Thursday, April 19, 2012 4 comments ++[ CLICK TO COMMENT ]++

Peter Thiel on What Makes A Great Technology Company & Other Thoughts

(Image source: Vator News)

Some of you may have heard of Peter Thiel; most probably have not.

Peter Thiel is a successful Silicon Valley entrepreneur and venture capitalist, who is famous for being a founder of PayPal and being the first outside investor in Facebook. He is somewhat controversial in that he is a libertarian and is influenced by Austrian Economics and has some extreme views (I actually share a lot of the libertarian views but I'm more of a liberal-libertarian and think that pure-libertarians sometimes forget that humans have a heart). If you find him interesting, you may want read this excellent New Yorker profile by George Packer from November of last year. I don't use this word on too many people but he is a brilliant man who seems quite innovative in his thinking.

Blake Masters has been writing up the notes from a Computer Science course on entrepreneurship being taught by Peter Thiel. The notes were taken by him (@bgmasters) along with some notes by @erikpavia and @danrthompson. Anyone interested in history of technology, entrepreneurship, business, or technology investing, will find it worthwhile to read the lectures (so far four of them and accessible here.)

Like anyone tackling complex topics, not everyone will agree with Peter Thiel—either because of his econopolitical stance or his attempt to simplify complex issues. For instance, Thiel has suggested (in other speeches) that the benefits from the development of the Internet, not to mention tools like Twitter, are over-rated but I disagree with that. Nevertheless, even if one doesn't agree with someone, they can gain great insight from contrary views.

I think Peter Thiel's comments on what makes great technology companies quite insightful to investors and other readers of this blog. I thought I would highlight those comments (from lecture 3). Note that the quoted text is transcribed comments and it may not reflect actual comments by Peter Thiel. Also, do note that Thiel's comments about what makes a company great are from the perspective of an owner or an entrepreneur, and this may or may not be the same as what makes a company great for employees, government, or society.

NOTE: Bolds within quotation are by me, but existing emphasis is underlined and bolded. Furthermore, I am not quoting in sequence!!

(source: "Peter Thiel’s CS183: Startup - Class 3 Notes Essay," Blake Masters blog. April 12, 2012. Content from lecture, "CS183: Startup—Notes Essay—April 9—Value Systems.")

What Makes A Great Technology Company

Peter Thiel comments about technology companies but his comments are just as applicable to any company out there. In fact, you'll see a parallel between what he considers a great company and what value investors such as Warren Buffett (and even amateur investors like Geoff Gannon) have highlighted as being key qualities to look for in companies. It's quite remarkable how the comments by a "growth investor" like Thiel are not that far off what value investors might say. Growth investors pay up for future growth, whereas value investors tend not to, but the core notion of what type of company is highly profitable is quite similar.

So, what separates great companies from the rest?

Great companies do three things. First, they create value. Second, they are lasting or permanent in a meaningful way. Finally, they capture at least some of the value they create.

The first point is straightforward. Companies that don’t create value simply can’t be great. Creating value may not be sufficient for greatness, but it’s hard to see how it’s not at least necessary.

Great companies last. They are durable. They don’t create value and disappear very fast. Consider disk drive companies of the 1980s. They created a lot of value by making new and better drives. But the companies themselves didn’t last; they were all replaced by others. Not sticking around limits both the value you can create and the value you can capture.

Finally—and relatedly—you have to capture much of the value you create in order to be great. ...The airlines certainly create value in that the public is much better off because they exist. And they employ tons of people. But the airlines themselves have never really made any money. Certainly some are better than others. But probably none can be considered a truly great company.
You may notice how the second trait quoted above parallels what value investors look for in companies: durable competitive advantage (aka moat). The other qualities are more obvious; however, it's hard to determine which companies actually have any of these traits. The successful investors are able to separate the companies that satisfy the listed requirements from the rest.

Your goal as an investor should be to find companies that (i) create value, (ii) that is durable and, (iii) can be profitable for the owner.

That's pretty much the main point I wanted to make in this blog post. What follows are some miscellaneous ideas from Thiel that I found interesting.

