The S&P Paradox

Despite all the complex options available, one of the most effective investment strategies has been to simply play the S&P index.  I readily complied with success without giving much thought to the underlying paradox that was always in the back of my mind.  Large companies are riddled with inefficiency, myopia, and an overall lack of agility; so it seems counterintuintive to bet on them.  I never quite understood why S&P returns were higher than others because in my mind bigger is not always better.

For one scale matters.  In the past, large capital expenditures were required for entry into top industries like automotive, real estate and oil and gas.  Even today, most markets still tip to the big players.  In healthcare, it is required to extract better rates from payers.  In distribution, size helps gain operating leverage over fixed costs.  In retail, the likes of Amazon and Walmart use it to squeeze unmatched purchasing savings from suppliers.  Large companies use its power to build barriers that make it difficult for smaller companies to compete with them.   Warren Buffett calls it a "moat".

The numbers don't lie.  Over the past 50 years, the S&P 500 has gained 10% a year on a compounded basis compared with 3% for the US GDP over that same period.  Despite what people say about small companies being the "growth engine" and "lifeblood" of the country, large companies have grown more than three times faster than the overall economy over a long period of time.  Further, valuations of the S&P have historically been around 15 times earnings (with a current P/E closer to 20), which is at least twice as much as private companies.  Simply put, larger enterprises are valued more than smaller ones.

But isn't this counter to those in the inside of a large company know to be true?  Meetings to discuss meetings.  Consultants to develop ten year strategic plans.  Steering committees to make even the smallest decisions.  Meanwhile, nimble entrepreneurs come up with new products and services, focus on customer service, and find new approaches to enter established markets.  At some point, diminishing returns come into play as companies grow.  And it today's market, that size is getting smaller and smaller.

"Moats" are harder and harder to keep thanks to rapidly deployed technology and more open markets.  Uber and AirBnB, for example, are scaring some of the most powerful oligarchies in the world.  Further, some of the tailwinds that have been fueling S&P companies such as global gains and consolidation are in the rear view mirror.  For years, successful private equity firms have yielded superior returns in the small company space; perhaps there will be a more broader movement towards entrepreneurial companies.  It is very interesting and hopeful to think about; but no question it will be hard to fight a trend that has withstood the test of time.

Will local come back ?

Is the age of the local services company over? Outsourced call centers, online help tickets and IVRs have been around for decades, but the progression towards centralized support has now moved into the once untouched neighborhood service provider. Rapid consolidation and the introduction of technology into fragmented service industries have brought about some positive changes, but has the pendulum swung too far the other way? Or is Joe the Plumber on his way out?

To be sure, many of the local businesses you normally frequent are consolidating at a fast clip. Local auto repair concerns like Service King, for example, have been recently purchased by PE firms with large expansion plans. The last three pest control companies that serviced my house have all scooped up by Terminex, a subsidiary of publicly traded Servicemaster. Even the local medical providers and lawn care concerns have become targets of consolidators. All of these companies employ similar playbooks: cut costs, centralize functions, and grow a small menu of highly controlled services into new locations. In many instances, even if customers want more beyond the 800 number, there are very few options on the table.

Walmart and Amazon has trained us to think that only price matters. Big business wins when we as a society expect no frills, price matching, and a ubquitious customer experience. I think this is helpful for some things, but not all of it. Today’s airline experience is very uniform - it sucks. Online shopping has gained mass adoption in commodity items, but still only represents 8% of total retail purchases. People still stop at local stores and want customized solutions and local touch points.  There is probably a finite saturation point.

Many of the big entrants try to delicately balance the best of both worlds. Whole Foods has done a good job of localizing their stores to cater to its serving area. Nordstroms and Best Buy have been successful at an omni-channel solution brings both the power of scale and good customer service. But local players are responding using similar playbooks as evidenced by the emergence of multi-location local restaurants and retailers.

But the current trend is real.  A recent study conducted by HBS highlights, for the first time, the diverging performance of small business compared with its larger peers in the most recent economic turnaround. Simply put, big business is taking market share and jobs away from small business. However, I think there are cyclical trends at play here and pockets of the small business sandbox that wont't get "rationalized." As I like to say, Dallas has cheaper food at the chains, but I don’t mind paying extra for the PHD wait staff at Shady Grove.

The Bankruptcy Boon

The US bankruptcy process is amazing. When a large mismanaged company goes under, it is a boon for many parties. Consultants and attorneys bill four figures an hour, opportunistic investors prey on the carcass, all in the vein of cashing in on a distressed situation. Despite all the excess, however, the process does work in many instances. The high priced consultants are often able to make the structural changes required to create a sustainable business. Is it the process in play, or should we hire these experts on the front end in the business building game? More importantly, while it may work on the large business side, why isn’t there a similar process for small business?

