I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Friday, January 31, 2020

Lost Productivity or Found Hyperefficiency?

Labor productivity creates economic prosperity. Increasingly productive labor results in lower cost products (greater output from the same number of employees == lower labor input costs), higher salaries (productive workers are valuable workers), greater purchasing power (labor productivity allows households to keep monetary inflation in check), increasing sophistication (skill maturity to take on greater challenges), and higher returns on capital. The more productive a nation's workforce, the higher the average standard of living of its population.

In recent years, economists have drawn attention to low productivity growth in western economies as a key factor restraining economic growth and perpetuating low inflation and low interest rates. In particular, they cite the lack of breakthrough technologies - e.g, the emergence of the personal computer in the 1980s - to spur labor productivity and with it, more rapid economic growth. By traditional economic measures, things do not appear to be getting much better.

There is an alternative perspective that is far more optimistic: digital companies drive down costs through hyper-efficiency (speed, automation and machine scale) and price transparency. Algorithms are cheaper than humans and can be networked to perform complex collections of tasks at a speed, and subsequently a scale, that humans cannot achieve. Twined with the radical reduction of information asymmetry (particularly with regard to product price data), it stands to reason that there has been significant productivity growth in western economies: supply chains have never been so optimized, retail and wholesale transactions so price-fair and friction-free. This stands to reason: it is considerably less time- and energy-intensive to ask an Echo to order more Charmin toilet paper than it is to drive to a grocery store or pharmacy, walk in, price compare to justify those few extra pennies for softness, queue, pay, and drive home. The argument for this invisible efficiency is that economic models have simply failed to change in ways that reflect this phenomenon. The productivity is there, and will intensify with technologies such as AI and ML; the instrumentation simply doesn't exist to measure it.

In this definition, productivity through technology is a deflationary force that makes products more affordable. Even if real wages remain stagnant, the standard of living increases because people can afford more goods and services as they cost less today than they did yesterday. In theory, the increasing standard of living will occur regardless the cost of capital: because retail prices are going down, interest rates could move higher with no ill effects to the economy, juicing returns on capital. The bigger the tech economy, the better off everybody is.

There is truth to this. Consider healthcare: although medical costs are much higher today in nominal terms than they were in 1970, they are much lower in real terms when adjusted both for monetary inflation and medical-technological innovation. If medicine were still practiced today as it was 50 years ago, the cost of delivery would be lower in real terms, but the standard of care would be much, much lower than what it is today. Would you want to receive cardiac treatment at a 1970 standard, pulmonology treatment at a 1980 standard, or HIV treatment at a 1990 standard? Or would you rather be treated for all of these to a standard of care available in 2020? Technology is clearly a deflationary force that increases individual prosperity.

Still, there are three factors that should temper enthusiasm for an unmeasurable tech-led labor productivity bonanza.

The first has to do with the real price of and the real payers for tech-generated benefits. Ride sharing services have added driver/fleet capacity and accelerated speed-of-access for local transportation service. However, the individual consumer isn't fully picking up the tab; the ride is heavily subsidized by private capital. That makes the price affordable to the user. The question is, how sustainable is the price without the private-capital subsidy?

Economic subsidies are a common practice, typically sponsored by governments to protect or advance economic development. Sometimes a subsidy is direct, as is often the case with agricultural commodity price supports: if depressed crop prices drive farmers out of business, a nation loses its ability to feed itself, so in years of commodity gluts governments will offer direct assistance to make farmers whole. And, sometimes a subsidy is indirect. The United States was dependent on oil from foreign countries for much of the past 60 years. The price of petroleum products in the US did not reflect the cost of US military bases as well as having the Fifth Fleet patrol the Persian Gulf. The federal government prioritized energy security to guarantee supply and reduce the risk to energy prices of supply shocks. The immediate cost of that security and stabilization was borne by the US taxpayer; the policy was founded on the expectation that the federal government would be made whole over the long term through increasing tax receipts from economic growth that resulted from cheap energy.

There are subsidies that are sustainable and subsidies that are not sustainable. In theory the US projecting military power to secure Middle Eastern oil was a sustainable economic subsidy: containing energy prices while your nation gives birth to the likes of Microsoft and Apple and many other companies seems a good economic bargain (exclusive of carbon emissions, which did not historically factor into economic policy). By comparison, productivity in the Soviet Union grew in lock-step with direct government investment in industry (primarily steel production) through the 1950s and 60s, Trouble was, when the Soviet government pulled back investment, labor productivity growth flatlined. Labor productivity was entirely dependent on outside (e.g., government) financial injection. The lack of organic productivity growth translated into stagnation of economic prosperity of the masses. A standard of living that was competitive with the United States and Western Europe in the 1950s was hopelessly trailing by the 1980s. Turns out Maggie was right: eventually you really do run out of other people's money.