First-mover Advantage Over-rated

Anyone investing for a while, or who has looked through history, would quickly come to the realization that being the first to enter the market doesn't necessarily mean you will have the highest chance of success. Thiel's thoughts on first-mover advantage is as follows:
People often talk about “first mover advantage.” But focusing on that may be problematic; you might move first and then fade away. The danger there is that you simply aren’t around to succeed, even if you do end up creating value. More important than being the first mover is being the last mover. You have to be durable. In this one particular at least, business is like chess. Grandmaster José Raúl Capablanca put it well: to succeed, “you must study the endgame before everything else.”
Although you do gain an edge by being the first one in the market, you can fail spectacularly. Depending on where you draw the line on 'first,' companies like Yahoo!/Altavista/Lycos (Internet search engines) and Friendster/MySpace (Internet social networking) come to mind. Clearly the last big entrants ended up profitting the most (Google and Facebook in this case).

One additional point—one that value investors pay attention to, and growth investors tend to ignore—is the common occurrence that new industries often result in bubbles when they are initially created. So, on top of the possibility of the first companies not succeeding, there is the bigger problem (for investors) of valuations being sky-high. It is very easy to overpay for newly-created companies in new industries. Growth investors tend to pay up (and often suffer the consequences) but value investors tend to avoid it.

Ever Played the Game, Monopoly?

From a consumer or societal perspective, you want companies to operate in heavily competitive markets. However, as an owner or shareholder, you actually want to own monopolies and oligopolies. There is always a struggle between owners that want to turn their companies into monopolies, and the government/society/customers, who want as much competition as possible.

In the transcribed comments (but not covered here), Peter Thiel goes into why perfect competition is not necessarily the best solution. It's interesting how a libertarian—who tend to be extremely free-market-oriented—makes such an argument. I actually don't agree with the thrust of his argument; I think perfect competition is actually preferable in nearly all cases if you are a consumer. However, my view is that owners will almost always prefer monopolies. So there is a battle between owners and customers/society, and what you observe in business is often the ebb and flow of this battle.

The difference between perfect competition and a monopoly is as follows:
The basic economic ideas of supply and demand are useful in thinking about capturing value. The common insight is that market equilibrium is where supply and demand intersect. When you analyze a business under this framework, you get one of two options: perfect competition or monopoly.

In perfect competition, no firms in an industry make economic profit. If there are profits to be made, firms enter the market and the profits go away. If firms are suffering economic losses, some fold and exit. So you don’t make any money. And it’s not just you; no one makes any money. In perfect competition, the scale on which you’re operating is negligible compared to the scale of the market as a whole. You might be able to affect demand a little bit. But generally you’re a price taker.

But if you’re a monopoly, you own the market. By definition, you’re the only one producing a certain thing.  

Consider great tech companies. Most have one decisive advantage—such as economies of scale or uniquely low production costs—that make them at least monopoly-esque in some important way. A drug company, for instance, might secure patent protection for a certain drug, thus enabling it to charge more than its costs of production. The really valuable businesses are monopoly businesses. They are the last movers who create value that can be sustained over time instead of being eroded away by competitive forces.
To sum up, it is extremely difficult to make "excess" profits under perfect competition. Companies will enter and leave/go-bankrupt such that you barely earn anything above cost of capital. In contrast, if you own a monopoly or an oligopoly, you generally set the price (within reason) and can earn excess profit.

Some of Warren Buffett's most successful investments have been monopoly-like businesses: Coca-Cola (KO) and Washington Post (WPO). You don't necessarily have to dominate the whole market throughout the country or the world (for instance, Washington Post wasn't the #1 newspaper in USA, but was the dominant paper in the Washington, DC and several metropolitan areas.) As Thiel points out below, it may actually be advantageous for you to focus on niche markets that you dominate:
Maybe making the world a smaller place is exactly what you want to do. Maybe you don’t want to work in big markets. Maybe it’s much better to find or make a small market, excel, and own it. And yet, the single business idea that you hear most often is: the bigger the market, the better. That is utterly, totally wrong. The restaurant business is a huge market. It is also not a very good way to make money.

The problem is that when the ocean is really big, it’s hard to know exactly what’s out there. There might be monsters or predators in some parts who you don’t want to run into. You want to steer clear of the parts painted red by all the carnage. But you can’t do that if the ocean is too big to get a handle on. Of course, it is possible to be the best in your class even if your class is big. After all, someone has to be the best. It’s just that the bigger the class, the harder it is to be number one. Well-defined, well-understood markets are simply harder to master.

In other words, it's better to be a big fish in a small pond, than a small fish in a big pond. A good strategy is probably to seek out niche markets that are dominated by a few companies.

The total absolute profits in the big pond may be larger but you won't have market dominance (you don't need to be in a big pond as long as your capital base is small. Once your investible capital grows to a large size, you will be forced to invest in companies that operate in the large pond.)

