SITALWeek #215

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, energy-storing concrete, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

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In today’s post: Porter evolves his broken 5 Forces; Silicon Valley overheats; puzzling reversals in post financial crisis lifestyle trends; Internet capex and semi demand is on the rise; investing beyond conviction; LeBron James is right about Zuckerberg’s view of free speech, i.e., they are both wrong! and, lots more below...

Stuff about Innovation and Technology
Porter Topples His Own 5-Forces
At NZS Capital, we have always felt Porter’s 5 Forces, detailed his book Competitive Strategy, should be taught as a way to NOT run a company. As we wrote in Complexity Investing back in 2014:
“Michael Porter’s book, Competitive Strategy, published in 1980, has informed corporate strategy and security analysis for over 3 decades. However, the popular concepts outlined in the book are now out of place and often foundationally wrong in an age of free flowing information. Porter’s framework was based on mid-20th century oligopoly structures that largely existed as pre-information age artifacts. Written just before the popularization of the personal computer, it failed to anticipate the rapid evolution from high degrees of informational friction to virtually no barriers to information flow...The essence of Porter’s Five Forces boils down to avoiding competition and driving profits rather than focusing on the needs of the customer. This is the fatal flaw - barriers turn into crippling vulnerabilities in an age of instant and complete information. We are seeing these artificial “moats” destroyed one by one in the world of business, and even government regimes around the world.”
We felt that Porter’s way of thinking was zero sum at best, and in many cases, when considered on a net basis, negative sum for the world. It’s a 20th-century framework that only seemed fit for industries with regulated, unnatural monopolies, and in fact Porter’s own consulting firm failed. Well, times change, and Michael Porter is now realizing that positive social impact can be a powerful economic driver, as he describes in this long essay he co-authored in Institutional Investor. The post contains the following analysis of power providers:
“A Five Forces analysis would have correctly predicted a stable and profitable power industry, and many investors bought utility stocks with the expectation of a predictable long-term yield. Now, however, many markets have been deregulated. European governments have imposed descending limits on use of the fossil fuels on which most major power plants depend. Solar and wind technologies have reached price parity, enabling distributed generation with very low barriers to entry. Most European utility companies and their investors missed these major shifts as they ignored changing societal factors in their investment analyses. The result was the destruction of €500 billion ($551 billion today) in economic value.”
We heartily agree, and would like to say “welcome aboard” to Michael Porter. We expand on our concept of NZS, or non-zero-sum investing – that goes well beyond ESG – in our whitepaper here.

African-Made Smartphones
Mara is launching the first made-in-Africa smartphones with a goal of increasing the 15% phone ownership level in Rwanda.

Coffee Grounds Reimagined
Coffee-ground-based degradable plastics: after you press the oil out of used coffee grounds for biofuel, researchers are using the leftover dry, odorless material as an additive in 3D-printing substrates. The additive strengthens cornstarch-based poly-lactic acid (PLA), which also has many medical product and food packaging use cases.

Next-Level Baby Monitoring
Sound Life Sciences leverages smart speaker microphones and white noise to monitor baby breathing. The white noise is canceled out, leaving the baby sounds only, and movement/location can be pinpointed using built-in microphone arrays.

Energy Storage Caveman Style
Swiss company Energy Vault is using potential energy to store excess power from wind and solar. The idea is you use the green power to lift giant concrete blocks in the air, and when you need power you lower them down (think of regenerative braking in your hybrid or EV, but with vertically dropping concrete mass). The product isn’t yet proven out, but it's reported to get 80-90% round-trip efficiency. Softbank’s Vision Fund invested $119M into the company because “It’s not a science problem. It’s fifth-grade physics” - no comment on how this investment philosophy has gotten Softbank into trouble recently!

VC Bubble in Trouble from Over-Subsidization
We should start to see some rationalizing of the VC bubble in Silicon Valley, which has seen several unsustainable consumer Internet business models raise too much money at too high of a valuation. This slowing funding will also probably give some pause to advertising growth on social networks and infrastructure spend at AWS, though I suspect these will be blips in the long term. My proprietary, if anecdotal, ‘Silicon Valley Traffic Index’ is spiking off the charts with new traffic jams in new places up and down the 101 lately. Likewise, last weekend at the San Jose airport, there was no parking available for nine hours – not one single spot – as flyers in 2019 increased 15% to 14.3M from last year! This congestion is historically inversely correlated with where we are in the VC cycle. This Atlantic article points out the rather humorous fact that Millennials will have a reckoning coming to their VC-subsidized lifestyles: “If you wake up on a Casper mattress, work out with a Peloton before breakfast, Uber to your desk at a WeWork, order DoorDash for lunch, take a Lyft home, and get dinner through Postmates, you’ve interacted with seven companies that will collectively lose nearly $14 billion this year. If you use Lime scooters to bop around the city, download Wag to walk your dog, and sign up for Blue Apron to make a meal, that’s three more brands that have never recorded a dime in earnings, or have seen their valuations fall by more than 50 percent.”

Wind Drives Renewable Energy in UK
Thanks to a rise in offshore wind power, the UK received more power from renewables than fossil fuels. Renewables were 40% compared to 39% fossil fuel, with the remainder coming from nuclear.

Supersaturation of Residential Delivery
Many investors conceive of the US residential delivery market as a duopoly of FedEx and UPS combined with the government-subsidized postal service. The reality is much different: depending on where you live, you might get deliveries from a dozen companies such as USPS, UPS, FedEx (Express, Ground, and Home), DHL, Ontrac (or other regional carrier), Amazon, Instacart, Uber Eats, Doordash, Postmates... In this WSJ article, I still get the sense FedEx is living in the “duopoly” past as they struggle to face heightened competition in this part of their business and CEO Fred Smith calls Amazon’s ambitions “fantastical” and Amazon’s head of logistics a “smartass.”

Anatomy of a Ghost Kitchen
Here's an inside look at DoorDash’s ghost kitchen concepts, which are staffed by employees of various restaurant brands with shared infrastructure and services. Partner restaurants are paying “modest” rent plus the normal order commissions, and presumably their employee costs, but are obviously saving on a lot of other costs of running a standalone restaurant. And, it’s a way to outsource capex to DoorDash, which further increases ROI for brands.

Old Habits Die Hard: Cars and Coca-Cola
Despite the rise of transportation services like Lyft and Uber, car ownership has climbed for the last decade – largely because it dipped in the great recession. Ownership levels are now back to where they were before 2008, but that still raises the question of why we haven’t seen a greater shift toward the ride-share alternatives and less car ownership. Perhaps the cyclical rebound is masking a different underlying trend. Another unexpected consumer shift is the rise in soda consumption, with Coke reporting 15% growth in smaller can sizes. I can't help but wonder if many of the health and lifestyle trends post the 2008-2009 financial crisis were temporary reactions, while human behavior itself remains stubbornly entrenched in its evolutionarily-driven desire for sweets and concentrated calories? Or, perhaps it was undulations in demographics as Millennials were postponing household formation, which obscured the lifestyle trends?

Internet Platforms' Dramatic Capex Increase, Spending Cycles, and Semiconductor Demand
Rising capital intensity at the big Internet platforms is notable. According to a report from Empirical Research Partners (report available for their clients), Facebook, Amazon, Apple, Netflix, Google (FAANG) and Microsoft have driven 25% of returns for large-cap stocks over the last five years, and they now account for 14% of large-stock market capitalization. The stocks also account for 14% of large-cap free cash flow (roughly double what it was 10 years ago), and 10% of large-cap earnings. Over the last three years, the share of capex from these six stocks has tripled from 3% to 9%. As demand grows for everything from machine learning to same-day shipping, Internet platforms are not as high ROIC businesses today as they once were. It’s perhaps time to dispel the myth of capital-light Internet businesses.

Rising capital intensity at cloud platforms is in part related to businesses shifting from owned data centers to the cloud. Going back to the early days of the client/server architecture, we often saw cycles of new hardware advances spawning new operating system releases driving new application demand. These cycles ran in several-year increments. Nowadays, with the shifting spending to the cloud, we might expect faster cycles of building large, physical data centers followed by outfitting those centers with chips and hardware. In the off years of investment, companies are seeing rising efficiencies from existing hardware through advancements in software and AI. Gavin Baker made this point on cyclical cloud capex recently.

TSMC, the world’s largest foundry for advanced semiconductors, is certainly predicting a robust data center spending cycle as leading-edge chips are in high demand. The company raised capex several billion to $14-15B and was also optimistic for the 2020 outlook. 5G and AI are drivers of this growth, as well as picking up share from AMD. All that said, it’s a little hard to know how much stockpiling going on in China given the escalating trade tensions.

Brave Browser’s Privacy-Driven Share Gains
The privacy-focused Brave browser (highly recommended) has passed 2.8M daily and 8M monthly active users. 290,000 sites have joined its token-based support platform and their attention ads are seeing a 14% click through rate vs 2% for the industry.

Video Games as Neuro PT
Quadriplegics are looking to use video games – and esports tournaments – as a form of recovery. For now, this is about kickstarting neural rewiring and the ability to use other muscles, but I can’t help but wonder if Neuralink or something similar will create a whole new type of video game interaction for esports down the road. Related: DARPA is working diligently to read minds to control drone swarms.

Amazon Waves Goodbye to Oracle from the Cloud
Amazon has switched off the last of its expensive Oracle databases in what has proven to be a long and difficult accomplishment. However, the end result is a 60% cost decrease, 40% latency reduction, and 70% reduction in database admin overhead for Amazon. The migration was no doubt prompted by the religious war between the companies, but it's an important milestone for others who want to do the same (and likely the reason Oracle is cozying up to Microsoft as I wrote about last week).

Improving Robotic Manual Dexterity with Rubik’s Cubes
OpenAI has used reinforcement learning and simulations to teach a physical robot hand how to solve a Rubik’s Cube.