The GM bankruptcy is a classic example. They needed over $30B in debtor financing just to navigate through the process. Like most in similar situations, they hired high priced advisors to lead them through the intricacies of the bankruptcy code (including a $16M a month contract to a single firm). I never understood why maneuvering through the process is so complex, but it is extremely lucrative for the few that are versed in it. As the city of Detroit was paying lawyers millions of dollars a month during its bankruptcy, their citizens would wait more than 30 minutes in response to a 911 emergency call due to lack of funding. Is there really no other way?

Sure it is easy to fault the winners in the process; but there is something to be said for how often the trustees are able to turn these companies around so quickly. Generally speaking, there are large fundamental issues that need to be resolved in a short time window. These turnaround specialists cut costs, prioritize payments, cut deals with debtors, and divest assets in such a manner that oftentimes entities thrive post-bankruptcy. Certainly leveraging the benefits of the process helps (ie. cramming down creditors), but there have been some impressive successes. Most of the airlines, for example, have all gone through the process; now just this week they announced record profits and huge stock buybacks. Six Flags, Trump, and many other household names are also in this group.

And what do small companies do that can’t afford $1000 lawyers? The law of small numbers works against them as they don’t have access to bankruptcy financing or experts to navigate through the process. When a small entrepreneur over-leverages the company, he or she loses all personal assets. When private equity pays too much for TXU Energy, they get most of their money back. Small companies generally don’t get a second chance like the big boys do and are usually forced to liquidate. It’s a complicated process for small business owners and creditors aren't as willing to work with entrepreneurs as they are in bigger deals.

So perhaps there is an opportunity for the experts to move downstream into the SMB market. Or maybe small business owners should look to take a page out of the GM bankruptcy playbook. It would seem reasonable that at least in the instances in which struggling entrepreneurs could be helped, they should. One idea is an SBA loan restructuring program for those that are behind; perhaps banks can have more flexibility to convert the loans to equity or higher interest loans. There could also be programs to incent creditors to give businesses some more time. While bankruptcy is never good situation to be in, it would be great to afford small businesses similar support that big businesses have during this dire time.

The Disruption of the Disruptors

I am like no other pundit waiting for the shoe to drop. Like the late 1990s. For yet another cloud storage company to shelf its IPO (sorry Box). Frothy valuations based on solely on a disruptive story are already becoming harder to come by. I wonder what will happen to the struggling ones that have already raised cash under lofty expectations; how will they handle the fallout? Now that a fresh batch of funding is no longer in the cards (at least not at current valuations), how will the newly minted blue chips change themselves amidst new market conditions?

I was the first to surprised to read that Square might be on the block due to cash flow issues. Mobile commerce has already hit mainstream and certainly the leader in the payments space should be minting money like its predecessor Paypal, right? But Square is struggling. They lost $100M in 2013 and faces a business model that doesn't scale well to profit (~20% gross margins after processing fees). Paypal was not forced to sell to Ebay in the 2000's, but does Square need a lifeline? No question it can raise fresh money if it has to, but probably not at the clip its existing investors would seek. As a standalone concern, it will likely face layoffs, cash conservation, and significant pressure towards monetization. These are not concepts that are in the Jack Dorsey DNA.

Reinvention is nothing new for tech firms of the past, but it will require a significant mindshift for the next generation of startups. IBM has gone through many periods of peaks and troughs and transformation throughout its long history. Amazon has experienced the same. However these companies had a culture of top grazing and restructuring. For the foosball playing startups with lofty aspirations, making money was never on top of the list. The last time around, the playbook was to hire MBA’s and black belts to “babysit” the business-lite founders. Does that logic still apply? I'm a bit skeptical in any approach that jeapordizes the culture of a promising startup, but perhaps a fresh mix of skill sets can bring new approaches to the problems. Maybe rightsizing will be modernized into a cool buzzword like "uncrowding" that the newbies can huddle around.

To be sure, Snapchat is no eToys. The companies of today are generally in a much better position than the late 1990s. Companies like Twitter have large cash warchests to buffer downturns. There are more fundamentals and less extraneous cash backing today's startups than two decades ago (remember price to eyeballs?). But the shakeout will be swift and painful. Once hot SaaS companies like Bazaarvoice and Fireeye, for example, have seen their valuations drop by more than half and face employee exodus and liquidity concerns shortly after their IPOs.

Lofty expectations have an ugly downside. As the second internet bull run comes to an end, the high flying startups that sought out to change the world will have to start with themselves. As external financing slows, these companies will have to become profitable and change their business models in order to keep their independence (with the exception of the fortunate Google and Apple acqui-hires). Cash flow forecasts and customer acquisition will take precedence over iterative coding and disruptive mentalities. This hard reality is not only necessary for saving face or generating returns for investors, but also for survival in itself. Expect the early signs of consolidation, bankruptcies, and growing impatience from their backers to continue. But then again, aren't we just getting started with virtual reality and 3D printing?

