October 1, 2020

Better, Cheaper, Faster: Why Companies that Reduce Friction Win | Modest Proposal on Invest Like the Best with Patrick O’Shaughnessy

Check out the Invest Like the Best Podcast Page & Episode Notes

Key Takeaways

• Today’s most successful investors need to be more comfortable with uncertainty
  • While some investors saw uncertainty in new business models, others had a qualitative insight that allowed them to take the risk
• It’s important to be willing to look at investments that look silly
  • Early on, few people understood what Airbnb could have become
  • It’s about having the ability to put all your preconceptions aside and ask “why are all these users here?”
• Step 1 to Building a Big Business
  • Remove friction from a process many consumers deal with every day
• The Scarce Asset in the Digital World is Distribution
  • “Acquiring and maintaining an audience is extraordinarily difficult and expensive” Modest Proposal
• Second-order effects of COVID-19 on E-Commerce
  • Offline retailers who were not investing heavily in online are forced to do so
  • Cost of acquiring customers will increase dramatically
• If you want to understand heterogeneous marketplaces you have to start with eBay
• Modest is interested in businesses that have high demand, but that are still viewed as silly

Books Mentioned

• Modest mentioned 7 Powers: The Foundations of Business Strategy by Hamilton Helmer, as a foundational book of business strategy
• To learn about Heterogenous marketplaces, Modest recommended:
  • The Perfect Store: Inside eBay by Adam Cohen
  • eBoys: The First Inside Account of Venture Capitalists at Work by Randall E. Stross

Intro

• Modest Proposal (@modestproposal1) is the pseudonym of one of the most respected accounts in financial Twitter
• Host: Patrick O’Shaughnessy (@patrick_oshag)
• In this chat, Modest discusses some of the biggest themes in the stock market, his favorite companies, and more advice for investors

Investing is About Underwriting the Future 

• The classic stereotype of the value investor is quantitatively focused on the past
  • This approach worked for a very long time, but not so much in recent times
  • Buffet’s biggest wins came from qualitative insights, while most of his capital was spent on quantitative analysis
• Today, underwriting the future has shown to be more successful and it’s a skill that any investor should have
  • Even within a “value” sector, a company can outperform its competition wildly
  • Quantitative methods are still but qualitative insights make a big difference in these situations
• Business knowledge is essential to underwriting the future
  • Being able to analyze a company’s position within its competitive landscape becomes much more important
  • Modest mentions important “tools” such as
    • Michael Porter‘s work
    • 7 Powers: The Foundations of Business Strategy by Hamilton Helmer
• Today’s most successful investors need to be more comfortable with uncertainty
  • They do a lot of work and learn about the latest, most innovative business models
  • While some investors saw uncertainty in new business models, others had a qualitative insight that allowed them to take the risk

Increasing Returns to Scale

• The idea that big companies can continue to grow without running into diminishing returns
  • Example of Facebook, approaching 3 billion users
• If 20 years ago you internalized this idea you would have wildly outperformed most investors
  • Today every manager has probably read about that idea
    • Still, being able to apply it in novel ways can provide a strong advantage
• It’s important to be willing to look at investments that look silly
  • Early on, few people understood what Airbnb could have become
  • It’s about having the ability to put all your preconceptions aside and ask “why are all these users here?”

Step 1 to Building a Big Business

• Provide a meaningfully better consumer experience
  • Remove friction from a process many consumers deal with every day
  • You’ll see consumer change their behavior to adopt your solution
  • Behavior change is a clear consumer signal that your product adds value
• Uber reduced friction from the process of getting a cab
  • Now Uber and Lyft are worth twice as much as the Taxi industry
    • By removing the friction of finding or calling a cab, they enabled a non-linear change in consumer behavior

iBuyer

• The three biggest disruptions that Modest noted in recent times were Uber, Airpods, and iBuyer
  • iBuyer’s removes friction from buying and selling homes
• Many people tend to scoff when they first hear about iBuyer
  • They see it as just a house flipping service
• You should ask yourself: Are they solving a consumer problem?
  • Buying or selling a home is the largest transaction that most people ever do
  • If you can provide a better way to buy or sell homes, don’t you think that many consumers will be happy to use it?

