an exponent to the steady growth rate. Said another way, a few more years of flat growth rate yields a nonlinear absolute return. For example, a 15% growth over ten years (1.1510) would deliver more than a 300% return. Not bad. But 15% growth over 15 years would almost double the 10-year return. If we could populate our top 20 positions with these types of resilient companies we’d only trim and add around periods of volatility and sip Mai Tai’s while reading a good book the rest of the time.
However, as one might expect, these companies are rare. Most company’s growth curves look like a power law – high growth upfront followed by slow to no growth for a long time. BUT, companies with long-duration growth have growth curves that look like a flat line.
Finding stocks like this is not easy but the best place to start is with a superior management team offering great products/services in a good industry that represents a REALLY big total addressable market, or TAM. This allows the company to put up high levels of absolute growth over a surprisingly long time. Because of their very long period of convexity, it’s difficult to understand where the company is on the S-curve (although market share is probably the easiest). As long as the growth curve remains relatively flat, these stocks can be bought without much risk over a long period of time (even though they almost always appear expensive relative to the market) because their period of compounding extends well beyond investors’ typical timeframes.
W. W. Grainger offers a great example. The company compounded operating income at 13.4% over the 50 years from 1962-2012. Because of Grainger’s long period of compounding, an investor could have paid 200 times earnings in 1962 and still made the market return of 8% per year before dividends assuming a current multiple of 18 times. This brings us to a short discussion on beta. According to economists, it’s impossible to outperform the market without taking more risk (higher beta) than the market. With the types of stocks, we’re talking about that statement is empirically not true. Because long-duration growth stocks tend to be more resilient than the market during bad periods but grind steadily higher during good periods, they often exhibit betas lower than the market while posting significant outperformance over the longer term. And, indeed, we see this phenomenon in the Grainger example with massive outperformance and a beta of .96.20To better understand the nature of growth, it’s important to grasp positive and negative feedback loops. Growth is a good thing, but hyper growth is a bad thing over the long term (although depending on the size of the TAM, sometimes hyper-growth can go on for a really long time). The pace of growth can tell us a lot about the health of the company and the ecosystem. There’s often a negative feedback loop in place with companies that exhibit the type of slower, long-duration growth we’re looking for and there’s often a positive feedback loop in place for the type of companies that go into hyper-growth mode only to crash into the growth wall over a short period of time.
Hypergrowth is dangerous and slow growth over a very long time is nirvana. In nature, we see positive and negative feedback loops with regularity. For example, the pine beetle ravaging the forests of the Rocky Mountains represents a classic positive feedback loop. Due to the loss of extended cold winters (which normally act as the negative feedback loop), pine beetles find their growth unchecked. They will continue to prey on susceptible pine trees until there is literally no more food left. Then their population growth will come to a crashing halt. We see something similar happening with the invasion of non-native Burmese pythons into the Everglades. Their inclusion at the top of the food chain has significant nonlinear implications for the ecosystem. As python numbers grow, wildlife sightings have fallen some 90%.
In the world and in companies we observe the same thing. Positive feedback sets things in motion through self-reinforcement, while negative feedback ensures stability against disruptions and excesses. We’d argue when a company comes into a large existing market with a disruptive product or business model, it’s very similar to someone releasing a non-native Burmese python into the Everglades: a new variable in a complex system changes the nature of the overall system in a nonlinear fashion. Sometimes there’s no negative feedback loop to check the new variables’ growth, which leads to hyper-growth and flame out. Sometimes hyper-growth can go on for a VERY long time because the opportunity is so vast (all the prey animals in the Everglades, all the pine trees in the Rockies, or the entire retail market in the case of Amazon). And sometimes the new variable creates an entirely new TAM by shifting lower efficiency resources into a higher efficiency way of doing things. Remember the positive feedback loop of home prices, easy money, rating agencies, collateralized debt obligations, and credit default swaps? The system got bigger and bigger until it became unsustainable. Positive feedback loops perpetuate until they exhaust the resources needed to sustain them. Negative feedback loops are the checks and balances that keep a system healthy. It was the loss of proper oversight, caution from rating agencies, and lax lending standards that removed the negative feedback loop from what became the housing crisis. Negative feedback loops are critical for a system’s long-term health (and for our purposes, the health of a company, and its products).
We argue (perhaps counter-intuitively) that quick growth is a bad thing while long periods of relatively stable growth mark the most compelling companies given the market’s ineptitude at valuing extended growth.
There’s another dimension to the simple S-curve that adaptable companies do all the time: stacking a new S-curve on the concave phase of an old one.
This represents an important aspect of combining Resilience (steady S-curve) with Optionality (adding on a new S-curve) – the ability to adapt and evolve. In essence, when we invest in a ‘value trap’, that’s exactly what we’re betting on. We’re betting that the company will use their large hoard of cash and know-how to disrupt themselves by stacking a new S-curve on top of their previous one. In practice, this proves incredibly difficult as it disrupts original products. Leveraging existing or slightly different products into a new TAM seems a bit easier. To sum up, companies that have very long periods of convexity are shockingly resilient over a very long period of time. They tend to exhibit these qualities because they are taking share in a BIG TAM. Often there is some sort of negative feedback loop that keeps them from growing too quickly but extends their duration of growth.
Extended growth duration is extremely powerful because time acts as an exponent to growth. These companies tend to have a lower risk than the market as measured by beta but outperform the market because of their steady growth through time. S-curves give us another helpful lens to visualize Resilience and Optionality. Finding such a company like this and sticking with the stock through thick and thin marks one of the holy grails of investing today.