The investment case for the ride sharing companies is that there will eventually be one dominant player with monopolistic pricing power. A market for on-demand transportation is now established, so a single surviving ridesharing firm will reap the winner-take-all benefit of that market, giving it scale. Being the only game in town, the surviving firm will have pricing power. In theory, the surviving firm should have access to a larger labor pool spanning Subaru drivers to software developers, thus depressing wages, and thus the cost of service. Lower input costs twined with scale should mean a lower price increase is needed for the firm to become profitable.

But there are a lot of variables in play here. Ridesharing firms are carrying billions of dollars of losses they accreted over many years that they need to make up for their investors to be made whole; that will create pressure to raise prices. There are other industries competing for the labor of these firms (especially those software developers), so input costs will not necessarily decline. Because drivers work for multiple ridesharing services, their utilization is already high, meaning economies of scale that will temper price increases passed on to consumers.

If or when a monopolistic competitor triumphs, prices are going to rise and individual consumer's "productivity" will be impaired by the withdrawal of the price subsidy. Consolidation and scale will not perpetuate the subsidy, so the price of service is going to rise. The subsidy is only sustained if a new entrant with deep-pocketed backers emerges to challenge what will by then be a "legacy" incumbent; in essence, the cycle of subsidy regenerates itself. Don't rule it out: it isn't out of the question as long as capital is cheap. While it's reasonable to assume the industry will run out of greater fools, there has always been a high degree of correlation between "minutes" and "suckers born". The WSJ reported today that Softbank is pumping cash into multiple meal delivery services operating in the same markets and therefore competing directly with one another, each firm engaged in an arms of subsidies with one another to sign restaurants, delivery labor and customers. It is difficult to fathom the logic of this.

The second factor is the implicit assumption that the tech cycle has triumphed over the credit cycle. There is a popular theory that technological innovation has become more important than capital in setting prevailing economic conditions. The evidence of this is the shift in economic activity steered by emerging technologies in areas such as ecommerce and fintech. A technology-centric business benefits from lower costs for facilities, lower inventory carry costs, and lower network (transaction) costs, and therefore has an intractable competitive advantage over incumbents. As I've written previously, unfortunately the evidence doesn't entirely support this yet. Plus, deep-pocketed incumbents can raise capital to acquire, compromise or corrupt the business models of would-be disruptors, not to mention that would-be disruptors are finding themselves engaged in technological arms races not with incumbents, but other would-be disruptors. This distorts the playing field, making it much more about capital than tech.

It's curious that contemporary strategy among big tech firms is to burrow into the existing economy as un-metered, un-regulated, subscription-based utilities, as opposed to betting on ever-accelerating revenue from their intrinsic value-generative nature. Consider entertainment streaming services: by selling subscriptions, they are willfully exchanging the potential for sky-high equity-like returns from the value of the content they produce (which is how movie studios used to operate) for more modest debt-like returns from the utility that subscribers will pay for access to a library where they can find something they can tolerate just enough to pass the time (which is how cable companies operate). While streaming services are engaged in a long-running competition for content and tech, they have concluded they are not going to win by out-tech-ing or out-content-ing one another. Streaming entertainment is not a value proposition, it is a utility proposition. A utility business model is one that is explicitly (a) not leading with tech innovation and (b) seeking immunity from the credit cycle.

What this tells us is that the tech cycle is not the dominating economic force. As it stands today, more people suffer economically when the credit cycle turns than when the tech cycle turns (e.g., a dearth of innovative new technologies). A turn in the credit cycle contracts business buying which creates layoffs. A turn in the tech cycle makes means there will not be a still more convenient way to get a ride from The Loop to O'Hare or food delivered from a Hell's Kitchen restaurant to an apartment in Midtown. While it may happen some day, we are still not yet at a point where the tech cycle is triumphant.

The third factor goes to the question of labor capacity versus labor productivity. Labor productivity and labor-saving efficiency are really measures on the same axis: less time, effort and energy necessary to complete a task and ultimately achieve an outcome. A different but equally important dimension is labor capacity: the more people engaged in gainful employment, the greater the level of household income, the more individual households reap economic benefit.

Labor participation in the United States took a direct hit in September, 2008, and hasn't recovered. After hovering above 66% for over 18 years, it went into sharp decline, bottoming at 62.5% in 2015 and recovering only to 63.2% today. To put it in absolute terms, there are 20 million more jobs in the US today than there were in 1999 (peak labor participation), but the US population has grown by 48 million more citizens. Job growth hasn't kept pace with population growth. This suggests that the economic benefits of productivity gains (through organic labor productivity or technology) are concentrated in fewer hands, implying that the economic benefits of technology gains are asymmetrically distributed.

Yes, labor capacity is a measure, not a driver. From 1950 to 1967, the labor participation rate hovered in the 59% range. And even with a growing population, technological advances can create price deflation that raises the standard of living for everyone: many and perhaps most of those 48 million additional US citizens since 1999 have smartphones, which none of the 279 million Americans had in 1999. Still, there is asymmetric benefit to those technological advances: those not working are not enjoying the totality of economic benefits of increased productivity described in the opening paragraph. As much as proponents advocate that technology improves labor productivity, that same tech is also increasing in the Gini coefficient.