The Scarce Asset in the Digital World is Distribution

• “Acquiring and maintaining an audience is extraordinarily difficult and expensive” Modest Proposal
  • CAC (Customer Acquisition Cost) is the new rent
• Instacart’s unit economics were not great (losing money on every transaction)
  • As Instacart’s customer base grew to tens of millions, CPG companies had a strong interest to advertise their products
• More and more companies are now leveraging their audience to sell ads

E-Commerce Penetration (during and after COVID)

• Modest’s stance is that E-commerce is a very difficult business
• Due to COVID, many competing channels to E-commerce were shut down, causing huge demand to spill to online channels
• Some behaviors will probably continue in the long term
  • Online grocery is likely to continue to benefit
    • Getting a taste of the convenience of online shopping, many consumers will likely continue to use it
  • Digital fitness will also see a permanent benefit
• Second-order effects
  • Offline retailers who were not investing heavily in online are forced to do so
    • The competitive intensity once the situation normalizes will be very different
  • Gavin Baker mentioned that changes in competitive intensity in tech will create non-linear effects
    • Cost of acquiring customers will increase dramatically

Predicting the Consequences of COVID By Looking at the Supply Side

• Modest likes to use the Capital Cycle Framework
  • This framework focuses on the supply side than the demand side
  • Many people today are mainly concerned with changes in demand
• The restaurant industry
  • Sysco is a huge food distributor, but only owns around 16% of the market
    • There’s a long tail of small food distributors
  • As the industry continues to decline, many small distributors will die leaving a larger share for Sysco
  • Demand will eventually normalize but the supply side will be very different
• In the Retail industry, also the supply side will look very different once the demand normalizes

Homogenous vs. Heterogeneous Products and Services

• Heterogenous Products
  • If you want to understand heterogeneous marketplaces you have to start with eBay
    • Modest recommends reading:
      • The Perfect Store: Inside eBay by Adam Cohen
      • eBoys: The First Inside Account of Venture Capitalists at Work by Randall E. Stross
    • eBay reduced friction dramatically
    • They brought buyers and sellers of heterogenous goods together, globally
    • Plus, they take advantage of network effects
• Homogenous Goods
  • Direct to Consumers sellers of homogenous goods are not generally good businesses
    • They ultimately compete on their brand
    • Homogenous goods are fungible
      • Once you start selling it, the competition will come
• Homogenous Services (e.g. ridesharing)
  • Supply becomes a commodity (you don’t usually care if a Prius or another car picks you up)
  • Take advantage of network effects up to a point
    • Ridesharing’s network matters insofar as it allows users to get a car within less than 5 minutes
    • The network still works for a second player (Lyft, but it becomes difficult for a third one to assert itself
• Heterogenous Services
  • Providing a digital service on a local level across multiple categories
  • Hasn’t really been done successfully
  • “You need frequency to build a marketplace” Modest Proposal
    • Average transactions tend to be small, so without high frequency, you are not able to pay for the costs
    • Cleaning services (i.e. Homejoy and Handy) were not able to scale before running out of money
  • This model hasn’t worked because you have the cold start problem
    • You have to build both sides of the marketplace
  • The solution would be to start with an existing asset that allows you to access the demand side and avoid the cold start problem
    • ANGI Home Services is doing this
      • They have a business called Home Advisor where consumers request the services they are looking for
      • The question is, can they build a product that is so much better than the alternatives and own demand over time?

Businesses that Fascinate Modest

• If Modest had to choose a sector to focus on, it would be communications, marketplaces, and network-effect driven business
  • Even better to invest in unregulated monopoly networks
• Modest is most fascinated by ridesharing companies
  • There used to be many questions about the unit economics of this model
    • Modest’s calculations found that Lyft was earning a margin of about $1 per ride
    • When Lyft went public they were losing $0.20 per ride
  • To this day there is still prejudice against this business model
    • Maybe because the network effect is not as dominant as other marketplaces
• Food delivery is interesting because it’s less proven that ridesharing
• Modest is interested in businesses that have high demand and strong consumer signal but that are still viewed as silly

Case study: IAC/InterActiveCorp

• Modest spent a lot of time analyzing InterActiveCorp
• IAC is Barry Diller’s vehicle to make investments in the digital landscape
  • Since the late 90s, they were very early into online dating, online travel, and online home services
    • In travel, they acquired Expedia, TripAdvisor, Hotels.com,
    • In dating, they bought OkCupid, Match and incubated Tinder
• “They are maniacally talented at taking a product and figuring out ways to bring users to it, in an economically efficient manner and making a lot of money doing it” Modest Proposal
  • They have done it across so many market and so many times, that there seems to be repeatability to it
• They just bought Care.com, a public company that was struggling
  • Modest is extremely optimistic about that
    • With COVID demand for both B2C and B2B health care is going to surge
• “IAC’s has been very good at identifying large, growing end markets, finding assets that are already there and turbo-charging them into leadership positions” Modest Proposal
• Related companies to explore
  • Liberty Media
    • Similar situation to IAC
  • Facebook and Google have aspects of it

Invest Like the Best : investing, popular, tech companies, technology
Notes By Giorgio Parlato