The world has been fundamentally changed by digital networks and software. Businesses and customers which are connected by networked digital systems create amplified network effects which means the velocity of business and the level of competition and innovation are higher than they ever been ever been. To survive in this new environment every business, from the largest enterprises to the smallest sole proprietor, must accelerate and fundamentally change their customer development processes. Increasing the ability of a business to adapt to a changing world has never been more important. Virtually every niche in the business world is being constantly explored by challengers using a lean customer development process which I wrote about in my previous post. This constant experimentation by entrepreneurs makes profit harder than ever to sustain, especially if its source was traditionally information asymmetry (i.e., the buyer knew more about something than the customer). Unless a business has a moat based on something like network effects, there is nowhere to hide from the constant onslaught of competition.
Even if a business is fortunate enough to have a moat based on network effects, the life of a business can still be nasty, brutish and short. In other words, since network effects are brittle and work in both directions, a moat can be torn down just as fast or faster than the time it took to create it in the first place. Steven Sinofsky wrote a great Tweet on this point the day before yesterday: “It isn’t enough to build a better mousetrap. Your mousetrap must connect to all the other mousetraps and improve as mice evolve.” Steven is saying that it is not enough to write great software any more or create a great device. Network and network effects matter more than ever.
Once producers and customers are connected via digital networks and telemetry like usage data is being shared it is possible to use the lean start up process to find product/market fit in ways that are more effective, faster and cheaper than ever before. Experiments can be conducted at speeds that were never before possible. Intensifying the process further is that fact that competition can come from anywhere on the globe. I wrote in my post on Naval Ravikant:
“The cost of starting a company has collapsed.” “As the cost of running a startup experiment is coming down, more experiments are being run.”“Three years ago, companies could for the first time get all the way through a prototype of a service before they even raised seed money. Two years ago, they could make it through launch before raising money. Now, they can start to get traction with a user base by the time they come looking for seed money.” A capitalist economy is an evolutionary system. Innovation and best practices are discovered by the experimentation of entrepreneurs who try to establish the evolutionary fitness of their business. Products and services created as part of this experimentation which have greater fitness survive and other less fit products and services die. Entrepreneurs are essentially running experiments in this evolutionary system when they create or alter a business.
“Success rates are definitely coming down but that is because the cost of running a startup experiment is coming down…so more experiments are being run. In the old days, we would have one company spend $10 million to figure out if it has a market. Today, maybe that same company could do it under $1-2 million. The capital, as a whole, may make the same or better returns, but yeah, if the failures don’t cost a half of what they used to, you are actually saving money, it is a more efficient market.” More experiments inevitably means more failures on an absolute basis. In addition, as the rate of business experimentation rises there will inevitably be an increase in the number of poseurs trying to create new businesses and that will increase failure rates. A lower overall success rate caused by an increase in the number of experiments is a positive trade off overall since society benefits from the increased level of innovation. This net benefit for society is created even though most experiments fail. What the collapse of the cost of running business experiments has done is radically increased the pace of the discovery process that creates innovation.
Any business that does not have connected customers who are sharing telemetry and a modern agile customer development process is bringing a pickle to a gunfight where the competitors have machine guns. Do products get created that do not use the lean process? Sure. That has always been the case. That vast majority fail and a few are a spectacular success creating a distribution that looks like a power law, but that is a topic for another post.
When I worked for Craig McCaw we would meet with various CEOs on a regular basis. It was interesting to see how different styles and approaches impacted business outcomes. One particularly memorable set of meetings we had involved a CEO who represented the third generation of his family to run a major public company which his grandfather started. When we met with him he was nearly always focused on macroeconomic issues like Federal Reserve interest rate policy and forecasts about the economy. Talking about these macro issues seemed to make him feel better. He never seemed to know much about his actual business. Over the years that business has declined to a point where all that is left today is the brand. It is a tragic story that negatively impacted not only him and his family, but tens of thousands of people. Of course, startup founders can fail for essentially the same reason at this CEO when they spend too much time on macro, attending industry conferences and shows and posing for photo shoots.