Does technology improve productivity? Undoubtedly. But before hailing any technology as an economic windfall on par with traditional measures of labor productivity, best to scrutinize how it organically it achieves it, how resilient it is, and how widely its benefits are spread around the work force. Technology may eventually change traditional economics, but there is one thing even the best technology cannot overcome: there is no such thing as a free lunch.

Tuesday, December 31, 2019

But Is It Really a Tech Firm?

There are lots of executives who would have you believe that the business they run is really a tech business. With tech firm valuations still at sky-high levels, it's easy to understand why. Tech commands a premium valuation because (a) the potential for non-linear growth relative to investment; (b) low barriers to entry into adjacent markets amplifies that growth; (c) scale of offerings changes the commercial model from transactional to flat-fee subscription, making a tech firm an unregulated utility; (d) payments take place behind-the-scenes of the tech consumption, creating sustainable recurring revenue; and (e) tech industries tend to be winner-take-all.

Translated into investor-bait, here is what this means. Selling access to movies is all well and good. Selling all forms of entertainment - on different media, on different frequencies, for different prices - is even more interesting. Selling access to it as a service on a fixed price makes it an uninterrupted cash flow. Getting a significant number of people on the planet to pay a fixed subscription fee once a month every month is epic scale.

This kind of reach isn't a new or even a recent phenomenon. You may recall a time when McDonald's restaurants used to show the number of burgers they sold on the golden arches signs, in the tens and later in the hundreds of millions. Then it simply became "billions and billions served." You may not recall that twenty years ago, McDonald's (briefly) targeted their sales in terms of the percentage of total meals consumed globally on a daily basis. Around the same time, the largest of the large banks was targeting a total number of accounts across all product categories relative to the entire population of the planet. 'Twas ever thus: Standard Oil achieved monopoly status over American oil in the late 19th century; Rome achieved hegemony over Europe.

Tech didn't invent the economic harvesting of humans at scale, it's simply the current means of achieving it. In Roman times, it was achieved through territorial conquest (tax revenue through subservience of subjects). In the industrial age, it was achieved by selling productivity, e.g., labor-saving machines and the energy to run them (revenue from products to improve productivity of business and household activities). Today, it is achieved by selling entertainment (revenue from selling services that fill the passive time of individuals). At a time in history when conquest is out of favor and productivity gains have slowed, monetizing everybody's abundant downtime from all those labor-saving products of the industrial age is the next frontier.

Not exclusively, of course. There are still plenty of opportunities for productivity gains. Electric vehicles require fewer components, which means less labor is required to manufacture them. Tax compliance is mostly rules, and rules can be implemented as algorithms and therefore replace large number of auditors. And when cars can drive themselves, individual, on-demand transportation isn't limited by the number of drivers but the accessibility of vehicles. There are still plenty of productivity gains to be realized, and their potential still grabs headlines, but productivity is the old frontier; entertainment is the new.

Regardless the source - political domination, economic productivity, or entertainment - the potential for scale drives equity value. Potential is more lucrative to investors than reality. Bond investors are told the company is growing at a predicable rate and spending is under control, which secures the credit rating and coupon; equity investors are told that it isn't the sky that's the limit, but our ability to fathom every quantum reality of where the business could go, and that tech is the enabling factor. Hence there are plenty of CEOs and CIOs alleging they are "tech companies that happen to operate in the [insert-industry-name-here] industry."

You've probably heard this statement hundreds of times from hundreds of executives, to a point that it doesn't merit even as much as an eye-roll any more. I've always thought it would be helpful to have a consistent and objective means of assessing whether they really fit the bill of a tech firm or not.

Andy Kessler wrote an interesting op-ed in the WSJ a few weeks ago cataloging five characteristics that define a tech firm. They are: growth; R&D intensity; margins; productivity; and tech spending intensity. This is a very useful heuristic.

Growth: "Even though prices go down, units go up faster so you get rapid and sustainable growth." Among other things, that means race to the bottom pricing isn't destructive if volume rises ahead of it. A good litmus test of growth: "Beware of fake growth like market-share growth: If you sell seat cushions for a 50,000-seat stadium, you can double sales every year but eventually you’ll run out of seats. Instead look for giant markets." If the company does not have truly exponential growth potential through tech, they are not a tech firm.

R&D: This is a positive and negative indicator. On the plus side, tech firms have to invest for invention and innovation. On the minus side, "Companies often boost earnings by starving research, a serious red flag." A company not investing in original research in tech is not a tech company. But it isn't the creation of tech that matters as much as how effectively it is mainstreamed. Mr. Kessler wrote another op-ed this past week in which he points out the rapid rise of such things as voice command, live streaming and medical monitoring have gone from new to commonplace and, in some cases, depended upon. The ability to create technology simply yields another Xerox PARC or Kodak digital camera; the ability to operationalize R&D is entirely another.