Ways to Identify Dominant Firms

If the goal is to invest in monopoly-like businesses, how do you identify them? Well, Peter Thiel suggests (in a different context; I'm using it in a slightly different context) how the Department of Justice determines if companies are abusing their monopoly power:

The DOJ has 3 tests for evaluating monopolies and monopoly pricing. First is the Lerner index, which gives a sense of how much market power a particular company has. The index value equals (price – marginal cost) / price. Index values range from 0 (perfect competition) to 1 (monopoly). The intuition that market power matters a lot is right. But in practice the Lerner index tends to be intractable with since you have to know market price and marginal cost schedules. But tech companies know their own information and should certainly pay attention to their Lerner index.

Second is the Herfindahl-Hirschman index. It uses firm and industry size to gauge how much competition exists in an industry. Basically, you sum the squares of the top 50 firms’ market shares. The lower the index value, the more competitive the market. Values below 0.15 indicate a competitive market. Values from 0.15 to .25 indicate a concentrated market. Values higher than 0.25 indicate a highly concentrated and possibly monopolistic market.

Finally, there is the m-firm concentration ratio. You take either the 4 or 8 largest firms in an industry and sum their market shares. If together they comprise more than 70% of the market, then that market is concentrated.
The three tests seem intuitive (although I don't know the real theory behind them). DOJ uses the tests to weed out abusers but we, as investors, can use it to identify dominant firms. The goal is to get a feel for the industry and see if potential investment opportunities can earn "excess" profits.

Growth Investors vs Value Investors

As Warren Buffett has remarked, "value investing and growth investing is joined at the hip." That is, it is the same thing—two sides of the same coin. You want to purchase a company at value-like prices with growth-like attributes.

Yet, I, like many others in the investing community, like to separate out the two. I think the thinking behind the two styles are quite different and the way Peter Thiel thinks illustrates the divergence.
Thiel briefly comments on how value investors, who tend to favour "old economy" companies, think about valuation:
Valuations for Old Economy firms work differently. In businesses in decline, most of the value is in the near term. Value investors look at cash flows. If a company can maintain present cash flows for 5 or 6 years, it’s a good investment. Investors then just hope that those cash flows—and thus the company’s value—don’t decrease faster than they anticipate.
Some may say the view expressed above is not 100% perfect but I do think it sort of gets at the essence of value investing. Namely, value investors tend to buy established, and possibly declining, businesses, and focus on low valuations and cash flows.

Growth investors, who tend to purchase fast-growing businesses, look at things a bit differently. Again, not all growth investors will agree with the approach shared by Thiel but I do think it approximates how growth investors think about things. Value investors who always wonder why growth investors bid up money-losing businesses with no history to seemingly-ridiculous valuations will find the following passages quite interesting.
Tech and other high growth companies are different. At first, most of them lose money. When the growth rate—g, in our calculations above [not shown]—is higher than the discount rate r, a lot of the value in tech businesses exists pretty far in the future. Indeed, a typical model could see 2/3 of the value being created in years 10 through 15. This is counterintuitive. Most people—even people working in startups today—think in Old Economy mode where you have to create value right off the bat. The focus, particularly in companies with exploding growth, is on next months, quarters, or, less frequently, years. That is too short a timeline. Old Economy mode works in the Old Economy. It does not work for thinking about tech and high growth businesses. Yet startup culture today pointedly ignores, and even resists, 10-15 year thinking.
I don't think like Peter Thiel and I am generally not interested in early-stage, high-growth, companies. His comments are really more applicable to startups and early-stage companies. Yet, it is interesting to see how growth investors justify their valuation. Essentially, growth investors think about 10+ years into the future.

The vast majority of the value created by high-growth companies are far into the future. In contrast, the value created by many investments favoured by value investors—slower growth, established, businesses—occurs in the nearer-term.

The following example with LinkedIn (LNKD), which a lot of value investors and non-value investors are bearish on, is quite illustrative of the growth-investor thinking. Most people think LinkedIn is wildly overvalued but Peter Thiel suggests that the valuation makes sense if you think its long-term future earnings are sustainable.
LinkedIn is another good example of the importance of the long-term. Its market cap is currently around around $10B and it’s trading at a (very high) P/E of about 850. But discounted cash flow analysis makes [sic][of] LinkedIn’s valuation make sense; it’s expected to create around $2B in value between 2012 and 2019, while the other $8B reflects expectations about 2020 and beyond. LinkedIn’s valuation, in other words, only makes sense if there’s durability, i.e. if it’s around to create all that value in the decades to come.
So there you have it! Now you can see the rationale for why investors invest in companies with P/Es of 850. Earnings are expected to grow rapidly for a long time. In fact, most of the wealth will be created 15+ years from now, whereas many value-investing-type investments don't generate much wealth beyond 15 or 20 years.