Samsung Joins the RISC-V Bandwagon
Samsung is rumored to be working on a 14nm Exynos processor based on the open-source RISC-V instruction set. Previously, all Samsung processors have been ARM-based.

Lots of $$$ in Streaming as User Shift Accelerates
Viacom-owned South Park is near a $500M deal for the exclusive streaming rights to it’s past and future episodes. This follows recent high-profile digital “syndication” deals for Friends and Seinfeld. The reality of consumers spending more time watching more premium content on more devices is settling in, and high quality content is increasingly more valuable, even when it’s library content that goes back decades. An accelerated shift to streaming is underway, spurred by price hikes for digital versions of cable packages – AT&T is raising their streaming live-TV service to $65 following price hikes at Hulu Live and YouTube Live to around $50. These services are thought to be breakeven in the high $50s monthly ARPU range. Further, the explosion of consumer streaming apps coming from Disney, WarnerMedia, and NBC Universal along with existing apps from Hulu, Netflix, CBS, and a long tail of niche content providers is likely to drive a faster shift away from linear TV, but it will be balanced by older demographics, who watch live cable news, and sports fans who are likely to cling to legacy TV bundles. Netflix said this week that they expect new offerings to speed up the shift to digital as well. This leaves consumers desperately needing a common universal interface and universal search to manage the increasingly complex ecosystem. Absent a good UI, it’s possible one of the existing streamers, like Netflix, creates a winner-takes-all video service for users fed up with the unbundling fragmentation.

Miscellaneous Stuff
Waxing Poetic about Honesty and Conviction
Nick Cave outdid himself with these words in his Red Hand Files this week:
“My duty as a songwriter is not to try to save the world, but rather to save the soul of the world. This requires me to live my life on the other side of truth, beyond conviction and within uncertainty, where things make less sense, absurdity is a virtue and art rages and burns; where dogma is anathema, discourse is essential, doubt is an energy, magical thinking is not a crime and where possibility and potentiality rule.” This made me think of Dylan’s line in Sweet Marie: “to live outside the law, you must be honest,” which for me has always meant that doing things differently than others requires you to always do the right thing. And, the words “beyond conviction” from Cave resonate loudly with how we try to invest: going beyond the cognitive bias traps and trying as hard as possible to have no solid, immutable views of how the future might play out.

One Cookie Now, or Two Later? A Better Predictive Model
Many of you enjoyed the Farmer’s Fable, an interactive graphic that explains the power of combining arithmetic with geometric compounding (more on that in SITALWeek #202). A new paper attempts to put some of that same logic to the test in discounting of future rewards. Standard exponential discounting, used in most economic models, doesn’t explain many actual behaviors by people with regard to future rewards. This paper explains discounting without psychological biases: instead of changing expectations being a symptom of the mind, they are instead a symptom of changing circumstances.

Ditching Plastics for Aluminium: A Supply-and-Demand Disequilibrium
Can giant Ball Corp discusses the market dynamics as consumer drink brands increasingly want to shift away from plastic to aluminum: The firm is “just trying to keep up with existing customer demand, because we have very little inventory; it’s a high class problem, but it’s a problem nonetheless,” Hayes said. “The biggest challenge we have is procuring the necessary aluminum and having our own production capability.” Ball also announced a partnership with Kroenke Sports to bring their new aluminum cup to Denver’s Pepsi Center.

Stuff about Geopolitics, Economics, and the Finance Industry
Squawking about OOTMO
I was on CNBC’s Squawk Alley on Tuesday squawking about the out-of-the-money optionality (or OOTMO as we call it) in Uber and Lyft along with the risk of regulation for the giant Internet platforms.

Benioff Needs to Walk the Talk More
Benioff penned an editorial in the NYT, coinciding with his new book launch, about new capitalism recommending a “broader vision of [corporate] responsibilities by looking beyond shareholder return.” I'm glad to see this idea, which we put forth last February in our NZS whitepaper (Non-zero Outcomes in the Information Age: Broadening the Definition of Fiduciary Duty for the Mindful Investor and Company), voiced by others. However, Marc could be doing so much more to further the cause if he means what he says. As I discussed in SITALWeek #210, tech companies are in an unprecedented position to incentivize social change by companies that use their software and hardware platforms. I don't want to be too critical here – Marc has accomplished a lot, and I have great admiration for him as an operator at Salesforce and the causes that he has supported over the years – but I do wish he would take advantage of his position and go beyond suggesting how people should act and actually set a benchmark for incentivizing good behavior.

Investors Flee Active Equity
Active equity funds saw the biggest withdrawal for any quarter since 2009 at $60B in Q3 as the 'bubble of fear' continues to inflate. Bond funds took in $118B, up 2x over the same quarter last year, and money market funds took in a ten-year record of $225B.

Cracks in Communist China
Are China’s “tantrums” done intentionally with justifiable outcomes, or simply like a bully on the playground who gets called out and backed into a corner? When we think of the range of outcomes in our investment process, we put a meaningful credence on the risk of Chinese communism completely failing. The world might view that as a 1 in 10,000 chance, but we’re likely to invest as if it’s a 1 in 10 because non-zero-sum forces apply to governments just as much as they apply to businesses. From an article in the Atlantic: “China might be experiencing its own form of failure and weakness, with a more and more centralized rule pushing a cult of personality around the leader. After all, China has its own problems with decadence, corruption, and inequality. Many high-level officials have families with multiple passports and expansive overseas wealth. A mixture of authoritarian malaise and loss of agility might be causing the country to lash out, without proper strategic analysis. This same dynamic seems to be at work in China’s approach to the Hong Kong protests, which could have been defused early through a few symbolic concessions. It’s as though China doesn’t even understand a city that is under its own jurisdiction.”

This long article in the FT is a great tutorial on the civil war for freedom in Hong Kong. “If we burn, you burn with us.”

LeBron James and Mark Zuckerberg are Wrong About Free Speech; Tim Cook is Just Wrong; but, Quentin Tarantino is Right
A bipartisan group of senators expressed concern to Apple this week over the Chinese censoring of apps in the Apple app store. And, it’s been reported that Apple won’t be bidding on those South Park streaming rights, fearing repercussions from China. But, hopefully Tim Cook doesn’t channel “Taco Tuesday” LeBron James or Eric Cartman in his defense: “Yes, we do have freedom of speech, but at times, there are ramifications for the negative that can happen when you’re not thinking about others, when you only think about yourself...So many people could have been harmed, not only financially but physically, emotionally, spiritually. So just be careful what we tweet and what we say and what we do. Even though yes, we do have freedom of speech, it can be a lot of negative that comes with it.”

Much was written about Zuckerberg’s speech on freedom of speech this week (including his re-writing of the entire origin story of the company!). This piece in The Week was the smartest take I read on the Zuckerberg speech: “This is all emblematic of a man who is employing pre-web thinking in a post-web world. Facebook — and other sharing platforms — have indisputably made it easier to share one's views with the world. But the original idea of free speech didn't account for the dynamics of virality and algorithms. Platforms like Facebook are designed to favor and amplify certain kinds of speech — the reassuring, the inflammatory, the controversial — even if the claims being made and the views being shared aren't true.”

I'd like to make some important distinctions regarding the last couple of paragraphs: when LeBron James says that freedom of speech is wrong because it can hurt people, that misses the point of freedom of speech – if the truth hurts, it's still the truth. When Zuckerberg says more speech is better, he's wrong because his platform can't consistently identify intentionally weaponized misinformation. When Tim Cook checks his moral compass at the door for more money for Apple shareholders, he's simply being unethical, and his actions seemingly have nothing to do with his views on free speech. And, when Quentin Tarantino refuses to re-edit a movie for China because they don’t like a parody of Bruce Lee, it's the right thing to do on behalf of free speech – he's protecting a truth, or satire, not intended to harm or manipulate.

Erratum: Zero-Fee Trade Scenarios
Last week, when I was discussing the ability to create synthetic indices, a reader kindly pointed out a math error I made. Recreating the S&P index (500 trades at $5 a trade) would cost $2500; a 10 bps fee on an index backs into $2.5M investment breakeven, not $250,000 as I stated. A 5 bps index fund would likewise suggest $5M. So, my point is weakened, but for now I remain intrigued that you could more cheaply create custom index-like funds, or recreate elements of indices more thoughtfully for much less money. The reality is, indices are backward-looking by their very nature in the way they are rebalanced, and now even more so with the rising pace of disruption; but, now with free trading, there should be much better opportunities for investors and advisors to actively and cheaply beat indices going forward.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #214

SITALWeek #214
Stuff I thought about last week 10-13-19

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, air-breathing batteries, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

In today’s post: Jeff Bezos’ “Reverence Power Law” that drives the Amazon flywheel; Libra under pressure from the credit card monopoly; astrophysicists help you with your wardrobe; the difficult relationship between freedom and equality, and how to deal with the crumbling Great Communist Wall of China; zero-cost stock trading enables creation of cheap, custom portfolios replacing index funds and ETFs; and, lots more below...

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Stuff about Innovation and Technology
Call of Duty Mobile has smashed the records that were previously smashed by Fortnite and PUBG, passing 100M downloads. It's a classic example of mobile expanding the market for a game to new players and new devices. (Note: there is more commentary on the Activision/China/Tencent controversy in the Macro Section at the end).

Automatic license plate readers are making obsolete the "getaway" car for criminals. Maybe they can switch to scooters or e-bikes?

Form, a grid battery storage startup, has developed a new type of “air-breathing aqueous sulfur flow" battery, which separates electrodes (energy delivery) from electrolytes (energy storage). This long article in Technology Review discusses Form as well as various challenges of large-scale energy storage.

Borophene, the one-atom thick version of boron, can be laid on silver to form one-atom wide nano wires in wearable or transparent tech and energy storage.