Margins: "the ideal tech product doesn’t cost anything to distribute—roughly zero marginal cost, like software." This is true for bits, silica and advertisements. Whatever a tech firm is selling should have near-zero marginal cost for each additional sale. By this definition, consulting firms are not tech firms: because they rent bodies, they have direct costs proportional to sales.

Productivity: Marginal improvements in productivity have been with us since the dawn of time; replacing entire swaths of labor activity is transformational. Levers and pulleys allowed humans to power simple devices to create incremental labor saving, while the flywheel engine completely replaced the need for people to perform specific tasks. Organizing people to drive their cars to transport others is not a productivity boost; cars that navigate themselves to people in need of mobility without the presence of a driver is a productivity boost.

Tech spend intensity, or the extent to which a company must continuously upgrade core capacity. A company on the technology treadmill has no choice but to spend capital on enhancement and expansion. Note that this does not apply to self-inflicted woes. I've worked with entirely too many firms that are hostage to tech spend commitments due to poor tech lifestyle decisions: vendor spend is directly proportional to cleaning up mistakes made by those very same vendors. Committed spend for purposes of hygiene is not the same indicator of tech intensity as disciplined spend for purposes of improvement.

This simple heuristic makes it easy to score (Mr. Kessler suggests awarding one point for each). By his reasoning, a score of 3 or above qualifies a company as a tech business, while a 1 qualifies them as a tech user, and quickly applying it to firms with which I'm familiar it winnows out the wanna-bes. Next time somebody is touting their tech credentials, apply this simple rating to see how well they stack up. It will be more constructive than an eye-roll.

Saturday, November 30, 2019

Muddling Through

British trade in the West was never an instrument of empires. It had no headquarters like the compounds at Montreal and no capitol like the rock-rooted fortress at Quebec. It had no seasonal rhythm like the canoe caravans coming down the rivers on the spring race of water to the tall ships above the quaysides loading their pyramids of peltry. It had no trace of the pagentry of black-robed priests visioning by their campfires in the forest a new empire for the Church, and no imperial plan of feudal seigniories and savage nations submissive to the rule of the Rock. The British trade was sporadic, individual and motivated by simple greed. When forty dollars' worth of trade goods would secure a thousand dollars' worth of peltry, there was incentive enough to bring pack trains to Ohio.
Walter Havinghurst, Land of Promise

In 1959, Dr. Charles Lindblom posited that companies that had disciplined processes for experimentation and discovery had an advantage over those that operated, in the words of Dr. John Kay, against "a single comprehensive evaluation of all options in light of defined objectives". The argument Doctors Lindblom and Kay make is common sense. For those of us without the gift of omnipotence, the ability to reassess objectives and tactics with the benefit of first-hand market knowledge is a handy capability to have.

While this is intuitively appealing to entrepreneurially-minded managers, it is decidedly unappealing to risk-averse capital. Complex corporate strategy derived from analysis and modeling creates the appearance of authoritative expertise. Authoritative experts are in the business of selling predictability. Debt capital likes predictability. As long as there is cheap capital to be raised from risk-averse investors there will be complex business strategies. This doesn't make for good strategy or good investment. This just makes it something that happens.

There is an obvious contemporary comparison between Amazon (financed with equity capital) and WeWork (financed largely with debt capital) and no doubt there will someday be a good case study that sheds light on the differences between the two firms. Suffice to say for now that in the latter's case, somebody tells a good story (Adam Neumann at WeWork), somebody has money burning a hole in their pocket (Masayoshi Son at Softbank). The story makes for an eye-popping valuation, but the story doesn't make it a rational valuation.

Human history is rife with examples of big, ambitious, up-front design that fails to live up to the hype and reward the capital behind it. I've been doing some research into the development of North America from the time of the Renaissance. The opening of the North American continent created a massive trade opportunity for European countries. Although the Spaniards were the first to arrive during the Renaissance, the French were first to pursue opportunities in the North American interior. The interior was rich with wildlife. The indigenous peoples were adept at harvesting the pelts of that wildlife. European manufactured products could be profitably traded for those pelts: $40 of trade goods to $1,000 of prepared pelts, per the opening quote.

As lucrative as the trade opportunities were, the French dreams for the development of the interior were even more ambitious.

Having seen the immense forests of the Ohio and the broad prairies of the Mississippi, La Salle formulated his life's ambition. He would establish French civilization in the rich country between the two rivers. He would begin by systematizing and enlarging the fur trade, using cargo vessels on the lakes, erecting fur depots on the rivers, establishing a chain of warehouses and magazines. It was a bold undertaking that looked to the protection of French interests all the way from the mouth of the Mississippi to the Great Lakes and the establishing of stations of prestige and power at a dozen strategic points.
[...]
It was a dimly comprehended country, but La Salle saw it more clearly than any man of his age. He made the restless [Governor] Frontenac envision it like a panorama from the Rock above the St. Lawrence. And it made the ambitious governor grasp his program of a commercial empire with French goods going systematically to the strategic posts and the fur caravans drawing in over the great web of rivers to the broad sea lanes of the Lakes. Together they drew up a design of occupation, fortification and settlement.

