The below section was from Saga Partners' H2'20 Investor Letter.
One significant and undeniable change is the rise of the digital economy. It is even difficult for investors who historically shunned “tech companies” to ignore the meteoric rise and related returns of many within the sector. However, the rise is not simply an unjustified irrational exuberance like in the dot-com bubble but a genuine shift in where economic value is flowing. Understanding this tectonic shift in the economic landscape is crucial as it is affecting every industry throughout the economy.
While Mike and I developed early theories surrounding this new digital paradigm prior to starting the Saga Portfolio (it was hard to ignore the swift rise of Apple, Amazon, Google, and Facebook), it was not until our deep dive into The Trade Desk in 2017 that really forced us to better understand these concepts. To the benefit of our investors, it helped us better position the Portfolio on this more accurate worldview. As we continue to look across the economic landscape, we have only become more convinced of this long-term trend.
With Saga Partners being bottom-up investors, it is unusual for us to discuss a macro, top-down trend. However, this macro trend is so inevitable in our opinion, and has such prolific implications that it impacts the bottom-up micro economic dynamics of nearly every business. Investors who ignore or do not attempt to better understand the nature of this new paradigm risk being left behind.
Below is a chart taken from Michael Mauboussin’s recent paper, One Job: Expectations and the Role of Intangible Investment. The chart shows tangible and intangible investment as a percent of gross value added, a rough proxy for GDP, since 1977.
As their name suggests, intangible assets cannot be touched. They consist of computerized information (software, data), innovative property (R&D, intellectual property, patents), and economic competencies (business processes, brands, human capital). Since the dawn of the Information Age, the percentage of total investment that is intangible has grown steadily. The questions are therefore: why is this happening and what are the economic and investing implications?
The digitization of the world, and consequently the rise of intangible assets, is largely attributable to man’s ability to manipulate electrons.
Early computer hardware used vacuum tubes for computing that still faced the physical limitations of nature. They were bulky, unreliable, and generated a lot of heat. By the 1960s, people figured out how to move tiny electrons around by placing them on silicon. These early semiconductors were able to control the input and output of electron flows and therefore turn transistors on and off, providing the ability to communicate through the binary language that computers use today.
Semiconductors further enabled the miniaturization of computer hardware, which moved us into this digital world. Being able to pack an increasing number of transistors onto a tiny silicon chip brought enormous cost savings, reliability, and increase in processing power.
The implications of having the ability to theoretically manipulate an infinite number of electrons are still unfathomable today. Eventually the hardware no longer becomes a limiting factor, and the potential of software becomes limitless. Processing and distribution costs effectively drop to zero. Data can live in this intangible world in the form of bits where the normal physical limitations of matter do not exist. Audio, video, text, image, everything can be stored, transmitted, processed, arranged, and combined.
The key outcome of this digital ecosystem is increased connectivity. As computers became faster and more powerful, it led to connecting them with wires and cables to form the modern-day Internet. Increasing connections increase the importance of networks, and from an investing standpoint the platform business model.
The traditional physical economy was driven by economies of scale; the digital economy is driven by the economics of networks. When individuals begin to interact with each other and establish connections, they naturally form networks. Physical networks such as telephones, railroad stations, or airports have been around for a long time. They have real physical linkages connecting nodes. Alternatively, the linkages and nodes of virtual networks are invisible although no less important for market dynamics. The digitization of data and the connections powered by the Internet enabled virtual networks to proliferate in the form of operating systems, search engines, social networks, digital marketplaces, etc.
Networks have important characteristics. The value of the network increases with each new member, forming a mechanism of self-reinforcement that compounds its impact. As the number of connections grow linearly, the value of the network grows exponentially. This positive feedback makes the strong get stronger and the weak get weaker, leading to extreme outcomes, and often the dominance of a single firm or technology in a certain market.
Positive feedback loops, virtuous cycles, and winner-take-all dynamics are discussed so frequently these days that investors often roll their eyes when it pops up on an investor presentation. Despite this reaction, the power of positive feedback is real and one of the most powerful forces in the network economy. Investors do not want to ignore this concept. The networking power of the Internet and rise of intangible assets throughout the economy has shifted the bargaining power within value chains upside down.
The traditional physical economy is organized around production and based on scarcity. It is the paradigm of supply-side economics and diminishing returns. Production takes place within the linear reasoning of the supply chain. Inputs are combined and manipulated until they are transformed into certain outputs. The name of the game is efficiency and scale gains. Controlling access to industry supply and distribution channels enabled the owner of that supply to charge premium prices and therefore earn attractive economics.
An important competitive advantage in this linear world was supply-side economies of scale; the ability to reduce average costs as production increases. However, in this paradigm, increases in supply eventually face higher production costs or dis-economies of scale. This is when increasing unit production results in rising costs per unit; more becomes worse. This is why companies like General Motors, Procter & Gamble, or Coca Cola were never able to take over their entire market. They largely competed in oligopolies rather than monopolies because traditional economies of scale end well before total market dominance.