The CEO I am referring to attended one of the most well-known business schools in the world where he was taught that the systems his company had to deal with could be explained by concepts borrowed from physics like “equilibrium.” This was both unfortunate and fatal since the reality is that a capitalist economy is an evolutionary system and the best metaphor for how it works is biology rather than physics. Charlie Munger agrees: “I find it quite useful to think of a free-market economy – or partly free market economy – as sort of the equivalent of an ecosystem.” Unfortunately for people like this CEO there is no formula that will tell someone like him what to do. People who claim to have such a formulas are never right more than once in a row. The good news is that there are processes which can be followed that will greatly increase the probability of success. One process that killed the huge business was customer development. The pace at which new products were developed at his company was so ponderous and expensive that they were unable to react with sufficient speed when customer demand changed.
Fifty years ago this CEO would not have found himself in so much trouble so quickly. There has always been change in the business world and competition is not a new phenomenon in business. This was true during Georges Doriot’s heyday of the 1950s and 1960s, when he famously said “Someone, somewhere is making a product that will make your product obsolete” competition was significant. The competition Doriot describes is central to what Joseph Schumpeter called “creative destruction.” Schumpeter believed: “The process of industrial mutation—if I may use that biological term— incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” What is new about business today is that the many systems that make up businesses, markets and an economies are part of globally connected digital networks. When systems get connected via digital networks, feedback effects become stronger. When feedback effects get stronger, outcomes become more uncertain and nonlinear. This name Nassim Taleb gives to this phenomenon is Extremistan. Taleb advises that in such an environment:
“Be prepared for the fact that the next large surprise, technological or historical, will not resemble what you have in mind (big surprises are what some people call ‘unknown unknowns’). In other words, learn to be abstract, and think in second order effects rather than being anecdotal – which I show to be against human nature. And crucially, rare events in Extremistan are more consequential by their very nature: the once-every-hundred-year flood is more damaging than the 10 year one, and less frequent.”
Capitalism has always been an unforgiving system. Capitalism without failure is like religion without hell, it doesn’t work. There is something important and new happening with respect to the level of failure: digital systems that are connected via networks have turned the level of competition and innovation in the business world “up to 11.”
People are not unaware of this competition levels have been turned up to 11 phenomenon, which means they are starting fewer new business. I am not talking about venture capital backed businesses which are a tiny percentage of new business starts each year. In 2016 there we only 800 new businesses that received a series A financing round from a venture capital firms in the United States. What I am talking about is small businesses that are bootstrapped or rely on bank financing:
This competition levels turned up to 11 phenomenon is perhaps most easily explained by another example. Mike Lazaridis was working out at home on his treadmill in 2007 when he first saw an iPhone on a television. Lazaridis is a co-founder of a business which at that time was selling millions of BlackBerry phones and secure network services to many of the world’s most famous people, including the President of the United States. The phone his business sold was nicknamed the CrackBerry since it was so addictive. The future of the business seemed as secure as its network. It was not simply possible for Lazaridis to have fully realized the extent to which Apple’s iPhone was about to radically diminish the fortunes of the fabulously successful business he had created. The Globe and Mail newspaper describes what happened:
“That summer, he pried [an iPhone] open to look inside and was shocked. It was like Apple had stuffed a Mac computer into a cellphone. The iPhone broke all the rules. The operating system alone took up 700 megabytes of memory, and the device used two processors. The entire BlackBerry ran on one processor and used 32 MB. Unlike the BlackBerry, the iPhone had a fully Internet-capable browser. That meant it would strain the networks of wireless companies like AT&T, something those carriers hadn’t previously allowed. RIM by contrast used a rudimentary browser that limited data usage. Mr. Lazaridis recalled ‘It’s going to collapse the network.’ And in fact, sometime later it did. “If that thing catches on, we’re competing with a Mac, not a Nokia,” he recalled telling his staff.”
The iPhone, of course, would go on to be an industry and global phenomenon, pummeling the fortunes of BlackBerry and other businesses, reshaping several industries and changing the global economy. BlackBerry was not just competing with “a Mac in a phone” but an entirely new hardware, software and services ecosystem unlike anything the world had ever seen before.
This is a chart of the Blackberry stock price beginning about the time I started using their pager for the first time in 1999.