The New Yorker printed a very long article on Amazon and Bezos, which has inspired me to write my own indulgently-long paragraph about it (and, if this still isn't enough Bezosian news, here is an insufferably long and less interesting article in The Atlantic from last week). The New Yorker article rehashes many points and criticisms that have been published numerous times over the last couple of years, but its narrative makes some provocative points. One thing that came to mind as I read it was how Bezos seems to assign reverence in a power-law curve that drives the Prime flywheel. At the very top of the curve is an extreme amount of veneration for customers along with process supported by “what won’t change” for customers: lower prices, more selection, and more convenience; then, as we near the lower, irreverent section where the curve starts to flatten out, come the employees, who seem to be a means to an end (at least from an outsider's perspective); lastly, at the trailing end of the power law, as it approaches the asymptote of near-zero, are the creators and merchants of products sold on the site. In a sense, this is the "power law of trailing 12-month FCF" growth. Elements of this reverence diagram likely map over to the way amazon makes video originals and the AWS business.

When we think about Amazon from our NZS-framework perspective, it's clear they aren't maximizing NZS for all constituencies, and they are not broadening their definition of fiduciary duty to create more value for constituents (beyond consumers) than themselves. Surely customers are winning, but at a cost to suppliers, the environment, and employees. Many pillars of Bezos’s Libertarian philosophy are being questioned as the last stretch of our 300-year capitalism experiment has resulted in puzzlingly large inequalities. One quote from a "Bezos acquaintance" did seem to resonate: "clearly there is an empathy gap... It's how he sees the world." As long-time readers know, I draw a very important line between skepticism and cynicism. It's great to be skeptical, but it's almost always wrong to assume the worst. So, I’ve remained somewhat skeptical of Jeff Bezos over the last year amidst rising critical coverage, but not yet cynical. I want to believe that his recent moves with the Day 1 Families Fund and Amazon’s late – but welcome – environmental and labor initiatives are win-win motivated, but it's very possible they are simply more important to maximizing that TTM FCF than anything else. I suppose at the end of the day this is the free market working to influence outcomes, as Jeff’s Libertarian views would predict.

I want to connect this Amazon analysis to one last point: we've written recently about the rising regulation of technology platforms, which is likely to cement current monopolies while making new growth areas more challenging. It strikes me that Bezos focusing so relentlessly on those three things that "won't change" has created dangerous blindspots with regard to both negative externalities and misunderstandings of the power of Amazon's platforms and network effects. Platforms are reshaping capitalism through the lens of data network effects, which seems to be transferring profit pools away from legacy "moats" – away from distribution, suppliers, brands – in a way that benefits consumers and platforms, but not necessarily employees and society as a whole. To quote again from the New Yorker article on Bezos:
David Farber, a University of Kansas historian who wrote a biography of Alfred P. Sloan, told me that the G.M. executive “didn’t see himself as someone that needed to be loved or respected by the public, but eventually even he gave in.” He noted a pattern in American history: “There’s an economic revolution, it creates amazing new opportunities, and then the companies that seize those opportunities become so powerful that the people revolt—they say the winners have become too powerful, they start attacking the people who are the embodiments of winning, sometimes with gossip, sometimes with facts. And then we have an era of constraint enforced by the federal government.” We may be at a breaking point now. “It’s like the eighteen-eighties or the nineteen-thirties all over again,” Farber said. “The pressure is going to continue building, the powerful are going to continue being watched and criticized and gawked at, until something pops.”

Perhaps in anticipation for the New Yorker article, Amazon posted its views on various social, environmental, and regulatory policies here. Of note appears to be a small positive evolution in the company's dangerous laissez-faire facial recognition technology policy.

Rounding out Amazon news, the company’s $10B+ advertising business held its first conference for sellers and partners this past week with 400 in attendance (the massive AWS started out with a similar number of attendees at their first user conference). A main objective of the conference was to explain all the ways in which you can advertise on Amazon, whose marketplace and ad offerings have become so complex that a lot of Amazon employees have left to start consulting businesses aimed at navigating the platform.

Uber is going more vertical in food delivery. This week, the company acquired South-America-based grocery delivery company Cornershop. Uber also partnered with celeb chef Rachel Ray to launch 13 virtual restaurants for food delivery in conjunction with her latest book launch. Wendy’s also said this week that cloud kitchens will be a significant growth area in the coming years.

Pro sports continue to be very important to the media ecosystem, and the +5% rebound in NFL ratings is emblematic of that. NFL viewing is up 8% from the rocky 2017 season, and about flat with 2016. Sports broadcasting rights at CBS and Disney in particular are likely not getting enough credit from investors who are overly focused on the “or” of streaming rather than the “and” (linear TV and Netflix and Hulu and Disney+ etc. as opposed to linear TV or streaming).

This week PayPal, Stripe, and others dropped out of Facebook’s Libra transactional digital currency initiative. Libra faces mounting pressure from regulators mainly because it’s tied to Facebook. (I wrote last week about how regulators are killing fintech innovation in the US and Europe.) I am not sure if these recent dropouts have more to do with the likely regulatory failure to launch for Libra, or if it’s something more insidious: Mastercard and Visa have a lot to lose if something like Libra gets off the ground, and they have a history of bullying their partners into killing digital payment innovation; Stripe and PayPal are nothing without Visa and Mastercard. Anthony Bardaro made the analogy “PayPal could be to Facebook’s Libra what Starz was to Netflix’s streaming upstart.” That’s an insightful point especially because the “content” on a wallet platform like PayPal or a processing platform like Stripe is the payment mechanism itself: credit cards, bank accounts, etc. A new digital payments platform needs to own its “content” in order to escape the chains of the 1900s payment system currently in use (outside of China).

Oracle retrenches in the cloud wars to focus only on offering its database and apps as a cloud service, no longer competing head-to-head with Amazon, Microsoft, and Google for workloads. This still falls short of giving customers what they want – the ability to run Oracle products on the other cloud platforms. However, a recently announced partnership with Microsoft to make it easy to connect Azure workloads with Oracle Cloud workloads is an important step given the overlapping customer bases. I suspect the lowered cloud ambitions could be good for Oracle margins, but they may need to go the last step in giving customers flexible and optimized versions of the apps to run on other clouds as well.

The CEO of ARM discusses the current state of the business in this interview. The irreversibly slowing pace of Moore’s Law (cool graphical representation here) has created an explosion in demand for heterogeneous workloads and chips, driving a multi-decade expansion of the chip market for processors, GPUs, MCUs, FPGAs, embedded functionality, chiplets, 3D architectures, etc. As a result, open source alternative processor instructions, like RISC-V, are gaining momentum because they allow extreme customization. NVIDIA appears to be expanding its Shanghai-based RISC-V team, and ARM announced this week that they will begin allowing customers to make minor modifications of their previously walled-off core processor instruction set – a baby step in the right direction. ARM is focused on vertical functionality, but even inside of verticals, customers might want much more customization, particularly as we see the rise of systems companies like Tesla designing their own chips. In the interview, Simon also expresses some doubts over chiplets at the leading edge given the slowdown in interconnect speeds between various parts of the package.

India is also leveraging RISC-V in new domestic initiatives for semiconductor design. I suspect India’s highly skilled engineers and entrepreneurial spirit will result in significant growth for semis in India, perhaps rivaling US semi designers in the not-too-distant future. For now, they are likely to rely on Taiwan for manufacturing of the chips.

Miscellaneous Stuff
Nearly 700 years of records on the grape harvest in the Burgundy region of France reveal just how warm things have gotten over the last few decades. Harvests are consistently 2-3 weeks early to keep the sugar and acid levels lower in the grapes. For now, the heat is producing better wine in many cases, but rising temperatures will eventually change that. The temperature shift is also enabling new (and/or improved) growing regions for the Pinot Noir grape beyond France, California, and the Pacific Northwest to include Germany and Austria.

Astrophysics PhDs now face the tough decision of whether to ponder the vast scope of the Universe and meaning of life, or help design an algorithm to better sell t-shirts or make TV-show recommendations, as tech companies hire all the data scientists they can get their hands on. This might be one of the most depressing commentaries on humans this year:
“We discovered the size of the universe. We measured the speed of light. We found pole stars. We found black holes. A lot of those big things, like understanding how space-time works or how gravity distorts, are what get people interested in the study of space and cosmology. But what you’re really doing is contributing to a very small subfield where you’ll work about three years on a paper that about 10 people in the world are going to read. You’re not going to be Carl Sagan.”...“When I go and explain this to my parents, they’re like, ‘You were doing such amazing things with the universe, and now you’re making people watch stuff!’”

Massive cones of radiation shot out of the black hole at the center of the Milky Way 3.5 million years ago as ape-like Australopithecines roamed the Earth. The beacon would have been visible for about 300,000 years.

Buffett and Munger trained generations of investors to think about capital allocation, which likely contributed to the wave of vehicles buying and owning of private assets (with low rates obviously being a big catalyst). This training created a host of competitors for Berkshire, all using the latter's own business model. Interesting Twitter thread from @bluegrasscapital about how “Buffett proving out success of these alternative frameworks AND educating current generation of investors on this opportunity set sowed his own decline. In the process, he gave us a richer & higher returning opportunity set. Just not in Berkshire's own stock.” I think if all any of us ever accomplish is to help others be better at what we do, then that should be enough, even if it means we obsolete ourselves in the process.

Stuff about Geopolitics, Economics, and the Finance Industry
“Instead of selecting one truth from a multitude you are increasing the multitude. What this means logically is that as you try to move toward unchanging truth through the application of scientific method, you actually do not move toward it at all. You move away from it!” -Robert Pirsig, "Zen and the Art of Motorcycle Maintenance"

The Great Communist Wall of China is attempting to stabilize itself – as Beijing grapples with a slowing economy, Hong Kong demands freedom, and Westerners express indignation over censorship – by pulling back on the previously-important Belt and Road initiative aimed at global Chinese economic dominance. Signs of instability further manifest in the Chinese tech sector where startup funding is down over 60% this year and tech sector job postings have dropped 13% as the mega platforms deal with these new economic realities.