Of course, all this is assuming, as Thiel points out, that the company's market position is durable and set to last.

The biggest mistake made by growth investors is assuming the competitive strength and profitability is durable, when in fact it turns out not to be. If you get the durable—essentially the moat—call correct, you'll make a fortune. If you don't, you will lose a fortune, often very quickly.

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4 Response to Peter Thiel on What Makes A Great Technology Company & Other Thoughts

April 19, 2012 at 1:17 AM

This is a *really good* article because I've been waiting to hear about a VC with solid value grounding. I think value investing can be performed anywhere - in pharmaceutical research investments, in startup investments, or even in companies that are very matured and seen more commonly in the value-investment circles.

The longer the time horizon for things to come to fruition, the tougher I think it is to make these investments, but I think it is possible, especially for someone with a deeper understanding of how the business works. At some point, based on all historical valuation metrics, companies like Google/LinkedIn/etc. will all (or have) looked very expensive. As they mature and their cash flows are actually created, they may turn out to be cheap at current prices. This is why Google IPO'ed with a very high historical set of multiples, but soon the earnings grew and the stock price would multiply by 6.

Growth/value investing, IMO, are all the same game and not that different at the fundamental level.

I really like Thiel's investment strategy because he doesn't seem to be focusing only on what the market will accept an IPO for in 3-4 years, but rather on the business value that will result when you look out 20 years from now. Pretty impressive stuff - thanks for sharing this.

April 22, 2012 at 1:25 PM

Sorry about not responding to this sooner. I saw your message and meant to post a response but forgot about it.

You are absolutely right in that Peter Thiel seems like a venture capitalist with an approach that somewhat mirrors some value investing principles. A lot of VCs appear to be short-term-oriented and are mostly concerned with getting a company off the ground and then exiting it; but Thiel seems to focus on the long-term.

I still find it a bit weird that a libertarian promotes the virtues of a monopoly. I actually think monopolies are generally bad for societies, but it is good for investors. Investors want to create and own monopolies--Thiel's point--but I believe society is generally better off without them.

Thiel, unlike most amateur growth investors, also seems to have a good grasp of the notion of a moat and how it needs to be sustainable. A lot of growth investors have a good "story" but often can't say why that story will last beyond 5 years.

April 22, 2012 at 11:28 PM

I think arguments can be made in either direction - against monopolies, or for them.

My personal distinction, so far, is that between having a monopoly and conducting monopolistic actions. Having a monopoly could be as simple as opening a sandwich shop close to people's homes. If the market of those homes can only support the sale of 70 sandwiches per day, and you need to sell 65 sandwiches in order to make an economic profit, then the market can only support 1 shop. If 2 shops open, you need to sell 130 sandwiches per day (65 x 2), but the market only has demand for 70. In that scenario, 1 will eventually go out of business and we are left with 1.

That is my definition of a "monopoly" - they have a niche that they are better at than everyone else. Let's say that there is suddenly a market for sandwiches that cost $50 each versus the $5 subway sandwich, but there are only 10 people who want those per day. Now, a second sandwich shop can open and they can cater to the high-class sandwich consumers. If they ever try to sell to the people who want $5 sandwiches, by stocking cheaper ingredients, they will alienate their $50 customers, because they come for a high-class atmosphere. Likewise, if the $5 sandwich shop starts to sell $50 sandwiches, they may alienate their $5 sandwich customers because they may not feel at ease in such a high-class place.

Essentially, both sandwich shops have a monopoly, because they're very much niched. Maybe monopoly isn't the best word here, but should instead be worded as a well defined "niche?"

April 23, 2012 at 10:59 PM

I think what you are referring to is more of a niche market with temporary dominance by one player but I see how it can be construed as a monopoly. To me, monopoly implies a captive customer with possibly a strong barrier to entry.

Although a sandwich shop that serves just enough to max out demand may monopolize the local market, I suspect it has no barrier to entry, and the customer doesn't appear to be captive. Even though only one sandwich shop can exist (in your scenario), there is no guarantee that the existing one is the one that will survive.

Having said that, your thinking has some strong reasoning because if you look at newspapers (when they were dominant), they were oligopolies within their local city/town but not if you look at it across the country.

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