Another chart tells the story of how quickly the business changed:
What happened to BlackBerry can now happen to any business at any time. NYU Professor Aswath Damodaran points out: “We can no longer assume that competitive advantage will last a century as it used to for the old and mature companies. Instead competitive advantage for tech companies comes with a life span that continues to shorten. What this means is that you’ll climb faster as a business but fall faster too – Blackberry being a classic example.”
You are not employed by or invested in a tech business you say? Every business is now a tech business. There is no escape from Extremistan. Let’s be clear about the point I am making here: I am saying that my generation rode a bike downhill to school both ways over a very short distance in balmy weather conditions and that young entrepreneurs today walk uphill both ways to school in the snow. Business is more competitive today than it ever has been. Thirty years ago my grandfather was a property developer who went to a club for lunch on most days where he played cards and had a cocktail. My friend’s dad was a stock broker who was playing tennis every day by 3:30 (on the West coast). There’s none of that any more that I can see. I would not want to go back to that time for any reason, but the competitive slack that existed in the system is gone. As another example of increased competition, I saw a woman in the grocery store last night “show rooming” containers of pre-washed lettuce on her phone (she was as an individual shopper comparing supermarket lettuce prices on a hand held supercomputer connected to the internet). That show rooming represents new competitive pressure which impacts the profitability of every product and service, from wealth management to services to retail of all kinds. Show rooming on mobile phones is great for consumers and is not going away! But for producers it adds to the competitive pressure they encounter every day.
Michael Mauboussin describes why the creative destruction process is inevitable: “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital.” Charlie Munger has said the same thing as Buffett many times, including this statement: “Over the very long-term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best. Capitalism is a pretty brutal place.” Warren Buffett recently said during an interview at Columbia University: “The first question I ask myself when I look at a business, is it important and easy. And a lot of [businesses] don’t make it. I’m looking for the one-foot bars to step over versus the eight-foot bars to jump over.”
When it comes to moats, durability matters. Some moats atrophy gradually over time and some much more quickly. This is not a completely new phenomenon. As Ernest Hemingway once said in his book The Sun Also Rises, a business can go bankrupt in two ways: gradually and then suddenly. The speed of moat destruction has greatly accelerated over time due to advances in technology and the way it spreads information. For some people this increase in speed can at times be disorienting. For example, the speed at which a company like Blackberry lost its moat was shocking to many investors and employees. This disorientation is having many second and third order effects like heightened political discord. People in many cases are terrified about losing their jobs. Angry, scared and confused people can do unexpected things.
How long a moat lasts in a business is called a “Competitive Advantage Period” (CAP) writes Michael Mauboussin. The speed of moat dissipation will be different in each case and need not be constant. The rate at which a moat atrophies is similar to what academics call “fade” argues Mauboussin. Even the very best companies can see competition make their moats shrink or even disappear. Munger has said: “Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’ Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out what could cause those results to stop occurring.”
That moats are hard to create and inevitably deteriorate over time is one very important reason why capitalism works. What happens over time is so-called “producer surplus” is transferred into “consumer surplus.” What I am saying in this post is that I suspect that the average “competitive advantage period” (CAP) of a business is shrinking. There is some supporting data such as a study which concludes: “over time competitive advantage has become significantly harder to sustain …seen across a broad range of industries.”
To illustrate the points I have made in this post with an example, if a business person opens a successful restaurant that success will inevitably attract imitators and competitors. Some of these restaurants will adapt and survive and thrive and others will fail. Charlie Munger describes the process: “The major success of capitalism is its ability to drench business owners in feedback and allocate talent efficiently. If you have an area with 20 restaurants, and suddenly 18 are out of business, the remaining two are in good, capable hands. Business owners are constantly being reminded of benefits and punishments. That’s psychology explaining economics.” The consumer wins because the products and services offered to them get better and better over time. What happens over time is what economists call “producer surplus” is transformed into “consumer surplus.” Producer surplus is lower since competition has been turned up to 11 and this makes GDP growth look anemic, but competition and innovation are anything but anemic. In Extremistan, producer surplus becomes consumer surplus faster. For a business this is problematic since producer surplus is what delivers the profits that makes the process called capitalism work.