The US ramped up the spotlight by putting visa restrictions on communist party members over alleged human rights violations. Meanwhile, Western companies find themselves in an increasingly challenging position, having to either overtly accept censorship to do business in China or draw a line in the sand with respect to freedom of expression. Activision, who depends heavily on China for revenue (and Tencent specifically for game development support and distribution), punished a professional gamer for supporting Hong Kong. Apple is facing difficult decisions and pressure from China over their product usage in Hong Kong. South Park creators Matt and Trey continued to stand up for freedom of speech despite its potential impact to their distributor Viacom. Many more companies will be facing moral decisions as China plays the victim with its citizens and dials up the Nationalism rhetoric to 11.

As investors focused on maximizing NZS (win-win), our framework attempts to go beyond ESG, and Western relations with China present a puzzle that requires a lot of 2nd- and 3rd-level thinking. This is an old debate, but the question is: is no NBA in China better for the world than a censored NBA? Is no Disney or Activision properties in China better for the world than censored versions? These are hard questions. We know that information velocity is increasingly difficult to control, but it's also easier than ever to fabricate any version of the truth. In "Zen and the Art of Motorcycle Maintenance," Robert Pirsig notes that the more information you have, the shorter the lifespan of any scientific truth (by accumulating more knowledge the more you observe and experiment, you often disprove, or refine, ideas that earlier seemed valid). This is the beauty of the scientific method, but it’s also a challenge in the Information Age as we try to wrangle the outputs of hyperspeed processing and informational overload. Throughout human history, there has been a spectrum of freedom and equality: if you have 100% freedom, you tend to end up with extreme inequalities; if, you have 100% equality, you tend to end up with very little freedom. Capitalism, on the one hand, has tended toward freedom, thus causing ever-rising inequality, while Communism strives for equality by suppressing freedom. There is some threading of the needle of equality and freedom that we still need to do as a global society, but for now the path isn’t yet clear. I’d suggest the ultimate tact to take for companies and investors struggling to make sense of the China situation is to support rising freedom over the long term.

As commissions for equity trading are now at zero for retail customers, we could see the rapid rise of custom portfolios and the rapid devaluation of ETFs and indices. New platforms are emerging to create custom "benchmarks" for individual needs, which allow advisors and brokerages to provide tailored performance with no fees to funds, ETFs, or indices. One such emerging platform is OpenInvest, which allows for custom values-based (i.e., ESG) portfolios. With zero cost trading any individual can just replicate an index for free with a list of stocks. You can make your own S&P 500 portfolio knowing publicly available market caps for free instead of paying 10 bps to someone. Previously trading 500 stocks and rebalancing them once a year would cost $2500+, now it’s free. At 10 bps, $2500 would be the annual fee on a $2,500,000 investment in a passive fund, but if an individual wants to take advantage of tax loss harvesting or more frequent rebalancing, the breakeven would drop quite a bit. Custom, modular benchmarks are likely to be in demand by institutions as well, so what’s the value of any of today's big index companies in the future? This is another example of a homogeneous, expensive 20th century business becoming a much larger and cheaper heterogeneous set of consumer choices.

Zero-commission brokerage Robinhood has launched it's 2% interest rate cash management product, further pressuring profit pools at traditional brokers. I mentioned one of the less-than-honest ways that Schwab and others make money last week, and I was disappointed to hear Charles Schwab himself give a very squirrelly answer when questioned on CNBC on Monday (6 minutes into this video) about the practice of sweeping client cash into low-rate products while Schwab makes money on the cash. This will be the next profit pool to disappear as the disruptors like Robinhood shift the broker model to data-based revenue streams (which is also a bit sketchy!).

Correction: I wanted to add an important point regarding the paper I linked last week demonstrating that all types of ETFs underperform in a similar fashion to active funds. In emailing with a reader (who happens to be my dad!), it occurred to me the authors of the paper didn’t take taxes into account. In retirement accounts, their conclusions would hold, but in taxable accounts, ETFs are often more favorable because they forego the annual distributions that you get hit with in mutual funds. Still, the underlying performance similarity of active funds and ETFs is striking.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #213

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, superluminal blazars, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

In today’s post: the shift from gas to electric cars requires a painful transition in the labor force; connected set-top boxes like the Amazon Fire are not platforms; online grocery curbside pickup is taking off; 2nd hand apparel is growing rapidly around the world; Facebook’s TikTok mistake; direct listing IPOs setup for VC insider trading; as disruption comes, what is the new value add of an investment adviser? new data shows all types of ETFs underperform the market; and, lots more below...

Click HERE to SIGN UP for SITALWeek’s Sunday EMAIL (please note some ad blocking software may disrupt the signup form; if you have any issues or questions please email sitalweek@nzscapital.com)

Stuff about Innovation and Technology
Major League Baseball has partnered with an eight-team league to experiment with technology: the Atlantic League is working on robotic umpires and rule changes. It turns out the “robot umpires” are machine vision that just tells a real umpire what the call is and they repeat it. I love this idea of experimentation, but it’s my impression that more than half of watching sports is complaining about coaching/refs/umpires, so if spectators can’t blame a real person, it could take all the fun out of it!

Call of Duty Mobile, co-developed with Tencent, had 20M players in its first two days of launch, exceeding expectations.

38% of Amazon’s top-10,000 sellers are China based. And, 7% of Amazon 3rd-party sales are said to originate from sellers in one zip code in Brooklyn.

Be careful crossing the road! Pedestrian deaths by cars have risen from 4,300 in 2008 to over 6,000 in 2018 after decades of decline. Increases in autonomous safety features in cars are not translating into pedestrian avoidance. While there isn’t one reason experts can trace the increase to, let’s just assume it’s not a good idea to look at your phone while you cross a street.

As America’s Funniest Home Videos kicks off its 30th season, one thing I have learned is that we now have a lot more footage of Americans falling down their front porch steps, backing their cars into various objects, and curious critters. This is all thanks to the rise of doorbell and other connected security cameras. And, this footage is increasingly becoming content for social media, local news, crime watchers, police, nosy neighbors, and more. Wired discusses some of these issues in “The Ringification of Suburban Life”.

Speaking of video surveillance, Motorola Solutions is fast becoming a supplier of video monitoring and AI to schools and law enforcement. The maker of radios and other government hardware is a potential competitor for Axon, the leading maker of body cams and non-lethal weapons (Tasers). So far, Axon is taking a much more cautious approach to facial recognition than Motorola, recognizing the risks involved before the technology is mature and regulations are in place.

An electric motor and battery takes 40% fewer hours to assemble than a combustion engine. The shift required in the labor and skills from manually building legacy gas cars to fabricating software-heavy EVs with autonomous features is creating a big gap in the workforce. Engines and transmissions (EVs don’t even have gears!) are just under half of the manufacturing capacity at legacy car makers in the US. Outside of Tesla, batteries for EVs are imported from Asia, further shifting value away from legacy supply chains in the US and Europe.

The shift to EVs really ups the ante on technology and integration. It’s not just a matter of replacing an ICE engine with batteries, as this Semi Engineering article explains. As batteries become bigger (for increased range) and charging speeds increase “[t]hey need to switch faster, because the faster you switch the less power you’re going to waste, and it’s all about efficiency”, which will drive a lot of semiconductor demand. One estimate for silicon carbide (for high power chips in cars) is 30% annual growth for the next 5-7 years.

Earlier this year, there was optimism that Square would be able to secure a federal banking charter (ILC, or industrial loan charter). The WP reports that Square’s application appears to have gone stagnant, but that hasn’t stopped them and other fintech companies from leveraging community banks as partners and offering bank-like services to customers. This setup of tech companies partnering to be bank-like without charters still feels temporary and risky – both for the small banks, which could lose the business if charters are given out, and for tech companies relying on the banks if the rules around leveraging them change. On the one hand, the US government is allowing for innovation with these community bank partnerships (even though their future is uncertain), but on the other hand, they are significantly impeding innovation by not allowing tech companies to get banking charters.

The WSJ reports that Amazon and Disney continue to fight over Bezos’s misplaced Fire TV demands. Bezos continues to overestimate the value of his Fire TV set-top box installed base to the detriment of his customers. At my house, we've already ditched our Fire boxes in favor of Roku (which also have their share of problems) after it became clear that Disney+ wasn’t likely to be available. I wrote about Bezos's video blindspot in SITALWeek #207, discussing how he is wasting $6B by overplaying his hand. Here is my message to Bezos: Fire TV with Prime Video isn’t a platform, and it’s not something you can use as leverage over your video competitors – Fire TV can be swapped out for $30 in approximately 30 seconds. It wouldn’t surprise me to see Disney partner with Roku to give the devices out to new Disney+ subscribers as the tensions with Amazon rise. The Disney/Amazon war is the equivalent of a network fighting over carriage fees with a cable or satellite company; however, in the new direct world, I don’t believe the content owners will give any ground to the new-era distributors like Amazon.

Click-and-collect grocery pickup is set to be a $35B market by next year according to this story. Retailers like Walmart could see over 10% of customers picking up groceries. The retailer is experimenting with robots and other tech to increase speeds and decrease wait times. Meanwhile, as Amazon plans to open more grocery stores – apparently with large kitchens – I’ll be eager to see if these are more delivery hubs/cloud kitchens versus traditional grocery stores. Amazon is also in talks to put its cashierless “Go” tech platform into other retailers like airport shops and movie theaters. For those that missed it, I wrote about the evolution of the grocery store and food supply chain here.