La Salle's big vision needed big execution. It did not suffer from a lack of big execution. He oversaw the construction of the 60-foot long Griffon, the first ship ever on the great lakes beyond Ontario; a vessel of that size could transport larger quantities of trade goods than the largest fleet of canoes. He established trade relationships with interior peoples. He established forts throughout the present day states of Ohio, Indiana and Illinois, reaching as far west as the Mississippi.

What the big vision did suffer from was unforeseen circumstances, to which La Salle was simply unable to respond. Advance traders squandered their French-made trade goods, trading for themselves rather than for their employer. One of La Salle's trusted lieutenants - Louis Hennepin - was taken prisoner by the Sioux. La Salle's men abandoned his key fortification of Fort Crevecoeur. A key trading partner - a village of the Illinois - was defeated by the Iroquiois. A storm over Lake Michigan claimed the Griffon, laden with pelts from the North American interior for Europe. Ultimately, La Salle's detractors were successful in discrediting him in Montreal and Paris, and his creditors closed in on him. While he would ultimately gain support from the French crown for one final expedition, it would fail for the same reasons his previous expedition did: ambition impervious to ground truths.

Though the ensuring years saw scattered new trading posts and mission stations - at Chicago and St. Joseph, at Detroit, Cahokia and Vincennes - there was no bold design of a French civilization encompassing the whole interior country.

The legacy of the French vision lingers on in the names of rivers, cities and counties that bear the names of the influence of the French explorers and of the explorers themselves: Eau Claire, Fond du Lac and St. Louis; Hennepin, Joliet and Marquette; and of course, La Salle himself. But these are just echoes of the past. As Dr. Havinghurst points out, the North American market for European trade goods fell into the hands of those who were not executing in pursuit of a grand design, but content to muddle through.

No surprise, then, that the 20th century instantiations of these 18th century ambitions - Singer Industries and TRW - if they are remembered at all, it is as legacy place names and not 21st century concerns.

Thursday, October 31, 2019

The Law of Unintended Consequences

Over and above all, it remains to be seen how far the super-Bank will make use of its immense facilities for credit expansion. This is the aspect of the scheme which deserves the most attention, as it opens up a vista of alarming possibilities. The scheme itself is sound, and it is far from its authors’ intention to make of the Institution a means for international credit inflation. But then, the bank scheme of John Law was also in itself sound....It also remains to be seen whether the scheme of our modern John Laws -- however sound their intention may be -- will not be brought to shipwreck...
-- Is Libra really the world’s most ambitious international settlement system? FT Alphaville

Technology is possibility. Technology is potential. Technology is hope. It drives out inefficiencies. It destabilizes authority. It rights wrongs. We've witnessed examples of all of these things in the last two-and-a-half decades, sometimes in dramatic fashion. They seem to occur at an ever accelerating rate.

Among the things that makes any technology magical is its ability to elevate each and every individual user to the center of the universe. One of the ways a technology does this is by rapidly and iteratively incorporating things users ask for. Short delivery times allow for feedback from a wide variety of current and potential users to be factored, explored, and refined continuously - and equitably - into the software. This gives iterative tech the unique capability of placing every individual at the center of value delivery, as there are many intersection points of features and types of user. When done well, there isn't a single person imposing their vision of what users should do, but community preferences and desires crowdsourced to achieve a goal state. This is the egalitarianism of technology, manifested through a product mindset and Agile practices.

Little wonder that tech sports a halo in the eyes of economists, politicians, and the masses alike. Yet we know from experience that tech is not a one way trip to a universally better tomorrow.

We think of technology as a force for good because of the benefits we have seen it yield, but we do not often consider the problems it is likely to leave in is wake. Cheap capital flooded into sales-tax free e-commerce at the cost of brick-and-mortar firms and their employees, and by extension the municipal & state coffers to which those firms and employees contributed taxable sales and incomes. Using advertising to subsidize innocuous user activities like information or product search gave rise to creepy surveillance capitalism. Energy-efficient buildings don't fulfill their promise because "buildings don't use energy -- people do." It's a phenomenon called the rebound effect: tech-driven advances in energy efficiency result in increased rather than decreased consumption. "[P]redicting what people will do is notoriously difficult."

Tech firms advocate big tech solutions to big economic and societal problems. Somebody thinks people pay too much in fees to transfer money, so they propose to "revolutionize payments" through cryptocurrencies. Somebody thinks that asset prices are too high, so they propose to "revolutionize asset ownership" through fractionalization. Somebody thinks that low-risk borrowers are penalized by being pooled with high-risk borrowers; somebody else thinks that too many high-risk borrowers are excluded from credit markets, so each build technology products targeted at the margins of credit markets.