Alternatively, the network economy is focused on the consumer and based on abundance. It is the paradigm of demand-side economics and increasing returns. Increased virtual connections powered by positive feedback, when combined with essentially zero marginal production, transaction, or distribution costs produce an environment of previously unimaginable scalability. As more connections are established it increases the value of a network. The more the resource is used, the greater the demand for it and therefore ever-increasing value creation.
Both demand-side and supply-side economies of scale have been around for a long time but only in relatively recent history have they been combined with essentially zero marginal costs of production. The result is an especially strong positive feedback force. This turns the traditional supply and demand curves upside down.
In a more traditional supply & demand curve, as prices increase, the market is typically more willing to supply a greater quantity and will demand less quantity. The opposite is true as prices fall.
In an intangible network, if the quantity & price equilibrium is to be reached, it will be at a point with much lower prices and higher volumes than could ever be conceived in the traditional physical economy. More demand creates more value and therefore further demand. When combined with nearly zero marginal costs of production, it means higher volumes lower the cost per unit infinitely.
In this upside-down world, the quantity of supply & demand can be infinite and offered at ever-decreasing prices. Note there is only one line in the chart below because in a world with infinite supply, increasing demand creates its own supply.
This leads us to the platform business model that has grown in importance with the digitization of data and the power of the Internet. I discussed platforms in the Q4’18 Investor Letter under the section “How platforms are eating the world” so won’t repeat all the details here. I simply want to explain the economic implications of the rise of platforms.
Using the broadest definition, all distributors could be considered platforms. Platforms are the middlemen between third party users and suppliers. Shopping malls, railroads, toll roads, newspapers, and the yellow pages are all platform businesses. They fulfill part of the distribution link to facilitate transactions within a value chain. The Internet has enabled an increasing number and much larger networks throughout the economy which have resulted in a growing number and greater importance of digital platform businesses.
If a platform establishes themselves as the dominant winner in a certain space, it puts them in the power position within the value chain. Third-party suppliers and users are forced to integrate with the platform’s central architecture, rules, and requirements in order to reach supply/demand.
For example, if a supplier wanted to ship something across the country on a railroad, they must fit their shipment in the railroad’s standard container and abide by the trains scheduling system. An app developer on Apple’s App Store or Google’s Play Store must abide by the established guidelines if they want to have their app available on the platform. In the intangible platform world, this integration feature has led to platforms catering to consumers, commoditizing suppliers, and driving much of a value chain’s profits to the platform that establishes themselves as the winner.
Clayton Christensen described the Law of Conservation of Attractive Profits in his book The Innovator’s Solution, stating, “when modularity/commoditization cause attractive profits to disappear at one stage in the value chain, the opportunity to earn attractive profits with proprietary products will usually emerge at an adjacent stage.” Products and services are in a continuous cycle of commoditization and de-commoditization in an effort to improve the performance of what is “not good enough.” When the functionality and reliability of a product or service become more than “good enough” the basis of competition changes.
Historically, the “not good enough” product/service was figuring out distribution. Getting physical supply to customers was the difficult problem to solve and where the profits were to be made. The power position and its attractive profits were in having a monopoly of supply, logistics, and distribution channels. This meant there was typically more customer demand for a limited supply, therefore customers were willing to pay prices in excess of costs to produce items, providing suppliers with attractive profits.
In the digital platform economy, the “not good enough” problem is no longer access to supply but in filtering the infinite amount of supply. Platforms, with the networking and data analytic capabilities of the Internet, can help customers filter supply. Value is no longer in controlling an asset base but in the aggregation of outside interactions, ability to reduce consumers’ barriers to use, and the ability to connect users with the most relevant and appropriate supply. User attraction is the name of the game therefore providing the best possible user experience is driving the paradigm shift from supply-side to demand-side economics.
Ben Thompson, a technology writer at Stratechery, illustrated this value chain paradigm shift in the chart below in his article Aggregation Theory.
Platforms that create the best customer experience draw the most customers, which then attracts suppliers to access that demand, which increases the value proposition to customers, creating the virtuous cycle that investors love. The positive feedback dynamic and scalability of digitally powered platforms unsurprisingly leads to market dominance and winner-take-all effects. It is not unusual to find quasi-monopolistic platform companies. These dynamics have fundamentally shifted power from the supplier to the consumer by changing scarcity into abundance. Suppliers are becoming more commoditized while customers are the priority.
From an investing perspective, it is possible to find these companies before they reach market dominance, and their competitively advantaged position is reflected in their financials. Before clearly establishing themselves as the winner, platforms will likely operate at a loss or require capital investment as they invest substantial amounts upfront to ensure they come out on top and then eventually be able to earn attractive profits. At these earlier stages, there can be evidence of a winning platform. Unit economics may continue to improve as the increasing value the platform generates provides improving returns on customer acquisition costs. While dominant platforms are generally attractive businesses, if one can find them before the market realizes their full potential, it could provide an attractive investment opportunity.