As food consumption shifts toward meals and away from ingredients, the availability of chefs will be a key hurdle. Picnic is a Seattle company with a pizza robot that can make 300 fresh ‘zas per hour to help out with the pending chef shortage.

Tencent and Alibaba helped create a $100B annual market for secondhand goods in China, in particular apparel, which saw new clothes purchases drop 25% between 2017 and 2018. Beyond the thrift factor, global awareness of the green factor in reusing textiles is likely to propel greater clothes renting and recycling. From an article discussing the bankruptcy of Forever 21: “Young customers are losing interest in throw-away clothes and are more interested in buying eco-friendly products. They’re also gravitating toward rental and online second-hand sites like Thredup, where they see clothes worn again instead of ending up in a landfill.”

Zillow provides more data to support the impact of student debt on home-buying Millennials. We’ve discussed the ramifications of Millennials’ large debt – advanced in this insightful Deloitte report – earlier this year in SITALWeek #201. Zillow highlights that 39% of renters can’t buy a home due to student debt; and, medical debt is another factor for many would-be home buyers. As I mentioned in #201, the multiplier effect on the economy of reducing/eliminating student debt could far exceed the moral hazard and political charge of such an action.

Consumers' use of social networks, and, more generally, myriad communication tools, tends to be fickle. We have decades of examples of this phenomenon with the rise and fall of various online services around the world all the way back to Prodigy and AOL. One of the reasons consumers move on from one social network is the loss of authenticity. I suggested last week that we’ve already seen peak Instagram, and evidence of the platform becoming just an advertising medium surfaced this week as Disney introduced the new line of ‘Frozen 2’ movie merchandise by enlisting 200 social media influencers across 30 countries to promote the products. The lack of authenticity is perhaps giving rise to the “getting real” movement on Instagram, which, as I understand, is people inauthentically pretending to be authentic.

Another example of the fickleness of social media user attention spans is the rise of TikTok, whose parent company in China, Bytedance, is said to have clocked $7B in revenues in the first half of 2019. A lot of that revenue is being funneled into ads on Facebook and Snapchat to drive usage growth on TikTok: double indemnity! Mark Zuckerberg seemed to write off TikTok in some leaked internal meeting comments by saying it was just a subset of something Instagram already does. This article in Techcrunch points out how risky that underestimation is likely to be. That said, a lot of TikTok usage today is simply teens driving their follower counts and connections on Instagram, Snapchat, and YouTube. However, there is one obvious difference between Facebook and sunny TikTok: not only does TikTok censor political views (as I covered last week), it’s also banning all political ads. Who wouldn’t want to be on a social network with no political comments and no political ads for the next year!?

This week, Microsoft reminded the world of the power shift away from the operating system toward apps. CEO Satya Nadella commented in a Wired interview: “The operating system is no longer the most important layer for us...What is most important for us is the app model and the experience.” They also reminded us of the declining importance of the processor with the introduction of ARM and AMD devices alongside an Intel-powered laptop (Intel is also aggressively cutting prices to compete with AMD). Microsoft is even working with AMD to customize future chips. The relevance of the “Wintel” monopoly of the olden days is now 100% dissolved. As we move more and more toward an app-centric world, the OS and processor become less and less relevant – it really becomes all about the apps, and, to a lesser extent, innovative hardware form factors.

Software buyout firm Thoma Bravo has $12.6B in its 2018 fund to lever up and go after $10B+ sized companies. I always loved that scene in Gene Wilder’s Willy Wonka where Charlie and his Grandpa float among the bubbles.

Licensing intellectual property for design into semiconductors generated $2.7B in 2018 but could exceed $10B in just a few years. Design software companies like Cadence and Synopsys have been ahead of this trend for a while.

Graphcore is a UK-based chip startup trying to build a general-purpose AI chip. For AI, you need to look at machine learning (training models on datasets) and inference (running queries against those models). Today, ML is done mostly on GPUs by NVIDIA with assists from x86 chips. For companies with specific workloads, custom chips (e.g., Google’s TPU) can be a good, but expensive choice. If you have specific math you need to calculate very quickly, then FPGAs from companies like Xilinx can fit the need. So far, companies like Graphcore haven’t had the software ecosystem for training models – like NVIDIA has had with their popular CUDA language – and their speed advantages have not been enough to break in. We are likely to see an array of winners as workloads become more and more heterogeneous; but, for now, NVIDIA remains far in the lead and they aren’t standing still.

Following last week’s pitch by Uber that it wants to transform into a broader platform, the FT reports they are trying a new app in Chicago today to match temporary workers with employers for a variety of job tasks.

Miscellaneous Stuff
Virgin Galactic is getting ready to fly space tourists at a cost of only $250,000, which includes pre-flight training. The company is targeting $600M in revenues by 2023.

I shared several of my highlights from Bob Iger’s new book The Ride of a Lifetime in this twitter thread for those interested.

Speaking of Mickey Mouse, the free speech heroes behind South Park just tackled China’s control of US-made movie and TV content. It’s a remarkable protest episode, especially given that it aired on a Viacom-owned network – the same Viacom that altered Tom Cruise’s leather jacket in the recent Top Gun sequel so as to not offend the Chinese. The episode features Stan’s dad getting arrested in China, where he runs into Winnie the Pooh in prison. Pooh bear is a banned image in China and last year’s Christopher Robin movie by Disney wasn’t screened in the country. As a long-lime Disney and media investor, I laughed out loud when a satirical version of Mickey Mouse asked “What’s South Park? Do I own that?” and someone in the background calls out “Not yet sir!” I also watched the episode on Disney-owned Hulu, because, you know, free speech wins. Hollywood does at the very least seem to embrace satire.

Stuff about Geopolitics, Economics, and the Finance Industry
Thanks to everyone for the comments on my post balancing the pros and cons of traditional IPOs versus direct listings last week. The claim of billions of dollars “left on the table” by the current IPO process is wrong and blatantly misleading, and I’d encourage anyone who is interested in the real math to check out my post. What became clear to me last week was that VCs are asking for what appears to be a type of insider trading privilege with direct listings. Because most companies use IPOs to raise fresh capital, which is not an option for direct listings, VCs (and late-stage public investors) are encouraging you to sell them shares at a discount right before a direct listing; then, they can then turn around and sell on the listing event. VCs typically have far greater information (e.g., from access to board meetings, product roadmaps, and internal forecasts) than what public investors have access to at the time of an IPO. This informational asymmetry has clear potential risk for insider trading. And, those pre-IPO fundraising rounds are going to cause more stock dilution than would an IPO, just by the very nature of investors trying to price a stock at a discount to what they think it will trade at in the public markets. The Silicon Valley VCs don’t look so “woke” attacking the “evil” Wall Street bankers. As I said in the post: I don’t have a dog in this fight, and I want each company to do what’s right for them. There is a lot of room for improvement in the current IPO process, and managements should not be intimidated by elite Silicon Valley VCs – it’s your company, your shares, and your IPO, so take the route that serves your employees and business best. Once you go public, the VCs become the short-term traders exiting a stock, while public market investors are your long-term holders.

Two recent IPOs experienced very large one-day increases from their deal price – Zoom and Crowdstrike. Both companies expressed, in this detailed CNBC article, that the IPO pops and related global press coverage have been very good for business, and ultimately worked out well. Direct-listing proponent Bill Gurley's reaction in the article to the comments from the two companies was: “I have zero doubt that someone that just did the biggest transaction and most important financial event of their life is going to answer that way”. He added, “I don’t think being short term oriented is the right way to think about financial markets.” I am not sure if Bill's response has been taken out context, but I see no reason not take Crowdstrike and Zoom management at their word that the IPOs were positive for their long-term businesses. In the same article, Gurley describes a "workaround" that involves a "pre-listing round using a term sheet that law firm Latham & Watkins has put together." Further "[Gurley] said that 40 late-stage firms, including the big private equity shops and money managers already doing private rounds, have shown interest in participating." This seems like the opposite of democratization of the IPO process to me.

ETFs underperform at a similar rate to mutual funds:
“In this paper, we analyze a comprehensive, bias-free sample of exchange-traded funds traded on the US exchanges that invest in US equities. We show that the performance of ETFs is not as impressive as one might expect it to be, as investors in these ETFs have collectively realized a performance that does not appear to be much different from the performance that can be expected from the conventional actively managed mutual funds. We perform textual and statistical analysis to group ETFs into common investment styles such as size, value, momentum, quality, and low-risk, and show that none of them have managed to consistently add value relative to a capitalization-weighted market portfolio of all US stocks. This can be partly attributed to the generally poor performance of equity factors over much of our recent sample period. On the other hand, the anti-factor ETFs, that is, the funds with significantly negative exposures to these factors, have done significantly worse than the market in three out of six cases, and in the other three cases, their performance was not significantly different from that of the market. We conclude that the allure of ETFs finds little empirical support in the data and that ETFs have yet to prove that they can generate better performance than conventional actively managed funds.”

Insiders continue to sell shares in September – setting a new 10-year high that follows a similar trend from August. And, companies are pulling back on buybacks: Q319 buybacks were $145B, down from $280B in Q2.

This week, in a delayed response to upstart retail trading platform Robinhood, Schwab, Ameritrade, and E*Trade all took trading commissions to zero. This is a painfully classic example of a company like Schwab, once considered a disruptor themselves, being disrupted, an event we will see with increasing frequency across all industries around the world. It raises the question: what business are brokers actually in? Most brokers like Schwab make a lot of money taking advantage of their clients' bad cash management choices, as Jason Zweig highlights in this WSJ article. How long before this anti-NZS behavior is also eliminated due to pressure from disruptors? So, if a brokerage is no longer the business of trade commissions, interest rate spreads, or investment management fees, what business is it in? What about the business of advice? Advice should in most cases be: buy and hold, then buy and hold some more, and allocate either toward and away from risk depending on age, big purchases, life events, etc. That’s important, but table stakes. Instead, I would argue that the real value of any investment advice and trading platform is to save investors from themselves. It’s fear, greed, and cognitive bias that keep most investors from realizing the real value of long-term investing. So, if that’s the real value, how do you monetize it as disruption comes faster and faster?