Because people have limited capacity to comprehend the world in a state differently than how it exists today (a phenomenon known as regulatory capture), the debate focuses on the past and present, not what the brave new world of "revolutionized payments" or "revolutionized credit formation" will mean.

Here is what those things mean. Unrestricted movement of capital across borders is a pro-cyclical driver of capital flight; that amplifies currency fluctuations and interest rate volatility. Siphoning off the extremes of the credit pool removes high quality borrowers and encourages loans to borrowers of extremely low credit quality; that increases interest rates charged to middle- and high-risk borrowers because it takes low-risk borrowers out of the pool. It also enables unregulated institutions to write usurious loans that find their way into the mainstream financial system because the notes are ultimately bought by banks. Banks will not write the loans due to the credit worthiness of the borrower, and banks will not write the loans because regulatory agencies prohibit charging the concomitant interest rate banks would need to charge given the credit worthiness of the borrower. Ironically, banks can (and do) buy the loans ultimately provided to those borrowers by unregulated financial institutions and put the loans on the books as high-yield assets. Fringe financial institutions win, banks win, borrowers lose.

Big tech solutions to problems real or perceived on the margins amplify volatility. That makes them contributors and potentially generators of Black Swan events. The technologies that aspire to increase accessibility or reduce friction in isolation of other market characteristics such as regulation actually contribute to volatility in the markets they allege to optimize. True, they may do so at their own expense: marketplace lenders, dependent on banks to buy the loans they write, are extremely vulnerable to the credit cycle they promised to circumvent. But as big tech is a winner-take-all-loser-take nothing proposition, and as big tech harvests rather than liberates the individual, big solutions from big tech are a one-way proposition that transfers income from the core of an economy to the big tech company that ultimately wins out.

Can technology make improvements in payments and credit formation? Sure. But perhaps better to take an evolutionary approach rather than a revolutionary approach. Lots of innocent people get hurt badly in revolutions. They are powerless to defend their interests.

Oh, and about that quote to start this blog. You might be thinking it's about Libra. It isn't. It was written in 1972 about the Bank of International Settlements. Plus ça change...

Monday, September 30, 2019

The Financialization of Disruptive Technology

It's fashionable to champion an investment-oriented model for software development, particularly around exploratory opportunities. Allocate risk capital, run experiments through software, learn what works and what doesn't work, re-focus, rinse, repeat, reap rewards.

I've been a proponent of companies doing this for a very long time. It twines the notion of devolved decision making with thinking of IT as an investment rather than a cost. Invest in what you know paid off handsomely for Peter Lynch. "Continuously adjust your investment position based on what you learn" seems an apt mantra for today's world. Organize for innovation, re-acquire lost tribal knowledge, challenge - but respect - commercial orthodoxy, and constantly re-apply what you learn to change the rules of engagement in an industry. Every day you're in business is a day you're able to bring the fight, and this is simply the new way of bringing the fight. Better figure it out.

What if this is not a viable strategy?

I've danced around this question for the past 7 or 8 years, challenging the invest-for-disruption premise from a lot of different angles. Among the problems:

  1. The labor density of new ideas has risen nearly 3x the rate of inflation. As the FT put it, that implies it is getting harder to find new ideas.
  2. Investment yields are highly concentrated. There are a plenty of analyses to show that a small percentage of investments yield the majority of the gains. A recent FT Lex article on biotech investing drives the point home: "A 20-year study found only one-fifth of exits were profitable. Just 4 per cent of investments made half the returns." Picking winners is hard.
  3. Regulated industries are unappealingly complex, but those complexities exist to protect consumer and provider alike. Denying, ignoring, or circumventing market sophistication results in bad outcomes for everybody: investors are subject to cycles they thought they were immune to, customers get robbed, and in the end management takes the same path their orthodox predecessors did decades ago.
  4. Cheap capital makes it easy for anybody to enter the innovation game. The multitude of companies competing to offer home meal kits and ride-hailing show there are no barriers to entry. Unique ideas aren't unique for very long, and the economics of exploiting them are much shorter lived.
  5. Deep pocketed investors make it expensive to stay in the innovation game. The WSJ has pointed out quite a few times that We Company, Uber, Tesla, and many other firms subsidize every customer transaction with investor capital. And as this graphic illustrates, that is an extraordinarily expensive investment proposition.

The whole point of the portfolio model applied to captive technology investing was to avoid taking a long position in any one thing. That created nimbleness at the portfolio level such that capital - and the knowledge workers that capital pays for - could be rapidly redeployed to the best opportunity given our most current information. This took advantage of a unique characteristics of software vis-a-vis its industrial (hardware) predecessors: real-time adaptability. Whether it was the accounting department building tools in Visicalc in 1982 or a team of developers creating the company's first e-commerce site in 1997, the ability to rapidly deploy a new capability in software created an operational differentiator. Manufacturing changes took years. Organizational changes took months. Software changes took minutes.