A New Perspective on Net Neutrality

Net neutrality seems to have lost its momentum. Little by little (as evidenced by the latest federal court ruling), the reality of an unfiltered internet seems more and more remote. Once thought of as a sacrosanct protection from traffic prioritization by internet providers, the practicality of a usage based pricing model seems no longer out of the question. On the one hand, we shouldn’t give infrastructure incumbents free reign to charge whatever they want for internet traffic, but we can’t also expect the Napsters of the world to get a free pass given the network buildout costs. Despite the pendulum shift, it’s still a controversial and important issue; after 20 years of debate, where should society end up on net neutrality?

In the early days of broadband, pro-net neutrality was an easy position to have (see my perspective from four years ago). During those times, options such as DSL relied heavily on existing copper wire infrastructure to provide internet access. These legacy networks were owned by a single entity in each market (the Ma bell spinouts) and it was precisely because the government mandated that incumbents grant access to competitors is why early adoption flourished. A bustling industry of CLECs, ISP's and others that leased lines brought innovation to century old networks. As a result, email, AOL, and the web was brought to the masses. Internet based startups such as Google came to prominence. But more importantly, it permanently changed the way we live.

The world has significantly changed since the dial up days. The copper infrastructure was insufficient. Despite billions of investment into equipment and fiber cables to build the next generation of networks, supply cannot keep up with consumer demand. Distrubuted content is the new normal as a streamed Netflix video is as common as checking email. The strains on internet networks are real. Why shouldn’t infrastructure companies like AT&T and Comcast be able to charge more for increased usage? It also seems to make sense for bandwidth-intensive content companies that demand more of them to bear some of the burden. Further, our current fixed price arrangement in which all consumers pay the same inherently charges everyone equally rather than specifically to those that use more bandwidth. And perhaps by allowing content providers to subsidize some of the network costs (like in television), consumers might even see better rates. If providers were able to better match revenue to actual costs, we may benefit from a more efficient pricing scheme.

The problem is that the internet toll takers are the same companies that are the gatekeepers to the internet. And much like the older days, there isn’t much competition at a local level. A typical consumer may still only have one or two choices of providers at their home or business. Not only that, the bad actors that we knew from the monopoly days are the same ones that are making the investments and gating the entrance onto the superhighway. Should we trust AT&T and Comcast to do the right thing? Given history, it's a hard pill to swallow. And on the other side, content providers are starting to get bigger as well. As evidenced this week by Netflix's access deal with Comcast, well capitalized content companies can afford to "pay to play". Google, Facebook, and the like, despite their net neutrality advocacy (which seems to have subsided throughout the years), can afford to make sure their needs are met. But what about the next round of startups, how will they fare? Who will make sure those without deep pockets have fair access to consumers?

Are there lessons to be learned from the AOL days? Perhaps a middle ground solution could force the current infrastructure players to lease access to their networks much like the ILECs did. What if the likes of AT&T and Comcast could begin to charge content providers but in return were mandated to lease a portion of their networks to competitive access providers? New competition could bring new models and innovation much like the CLECs of the past. Perhaps AT&T could realize a utility type return on this leasing arrangement while at the same time promoting choice. This is probably an oversimplification of the issue, but this type of solution would not only keep the network companies' power at bay, but also help them monetize their networks better.

As an early net neutrality supporter, it would be hard for me to say that the incumbent telco and cable providers should have an unencumbered right to filter traffic, charge discriminately, and leverage their unique market position. We’ve seen that movie before. On the other hand, free market and changing times should also be factored into the equation. As we lean on the private sector to lay down the cash to buildout networks, we can’t expect them to work solely on altruistic motives. It also still remains to be seen how new technologies and innovations can change the paradigm; Google is building fiber networks, mobile infrastructure is becoming more prevalent, and even satellite talk is back. Consumers deserve unfettered access to any content they want. But as I have wrote throughout the years, the days of free are over. We all have to bite the bullet at some point.

The Real Reason Big Businesses Fail

Inspired by holiday reading, i've decided to address a complex issue in a relatively short script (in the vein of Malcom Gladwell's latest opus). For leaders at large conglomerates, the risk of failure should turn heads. Only one of the original 12 Dow members still remain as does only a handful of the initial Dow 30 from 1928. And these were the best of the best. While there have been numerous explanations ranging from poor management execution to the Innovator's dilemma to explain this phenomenon, there is one simple commonality amongst all the companies gone bad. They stopped selling stuff that people wanted.