We discuss complex adaptive systems at length in our whitepaper Complexity Investing. With recent advances in AI allowing for more advanced agent-based modeling of things like the economy, a new effort to chase the ghost of “predicting the future” is upon us. We tend to think that anyone who really understands complex systems will conclude that you can never know the future by the very nature of the universe. The best you can hope to do, I think, is get closer to knowing the range and general likelihood of outcomes. However, even SFI-veteran Doyne Farmer continues to chase the ghost, as this Bloomberg article explains. Brinton and I prefer to focus on adaptability – the ability of a company to leverage future uncertainties to its own advantage – and the fewer predictions we have to make, the better we feel. So, when I see an article like this titled “Predicting the future is now possible with powerful new AI simulations” all I can do is laugh out loud.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #212

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, superluminal blazars, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

In today’s post: The Great IPO Debate: there is a lot of room for improvement in IPOs, but today's direct listings favor VCs and elite private investors while disadvantaging average investors; clothes with built-in energy storage; bowling-ball sized black holes; influencer marketing and authenticity on social networks; designing a compensation scheme for investors to align with client outcomes; and lots more below...

Click HERE to SIGN UP for SITALWeek’s Sunday EMAIL (please note some ad blocking software may disrupt the signup form; if you have any issues or questions please email sitalweek@nzscapital.com)

Stuff about Innovation and Technology
I was back on CNBC’s Squawk Alley this week discussing the long-term upside for Netflix along with the controversial state of the current IPO market and the clash between private and public investors' opinions on valuation and governance. The public markets are open and ready for companies to come public, and like always those companies need to be transparent about their potential paths to profitability so investors can do their analysis and ask the right questions. I also made a brief appearance this week in this article in The Information titled “Troubled IPOs Raise Questions for Future Deals” (which reminded me of this interview I participated in on high private valuations in The Information from way back in 2016).

Speaking of the IPO market, here is my new post, The Great IPO Debate, on the various elements that should go into the process of selecting a traditional, bank-led IPO versus a direct listing. Although a firm like NZS Capital would benefit from more direct listings, I believe in most cases, for the foreseeable future, companies should choose the traditional bank-led route. I also believe there is significant room for improvement in the IPO process and welcome the dialog, debate, and spotlight on this important topic. Here are the main takeaways that I dive into in the post:

• Shedding light on the IPO process is a welcome start to gathering more data and better aligning outcomes for companies, investors, and employees.

• Hundreds of millions of dollars are NOT being left on the table on the day of a traditional IPO. The cost of a traditional banker-led IPO is approximately 2% dilution to existing shareholders, which is less than most growth tech companies issue in equity every year.

• Direct listings make sense for a very small number of special situations that have already raised excess capital, typically at higher levels of dilution.

• Direct listings are not as democratic as they might appear, and tend to advantage a small number of elite late-stage VC and public market/strategic investors.

• Management teams miss out on a lot of constructive dialog with future public investing partners if they forego a traditional IPO roadshow.

• Traditional banker-led IPOs have lots of room for improvement: all constituents should be allowed to sell on an IPO and lockups should be eliminated or managed differently; commissions could be lower; greenshoes could be eliminated; share allocations could be more transparently auctioned.

• Management teams considering an IPO should do the work to understand their options and choose either a direct listing or traditional IPO based on their unique situation. Management teams are in the driver’s seat on IPOs! Contrary to some opinions, you are not a dumb chicken if you decide a direct listing isn't the best choice for your company.

Laser printing graphene superconductors onto fabrics creates flexible, washable textiles that can store energy without the need for batteries. “In a proof of concept, the fabric supercapacitor was charged by a washable solar cell, with stable performance for 20 days. It also remained stable and efficient in mechanical, temperature and washability tests.”

Uber is opening up its platform to employees and outsiders aiming to become an AWS of logistics and transportation. This comes along with a broader push to become “the operating system for your everyday life” including investing in more cloud kitchen virtual restaurants exclusive to Uber Eats food delivery.

If authenticity matters for the value of a social network – and I might argue it’s the only thing that matters – then peak Instagram* is already in the rearview mirror. The WSJ reports on the rise of influencer marketing on the app: “On a typical day, 421’s staff of about 30 workers churn out dozens of posts from more than 100 Instagram accounts with a total reach of around 300 million followers—more than celebrity Instagram stars Beyoncé and Kim Kardashian West combined. Advertisers on these sites pay by the eyeball—an estimated $373 million on influencer marketing in the U.S. and Canada in the first quarter of 2019, according to Instascreener, which tracks marketing on Instagram. About $265 million of that was on Instagram, up 62% from the same period a year earlier.” Instagram co-founder Kevin Systrom appears to agree: “The thing I’m bummed about is Instagram feels less authentic over time because of it.” (*I was last on Instagram in June 2012, so consider my knowledge of the platform slightly dated.)

A detailed New Yorker article on the uniquely addictive teen social app TikTok highlights its “primary selling point is that it feels unusually fun, like it’s the last sunny corner on the Internet.” No doubt this is in part because all political discourse is banned by the company’s Chinese parent ByteDance, especially if that discourse threatens the delicate social order of China. As long as the censorship is disclosed and transparent, it’s not all bad to create these “Disneyland” social network experiences (as I’ve called them in the past). Ironically, real-world Disneyland Hong Kong is seeing a massive drop in attendance because of political protests, but Disney CEO Bob Iger discusses his glass-half-full view on China (eight minutes into this video).

After Amazon straight up ripped off a shoe design from maker Allbirds, the sustainable shoe company’s founder graciously responded: “While he’d prefer that Amazon not copy Allbirds’s design at all, he’s encouraging the brand to borrow freely from his company’s eco-friendly supply chain practices, including some of the sustainable new materials Allbirds has invented.
“Given what I know about manufacturing, there is no way you can sell a shoe for that low while taking care of all of the environmental and animal welfare considerations and compliance we take into account,” Zwillinger says. “Amazon is stating that it wants to be a green company. It should be taking steps to make their products more sustainable.”

ZestFinance is partnering with Freddie Mac to help home buyers obtain mortgages by going beyond the current, shamefully-flawed credit score system that’s in place today in the US. “The ZestFinance software would parse a consumer’s financial history to analyze trends including borrowing and income. Mortgage applicants who could benefit include those who have a low credit score, high debt levels or other red flag but have other positive characteristics...”

This 35-minute video from Stripe’s developer conference titled “The Future of Payments” is insightful with respect to how quickly a payments market can change technologies and user behavior. (The video I am referencing is most of the way down the linked page.)

Some interesting data on video habits from 45M connected smart TVs and 200M connected devices: 26% of homes with connected TVs are still exclusively watching linear TV, 30% are exclusively streaming, and 44% shuffle back and forth between the two.

On the heels of last week’s news about the Walmart healthcare supercenter, Amazon announced a new health initiative focused (at least for now) on its employees. I am still eager to see how Amazon’s health JV with Berkshire and JP Morgan will come together – that JV was announced almost two years ago...is it still even happening?

Amazon announced a slew of connected Alexa devices including eye glasses, a ring, and earbuds. As they check off the list of apparel-based communication items that Agent 86 used, they still need a connected shoe, belt, tie, wallet, and handkerchief to complete the ensemble. Amazon also announced an anti-Google/Apple initiative to allow all voice assistants to be available on competing hardware platforms.

Google matched Apple’s gaming bundle with a new $4.99 monthly subscription for 350 games. One notable difference is that the new Play Pass also includes some apps that are not games such as AccuWeather. One thing I don’t quite understand on mobile game bundles: my impression is that most people play one game most of the time, or maybe a few games, not dozens or hundreds. Admittedly, I don’t play mobile games and could be totally wrong here, but I’m leaning on my impressions from console-based games and this recent comment from Take-Two CEO Strauss Zelnick (at a Goldman Sachs conference) who thinks game bundles don’t make sense for more avid gamers:
“So the average American household watches 5 hours of linear programming a day, 150 hours a month, but consumes about 1.5 hours a day of interactive entertainment, about 45 hours a month. If you're watching 150 hours of linear entertainment, unless you're less than 10 years old, you're watching 100 different programs or more. But if you're playing 45 hours of video games, you may be playing 1, 2 or 3 titles in a month. You're not -- it's not 100 titles, it's not even close to 100 titles. So it's not clear to me that a consumer wants to pay for a sort of all-you-can-eat offering in interactive entertainment. At the end of the day, for any new offering to work, you have to start by it appealing to consumers.”

Activision launches a 12-city esports league for Call of Duty in 2020.

The newly re-released World of Warcraft Classic edition is proving to be a censor-free zone for Chinese game players: “China’s Communist Party may still not be savvy enough to recruit night elves and trolls to spread its agenda, allowing WoW Classic to remain -- for now at least -- an island that fosters debate.”

Here’s a long and instructive article on the driving forces behind the rise of open-source processors in the semi world:
“It’s also about the time it takes to do 20 agreements with 20 different IP houses, noted Mendy Furmanek, director of OpenPOWER processor enablement. It’s become so cumbersome to go into building chips because of all these factors. At the same time, we really need the innovation. That’s why this [open ISA] movement is happening rapidly. We’ve got to get all of these barriers out of our way. It’s not just about money. It’s about all those things. But ultimately, it’s about faster innovation.”
“Custom processors represent the next logical step in architectural and power efficiencies. RISC-V’s modular architecture allows for elimination of extraneous logic without breaking software compatibility, and user-defined instructions can also be accommodated. And there is already a wide range of options in the market, from production-ready cores on GitHub, to commercial suppliers of RISC-V IP from companies like Andes and Codasip.”