That meant that software had the potential to be lower-case-i-investing: we knew in the early 1980s and again in the late 1990s that applied adaptable cheap technology could create incremental efficiency gains and therefore advantages. The formula was to exploit the adaptability of software and expedite its application: get new code changes deployed every month, every day, every hour when possible. As an operating phenomenon - that is, as it impacted day-to-day operations - this offered tremendous potential for competitive advantage: land punches left, right and center at an alarming rate and you put all your competitors at a disadvantage.

Yet per the above, software is no longer strictly an operating phenomenon. It's a financial phenomenon. Software is now upper-case-I-investing: all positions are long positions, and the stakes are winner-take-all. The incremental nature of the portfolio model has more to do with trench warfare in World War I than it does with sustainable competitive advantage. These are wars of attrition.

I've chronicled this phenomenon over the years, and over the course of that time have written up simple playbooks for strategic responses: i.e., the incumbent-cum-innovator and late movers. These are appropriate as far as they go, but incomplete once the tech has been fully financialized. If the tech business has been fully financialized, the playbook has to reflect the influence of the finance, not the tech.

Saturday, August 31, 2019

The Tortoise Strategy

Three years ago, I wrote that the unstoppable forces of Fintech were running into the immovable force of financial orthodoxy. Specifically, the technology cycle wasn't enough to overcome the credit cycle for peer-to-peer lending firms, which were resorting to selling their loan portfolios to traditional lenders, becoming buyers of last resort themselves when no buyers emerged, and offering deposit insurance for lenders.

Earlier this year, I wrote that incumbents had advantages - specifically, access to greater amounts of patient capital - which they can parlay in a multitude of ways to co-opt a would-be disruptors business: make the disruptor financially dependent by becoming one of their biggest customers buy buying their products (e.g., loan books originated by peer-to-peer lenders), licensing their technology, or investing in their business and getting board seats.

Last month, I wrote that being a late mover can be less financially ruinous than being an early mover. A fast-growth business with low barriers to entry attracts a lot of competitors who burn increasing amounts of capital chasing each other's customers more than new ones. Patience and playing to strengths is a better response than betting the balance sheet in an unfamiliar casino.

This week, the Financial Times ran an interesting article on the trials of peer-to-peer lenders. Finding lenders is hard, and finding borrowers is proving even harder. Incumbent banks have lower costs of capital, which allows them to lend at lower rates. In periods of economic uncertainty or downturn, banks offer safety to cash-holders in the form of insured deposits.

What does the FT article recommend? That the survivors will be those who follow a "tortoise" strategy:

That means working with investors with a low cost of capital [...], and avoiding yield-hungry hedge funds. It means not reaching too hard for high returns, which will become high losses in a recession. It means sticking to niches with good borrowers, who are too hard for big banks to serve. Finally, it means not spending excessively on marketing.
All this, of course, implies slow growth: hence the tortoise. But the hares are set for a very nasty couple of years.

'Tis better to arrive late than not to arrive at all.

Wednesday, July 31, 2019

Late Mover Advantage

Many years ago, I worked with a company that helped big pharma companies distribute free medical samples to doctors. Having pharma products on-hand is a convenience for doctors and patients alike, mainly because a doctor can initiate immediate treatment for a patient. Having pharma products on-hand is also good for big pharma, as starting somebody on a medication is highly likely to lead to a prescription. So pharma manufacturers were motivated to avail free samples of medicines to doctors.

It's a regulated activity. Doctors can only get medicines appropriate for their practice (e.g., a pediatrician cannot get free samples of Cialis) in limited quantities for specific lengths of time (usually every x number of days). Pharma companies keep track of which doctor got what product on what date. Because doctors exhaust their supply of free product within the allocation time frame, doctors create standing re-order requests. The pharma company decides whether or not to fulfill a doctor's reorder request primarily based on when the last order was fulfilled and the quantity supplied. A pharma manufacturer would not supply more free product to a doctor who had received the maximum volume just a week ago if the reorder window is 21 days.

Because doctors obtain pharma samples from multiple manufacturers, a lot of intermediaries popped up to provide a consolidated service. The value prop of the intermediary was that a doctor need only visit one site to replenish samples from multiple drug manufacturers. Again, because doctors exhaust their supply of free product every few weeks, they were encouraged to set up recurring orders through the intermediary, so a doctor might request multiple products from multiple manufacturers with different replenishment rules. The intermediary made money by charging the pharma company for each free sample request they fulfilled. The pharma company treated it as a marketing expense, effectively treating these intermediaries as a channel partner and paying them a commission. The volume aspect made every doctor acquired very valuable indeed.