Blockbuster missed on mail order. Yahoo missed search. The list goes on across industries around the globe. These companies were acting complacently as new competitors were ramping up. But even had the incumbents acted flawlessly, they probably wouldn't have succeeded. Sure Yahoo had a chance to buy Google early on; but it was so focused on advertising that the company missed the fact that search mattered more. Someone with that insight would probably have outseated them anyway. There have been countless case studies on Blockbuster's miscues, but the bottom line was that its bricks and mortar offering failed to meet new customer demands. Its' half baked home DVD offering was too little too late compared with Netflix's execution. When a company is generating signficant cash, it is difficult for them to have enough foresight to recognize their offerings will soon become outdated.

Sometimes overall shifts in consumer demand dooms companies. Coke and Phillip Morris have a real problem as overall consumption of their products continue to slide. Price increases and international expansion can only mask this reality for so long. Incumbents also often miss subtelties of the markets they dominate. In the early 1990s, Walmart took a huge cut of the grocery market as its competitors relied on a loss leader strategy that consumers ultimately shunned. Today, Tesla is on the brink of taking material share from its rivals who have sat on high fuel efficiency technology for years. They didn't think people wanted it.

Large companies that use its position of power to stimulate market demand are the ones that succeed in the long-run. People did not know what they wanted out of portable stereos or smartphones until Apple educated them. IBM's customer-centric approach has helped it seemlessly moved from hardware, software to services (and also remain on the Dow from the original 30). IBM is spending a significant effort today teaching its customers how to implement Watson-based big data analytics to drive their businesses forward (albeit with only modest success so far). Facebook is doing a similar thing for clients who are new to social advertising.

The numerous texts designed to help corporations build their organizations are helpful playbooks. However, the fundamental problem that companies face as they grow is that they shift focus inwardly instead of on its customers. Things like stock price, hiearchy, and motivation saddle companies and mask the importance of the one thing that matters most. If companies simply keep up with consumer demand, everything else usually will fall into place. Successful new entrants are often singularly focused on what customers really want. With business cycles increasingly shortening, market share shifts are occuring more frequently and more rapidly. Successful organizations that fail often do so by not keeping up with consumers' tastes as internal deficiencies are usually symptomatic of them missing this critical point.

Should we Crowdfund?

Angel List is one of the hottest capital sources around today. The benefits of crowdfunding sites like it are many - they offer a wide number of startups access to funds, gives small investors opportunities previously not available to them, and adds transparancy throughout the process. I am one of the biggest proponents of democratizing closed networks (Venture Capital is certainly on the list), but I can't help but wonder if the timing of the JOBS act could not be worse. Loosening regulations in a time of frothy valuations, high risk, and oversupply of undeployed capital reminds me of the Clinton-era push to make home financing more widely available. Will crowdfunding leave common investors in financial straits like those that were affected by the housing bust?

For one, early stage investing is hard. Even the experts get it wrong. According to some recent articles I read from Fortune's Dan Primack, almost 2/3 of tech Angel investors lost money and some 40% of early stage VC investments end up worthless. And remember - these are the professionals. Despite their expertise, exhaustive diligence, and access to exclusive deals, they still bet wrong more times than they do right. In fact, because of this difficulty, VC firms have systematically been shifting focus to later stage companies over the past few years. If the pros are moving away from this asset class, how do we expect individuals to fare better ? In the VC world, only 10-20% need to succeed for them to generate their required returns; there's not quite the same risk tolerance for Joe the Plumber who is investing his retirement funds.

Also, for the few that haven't noticed, we are in the midst of a capital bubble. Outsized pre-revenue valuations are back (really Snapchat, $3B wasn't enough?) as is hot public markets fueling a pace of IPO filings that hasn't been seen since the dot-com days. Large investors like corporations and private equity groups have never been flushed with more cash. Smaller companies have more choices as new angel groups, accelerators, and incubators compete fiercely for them. And if that isn't enough, the Fed continues to crank money into the system ensuring the record low interest rates remain. We are in an unusual environment in which capital is aplenty; if there was a shortfall in the market, it certainly isn't now.

On the other hand, before crowdfunding, a typical entrepreneur had very places to go. Local banks were out of the question given the risk. VC's and Angels were almost impossible to connect with. Friends and family, which is the typical route, is limited and sometimes complicated. As social, sharing, and mobile drive rapid efficiency in communication, it's only natural that those benefits extend to the investing world. Kiva brought microfinance to the masses helping millions of entrepreneurs; so why shouldn't Angel List do the same in the for-profit world? The notion of the Facebook next door that can't get funded should not be a reality nowadays.

In some ways, democratizing capital should level the playing field for entrepreneurs that aren't tied exclusive clubs like the Silicon Valley network or NY elite. But on the other hand, the landmines of early stage investing may not be well understood by smaller investors. I personally think the pros of crowdfunding outweigh the cons, but i hope the timing of its incubation during the capital boom doesn't shorten its life cycle. Buyer beware - just because your teenage kid is allowed to take the keys to the car doesn't mean you should give them to him.