Miscellaneous Stuff
A quad of cool astronomy stories this week:

• A network of radio telescopes caught a star being ripped apart by a black hole (there is a cool animated representation of the event in the article for astro geeks).

• Gamma Ray bursts from the centers of galaxies (which I studied in college) can go faster than the speed of light (because the superluminal speeds happen in the jet medium itself, it doesn’t violate special relativity).

• NASA has a new animated representation of how a black hole warps its surroundings.

• Planet Nine, the name given to the mysterious object that could be altering orbits of distant objects in our solar system, could be an ancient bowling-ball sized black hole instead of a large, difficult-to-spot planet. (This is more of a thought exercise than a theory, but it’s a fun one!)

Industrial chemistry’s use of fossil fuels accounts for 14% of all greenhouse gas emissions. Now companies ranging from startups to giants like Siemens are working on compound synthesis using alternatives fuel/material sources, such as using electricity (from renewable sources) to split readily-available, non-hydrocarbon starting materials (e.g., water, oxygen, carbon dioxide, nitrogen) instead of relying on fossil-fuel-powered reactors and oil-based ingredients. The increased availability of excess electricity during peak solar generating hours will make these new processes much cheaper as well.

Rising carbon dioxide levels have been shown to cause nutrients in plants to drop by 30% in some cases. As nutrient density drops, we have to eat more calories to make up for it. The same problem causes plants to produce less nectar and pollen to have less protein in it (key source of fuel for bees).

Rather than focus on a certain sensory input like a spotlight, the brain actually filters out other input. In order to overcome the risk of missing that other input, it appears the brain is wired to then periodically distract itself around four times a second in case it’s missing something important.

I watched the new Bill Gates documentary on Netflix and was fairly disappointed. It was about 30-40 minutes of breezy questioning of Gates spliced into three hours of miscellaneous Microsoft history. Basically we learn that Bill is on time, competitive, and thinks all complex analytical problems can be solved with more work. The arrogance of Gates and Microsoft 20 years ago in the antitrust period seems to echo today at the new Internet platforms; it seems as though no lessons have been learned about the role of government regulation.

Stuff about Geopolitics, Economics, and the Finance Industry
A JP Morgan survey of advisers notes that ETFs will double to roughly 40% of recommended funds over the next six years. That seems conservative, but it underscores the business risk of active managers with a “risk adjusted” view of performance, i.e., undifferentiated versus the index over time, who are relying on the advisor channel for assets and growth. Related: the SEC has introduced landmark changes to make it easier to launch new ETFs.

This article has some interesting insight into the compensation plan at Aperture, the new asset manager focused on better aligning client outcome with fund compensation: “Aperture looks at a three-year time period to calculate performance and pays portfolio managers once a year. However, half of their compensation is deferred and they only receive it if in the succeeding two years the cumulative performance over the three-year time period is equal to the performance that was achieved in that time period...He added that many firms use high watermarks, however those are risk-induced as if you outperform by 5% one year and the second year you underperform by 5%, then the next year you need to outperform by 5% just to get even.”

Trump’s negotiating tactics with China continue to be crazy like a fox as he threatened to de-list Chinese companies in the US (which Mark Cuban has smartly been calling for as a tactic for some time now) and curtail US investments in China. As the Chinese government dispatches more representatives to tech companies, be reminded that there is no such thing as a “non-state owned” Chinese company.

China is also extending its big brother oversight to select US companies by subjecting them to scoring and punishments in China. “United, Delta and American received letters last year from Chinese aviation officials saying their social credit score could be hit unless their websites labeled Macau, Hong Kong and Taiwan as part of China. Lower scores would lead to investigations, the possibility of frozen bank accounts, limitations on local employees’ movement and other punishments, according to a letter sent to United and seen by The New York Times.”

The SEC opens up the “testing the waters” meetings to all sizes of IPOs. TTW meetings allow companies to gauge investor interest and hot topics before they publicly release their S1 filing. Having done many TTW meetings in the past, they are almost always valuable for both companies and investors, and can help in some cases with the guessing in setting IPO price ranges.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

The Great IPO Debate

Takeaways:

• Shedding light on the IPO process is a welcome start to gathering more data and better aligning outcomes for companies, investors, and employees.

• Hundreds of millions of dollars are NOT being left on the table on the day of a traditional IPO. The cost of a traditional banker led IPO is approximately 2% dilution to existing shareholders, which is less than most growth tech companies issue in equity every year. 

• Direct listings make sense for a very small number of special situations that have already raised excess capital, typically at higher levels of dilution.

• Direct listings are not as democratic as they might appear, and tend to advantage a small number of elite late stage VC and public market/strategic investors.

• Management teams miss out on a lot of constructive dialog with future public investing partners if they forego a traditional IPO roadshow.

• Traditional banker-led IPOs have lots of room for improvement: all constituents should be allowed to sell on an IPO and lockups should be eliminated or managed differently; commissions could be lower; greenshoes could be eliminated; share allocations could be more transparently auctioned.

• Management teams considering an IPO should do the work to understand their options and choose either a direct listing or traditional IPO based on their unique situation. Management teams are in the driver’s seat on IPOs!

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The Great (IPO) Debate:

Let’s dig into the debate over direct-listed IPOs versus bank-led IPOs. I have been very active in the IPO market and allocation processes for over 20 years, and I have also been active in the late-stage private investing market for the last decade. While a firm like ours (NZS Capital) would benefit from more direct listings, I think for the foreseeable future, the majority of companies would be better served long term by traditional, bank-led IPOs. In my opinion, there is only a small, special class of companies that should go direct through an auction. 

Recently, legendary and extremely talented VCs Mike Moritz at Sequoia and Bill Gurley at Benchmark made several arguments against bank-led IPOs (here is Mike in the FT and Bill on a podcast), which are very much worth understanding and listening to. I completely agree with the spirit of their call for more transparency and change to the system, but I tend to think it’s more of a grey area than a black and white debate. (Side note: I am a huge fan of Bill’s – he recommended Complexity to me six years ago and it influenced the course of our investing style, leading to the creation of Complexity Investing, so everything I say here is solely in the spirit of constructive debate.) I don’t know what the ultimate truth is on IPOs, but I’m eager to put forth arguments on both sides so that we can get more data to discover the best options for each individual company.

As you’d expect, I am a huge fan of companies going public whichever way they get there. I also think that there is way too much misplaced fear in Silicon Valley about going public. Even if companies are still on the path of proving their business, they are better off being public as soon as they can – it’s almost always going to result in less dilution than a private round. For years, I have advocated for companies to go public sooner rather than later because of the huge benefits to going public and dangers of staying private for too long. Specifically, there are complications with raising too much money for too long as a private company without the constructive scrutiny and dialog a broader set of public-market investors can provide. My advice to private companies has always been: if you give us the data and the opportunity to understand your path to profitability, we can do the work to support you on that path as long-term investors. I’ve also been a successful late-stage investor with crossover investments, such as Workday, Okta, and Lyft. So, I am a fan of using private markets for late-stage companies when it makes sense. There is no religious war for me on either side of the funding fence – I want companies in all cases to do what’s right for their own business, employees, and long-term investors.

Money left on the table with bank-led IPOs:

Data suggests there is an average 18% “pop” from IPO pricing to close on the first day of trading over the last 10 years (I obtained this stat from the Bill Gurley podcast linked above). However, this is “money left on the table” only in the form of dilution to non-selling shareholders. For the vast majority of IPOs, the only shares for sale are the small fraction (~10% of existing total shares is common) of newly-created, company-owned shares. Adding in bankers' fees (~5%), that “cost” of the IPO is around 20% of that 10%, which works out to around 2% average dilution of the unsold primary shares for a typical listing. For perspective, 2% dilution is relatively modest – less than most growth companies give out in options and equity every year to employees! Here is a table showing dilution from various IPO scenarios:

No one is being robbed blind on that one-day IPO pop unless they sold pre-existing shares at the beginning of IPO trading – which, again, is typically not the case due to the lockup period – thus all remaining shareholders, on average, are facing a relatively low percentage dilution. This dilution is the only “cost” of a bank-led IPO. Companies need to determine if it’s worth it or not. If a stock falls 10% below its IPO price a few months later, then that money raised was actually anti-dilutive. Under the current system, most employees and VCs would be selling shares six months later (after lockups expire), often at higher prices than the IPO. I think in many cases a traditional IPO is worth this dilution for reasons I will go into below, but I also think there is room to get that bank commission down even lower, and a lot of room for improvement in the IPO process overall.

Excess demand and gaming the system in IPO allocation:

Another common claim against banker-led IPOs is that most deals are 10-20x “oversubscribed.” This is true but misleading: institutional investors know they will get filled, on average, a small fraction of what they put in for, and thus there is a game of putting in larger orders than desired. The actual demand for shares is ultimately very close to the actual supply at the given price determined by a bank – there is no high excess demand that is being ignored by banks. Again, this is NOT actual money left on the table.

Long-term investors that don’t flip IPO shares on the first day (or buy more shares after an issue starts trading) are typically rewarded with higher allocations in future IPOs (banks that lead IPOs typically have visibility into the first few days of trading so they can keep score on this). This positive feedback – enabled by banks – is good for companies as they build relationships with their long-term investor base, and good for companies who list in the future, as the data can enable optimal balancing of long-term investors and liquidity by banks. 