The theoretical market numbers were eye-popping. Just one of the big pharma firms measured the total product value they gave away in the form of samples, coupons and vouchers to be nearly $2 billion through all channels of distribution. At the time there were about a dozen or so bulge bracket pharma firms. The free pharma product business was big business indeed.

The company I was working with had a division that was one such intermediary. It was supposed to be a growth business in the portfolio: as mentioned above, pharma samples were a big business and the order volume had plenty of room to grow. But the performance was never all that impressive. When intermediaries made enough mistakes (e.g., process the reorder too early or not at all and doctors don't replenish their sample stock in a timely fashion), and the doctors will sign up with another intermediary. Since the pharma companies were the ones managing the replenishment data (what doctor received what product in what quantity on what date) and enforcing the replenishment rules, and since the pharma companies had no exclusive distribution agreements with any intermediary, a doctor could set up the same reorder profile with a dozen different intermediaries. The first intermediary to process the reorder successfully won the business that day. And, not only were there lots of intermediaries competing for the same business, the pharma companies operated their own direct-to-doctor channels as well - and distributed the bulk of the product that way.

Being a crowded field, intermediaries had no pricing power with the pharma companies. By way of example, at the time the internet travel booking business had a take rate of somewhere between 5 and 10% of the value of the travel services they were selling; intermediaries had a take rate of a tiny fraction of a percent of the value of the product order they were submitting.

In short, there was no customer loyalty, no vendor exclusivity, and no pricing power in this business. There was a market, but no obvious winning strategy. Infrequent site visits meant that user experience wasn't going to provide an edge. Orders duplicated across multiple intermediaries meant that even the smartest algorithms and the fastest technology would provide only a fleeting edge as competitors would quickly catch up. Acquisition wasn't an option as every seller would demand too high a price for little value in the form of assets or cash flow. Industry consolidation would simply formalize the value destruction that had already taken place but not been accounted for.

An intermediary couldn't crush the competition with customer love, innovation, tech firepower, or scale. They were in a state of mutually assured destruction. The only strategy was to hope that your competitors ran out of cash before you did.

Recent analyses in the financial press on the ride sharing, home meal kits and food delivery industries got me thinking about that company again. They compete in crowded fields amid the challenges of low switching costs, low margins, little differentiation, and no customer loyalty. As the Wall Street Journal put it, these companies are now engaged in "a land grab for overlapping customer bases". Every ride from Lyft and Uber is still subsidized by investor capital. There wasn't enough of a market for home meal kits to support the number of firms competing for it.

The Journal makes the point that the would-be disruptors in home meal kits have done more to disrupt one another than they have to established players in retail food, and that's an important point. That these firms are "disrupting" in a different competitive landscape to their technological forebears: building a business at the expense of sleepy competitors in legacy industries (as firms such as Amazon and Expedia benefited from in the 1990s) is much different than trying to do so with evenly-matched competitors.

This casts doubt on the investment case. The long play for all of these companies is winner-take-all: all the chips go to the last player standing. Reuters Breakingviews estimates that the total current market cap of food delivery firms prices in optimistic growth, profitability and value multipliers. Breakingviews goes on to point out that an "... optimistic ending would be one firm knocking out rivals and boosting its pricing power. A more likely one may be that valuations, far from getting hotter and rewarding venture capitalists, grow cold." And what if it isn't a contest worth winning? Groupon won the online coupon competition. It didn't work out too well on a total-return-on-capital basis.

As mentioned above, I've seen this movie before. The Journal article was titled "Mutually Assured Destruction in Silicon Valley." That's apt.

The chattering classes and management consultants advocate for incumbents get into the disruption game themselves. It's certainly good for the pontificators and suits if the incumbents do, because it generates clicks on articles and contracts for services. But doing so asks established firms to enter into very expensive gambles that don't play to any of their strengths, and may offer no payoff whatsoever. Pundits and consultants are very good at spending other people's money - on themselves. Incumbents need to concentrate on their strengths, not their weaknesses.

The incumbent's response to disruption in financial services offers some insights. Clearly, Fintech has had an impact: things like loan origination are far more efficient at banks today than they were just a few years ago. But the disruption storyline in finance is far more muted, in large part because of the way the incumbents responded to it. Incumbent financial services firms didn't try to enter as competitors to the startups, but employed a combination of tactics including infiltration (experienced bankers dominate FinTech boards), co-option (licensing and integrating new technology), and economic might (buying loan books). It should come as no surprise that today, FinTech lenders look more like banks than banks look like FinTech lenders.

Rather than taking a high-risk position well outside of a firm's comfort zone and competencies, patience can be a better strategy. Enter into non-exclusive partnerships and licensing deals and lightly finance the entrants to encourage competition, penetrate their boards to influence their strategy, and alter their book of business to make them economic dependents, all while cleaning up your balance sheet to have more equity and less debt. The incumbent that can do that will have a stronger risk footing when the time is right to strike in changing market dynamics.