There are obviously bad actors and flippers trying to gain from the IPO market. Often these are hedge funds that trade a lot in other stocks and derivatives that generate a lot of commission dollars for banks, creating a conflict of interest whereby a bank can allocate shares to a flipper knowing those shares will get flipped and that the bank will make more money on future commissions for other trades. However, it’s also important that stocks have adequate liquidity, and if 100% of shares are allocated to long-term holders, the lack of liquidity can create unnecessary volatility. A more transparent allocation process could curtail this type of behavior. Additionally, allowing more employee and VC shares to be available on day one of an IPO, like you have in a direct listing, would likely help the liquidity issue (I cover this in more detail below). 

Another problem with bank led-IPOs are greenshoes. Greenshoes allow banks to buy an incremental 15% of shares from the company at the IPO price. The details are a bit tedious, but greenshoes were essentially introduced as a mechanism to theoretically stabilize stocks following the start of trading. However, they seem to have become an unnecessary way for banks to make money on a transaction without providing a ton of value to companies or investors; as such, I don’t see much downside in eliminating them from the IPO process.

When does direct listing make sense?

A main reason for going public is to raise capital for the company itself (in the form of creating new primary shares, that ~10% discussed above). Direct listings currently don’t allow companies to create new shares (instead allowing sale of 100% of existing shares), but this situation could change with future legislation. So, currently, if companies want to raise money and do a direct listing, they would need to raise money ahead of the IPO – possibly using a banker and likely at a lower price per share than what they would garner in a future IPO. This is illogical to me because it would cause more dilution to all shareholders. Slack raised about $500M in a Series H round at about $14/share in 2018, which enabled them to do a direct listing in June of this year. That private round caused about 2.5x more dilution compared the $38.50 their direct listing traded at. Spotify raised about $500M at $55/share in their series G and $1.1B at $125 in their series H private fundraising to enable a direct listing IPO that started trading at $165/share. Were these dilutive pre-IPO rounds smart capital allocation decisions? I could argue that the direct listings of Slack and Spotify advantaged a very small number of VCs and strategic investors in the late-stage private rounds and disadvantaged the average investor buying in for the first time on the IPO. There are of course a small number of tech companies that generate cash and do not need to raise a big dilutive private round, which could consider direct listings.

Brokering owner-investor relationships – an advantage of bank-led IPOs:

When a company goes public via a direct listing – providing informational videos and a prospectus to potential investors instead of having one-on-one interactions – I think it’s a massive missed opportunity for open dialog. A bank-led roadshow allows management teams to meet a large number of diverse investors, and while they aren’t perfect, I know far more CEOs and CFOs that greatly valued an exhaustive set of meetings than management members who disliked the experience. Meeting as many investors as possible is also a critical way to establish beneficial, long-term relationships. To some extent, companies can “choose” their shareholders by educating them, being consistent, and under promising while over delivering on expectations over time. Investors that understand a business will provide ballast for the stock when companies inevitably hit a rough patch (and 100% of companies experience these!) and thus dampen volatility (which is, quite frankly, good for employee morale if nothing else). It’s not clear to me that a typical retail investor can watch a video, read a prospectus, and make an informed decision on their own about a soon-to-be-listed company, to the potential detriment of both owner and investor. As such, while direct listings may seem more democratic with respect to the ability for any investor to buy shares, they actually favor large funds who have the resources to meet with companies for years leading up to IPOs. I still see the potential benefits of opening up IPOs more to retail investors and advisors, and I think this is a clear change that needs to happen. IPOs are risky investments though, maybe not as risky as Bitcoin, but a lot of effort needs to be put in by retail investors to understand the risks and valuation of the businesses they are investing in.

The tricky business of valuation:

In addition to opening up participation, allowing for both more sellers and more buyers in an IPO transaction makes good sense with respect to valuation. I like the idea of VCs and employees being allowed to sell on IPOs, which is a big positive for a direct listing. Much of the price volatility following bank-led IPO results from the tiny float (recall that often only 10% of shares outstanding are available to trade) until a lockup expires. Lockups usually last six months and create a lot of problems for the stock, employees, VCs, and investors. Having 100% of shares available to trade day one is likely a better way of matching supply and demand and determining a fair starting price (assuming you have a good population of informed investors!). It’s important to note that more supply could actually mean a lower IPO price in some cases, especially if there are fewer investors who were able to meet with companies and understand the business better. Determining a price for an asset on a specific day – whether through an open auction or with an auctioneer like a bank – involves a lot of guesswork; how many IPOs trade exactly at that price 12 months later? 

Valuations, especially on young growth companies, are really a matter of opinion as they involve a lot of predictions of the future that may or may not ever come true. By definition, newer growth tech companies that are going public have a very wide range of potential outcomes. Valuing their future cash flows is a far cry from the practice of valuing a mature business or a bond. For several years, there has been a clash between public and private market valuations and expectations. Private market valuations are less efficient because they are set by one seller (the company) and a handful of buyers (VCs), whereas public valuations are set by a big population of diverse, global buyers and sellers. That said, all investors, whether they be VCs or public fund managers, can and do (all too often!) get it wrong over the short term. Valuations set too high in private markets hurt employees of those firms more than anyone else and can set up years of digestion that creates recruiting and morale problems. As legendary value investor Benjamin Graham said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, whether you conduct an auction with no auctioneer (direct listing) or an auction with an auctioneer (banker-led), the price at which a company starts trading on any given day is frankly a guess.

To pick on one example just to show how hard it is to value a company on a single day with a wide range of future outcomes, let’s again look at Slack and their direct IPO listing in June. Slack is a great company with a great product that is early in its adoption curve and facing a range of competitors. While it’s easy to be optimistic about the future of Slack, there is a wide variety of opinions on what the value of Slack’s future cash flows should be priced at today. The stock is down around 40% from its IPO compared to the S&P 500, which is flat, and the Invesco Dynamic Software ETF, which is down 5% over the same time period. There was a tech momentum market sell off in the month of September; if I attempt to normalize for that movement, Slack is down around 20% relative to the market. It’s hard to argue that retail investors benefited from this particular direct listing, yet it’s also impossible to know if a traditional IPO would have opened at a different price and how it would have traded in the subsequent couple of months. Valuing a stock with a wide range of outcomes on a single day is anyone’s best guess.

Brokers in the age of transparency: 

A broader point here – one that is near and dear to SITALWeek – is the role of brokers in the Information Age. The traditional broker in many industries is built on information obfuscation – holding dear the details that people need to pay you for. In this new age of transparency, that’s not going to work anymore, and that’s why there is now significant room for improvement to the bank-led IPO process. But that doesn’t mean there is no role for the bank either. 

We have seen a bifurcation and/or broadening range of broker value in other industries as well. For example, I’ve written extensively on Zillow and iBuying: in the real estate market, the traditional 5-6% commission is changing to a range of 1 to 10%; in some cases a broker adds 1% value, while in others liquidity provided in a transaction could be worth 10% or more. Or consider travel: we can go online and instantly book flights for no fees, but if we want to book a three-week tour of Europe, it’s great to have a human with experience help you out and earn a modest fee for doing so. 

I’d suggest the same is true of the role of banks in the IPO process: some companies don’t need them, but many could benefit from their involvement, especially if that involvement evolves into a higher win-win outcome for everyone. I’m not here to defend banks: although there are some banks that I think genuinely want to provide clear win-win outcomes, some are simply trying to maximize their own cash flow. The reality is that banks provide an efficient medium for new companies to meet a wide variety of investors, and that role has some value. Without banks, their conferences, analysts, and introductions, these encounters would be possible, but much more difficult and higher friction. Just like you wouldn’t necessarily want to list your house and leave the door unlocked, or make people rely only on photos and videos before they buy, it can be helpful to have broker remove some of the friction and qualify buyers. 

IPOs in an ideal world: 

I believe there is significant room for improvement in the current IPO process. I would favor a hybrid approach that involved banks and traditional roadshows combined with more informational videos and a more transparent, auction-based system that allowed more sellers upfront by eliminating the lockup periods. This system would set a price that is closer to market clearing even though it’s possible that price would be actually lower than a liquidity-constrained, traditional banker-led IPO. The reality is we need a lot more data on direct listings and we need more experimentation on bank-led IPOs. So, this dialog is welcome and needed for companies, VCs, investors, regulators, and bankers.

Advice to Management: 

Take an active role in your IPO process whichever path you take. If you choose to do a traditional bank-led IPO, then be aware that you are in charge. It’s your company’s shares that are being sold. You can actively allocate shares to investors you want to partner with for the long term, and you can have full and transparent access to the order book, client information, and the real demand level those clients have, not just their inflated share count they’ve asked for.

In a passionate editorial in the FT, legendary VC Mike Moritz penned the following taunt aimed at managements of private companies considering going public: 

“During the next couple of years, companies already well advanced with plans to go public will probably use the conventional approach. But, for all others, the choice of a direct listing or a traditional IPO has become a test of two attributes: courage and intelligence.”

Instead of telling management teams they are both chicken and dumb for not choosing a direct listing, I would instead suggest the courageous and intelligent thing to do is gather information and make an informed decision that's the best choice for your company, employees, and investors.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #211

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, concrete-healing fungus, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

In today’s post: hide-and-seek-playing AI teams learn how to use tools; how a modern payments platform would function; what’s worse: the IPO discount or the terms and valuations on VC deals? Drugstores face dual threats from Walmart and Amazon; increased scrutiny of Google and Amazon’s search prioritization; the great re-bundling of content; Netflix is not on its deathbed; Bob Iger is also not short Netflix, and other insights as his memoir comes out; and lots more below...

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Stuff about Innovation and Technology
Daimler will shift all of their resources to electric engines as they stop development on future combustion engines. I think the odds are against the traditional car makers as they find themselves a decade behind Tesla and the Chinese EV makers on software and battery technology.

A fungus called Trichoderma reesei can be used to self heal small cracks in concrete before they become bigger problems: “The fungal spores, together with nutrients, will be placed into the concrete matrix during the mixing process. When cracking occurs, water and oxygen will find their way in. With enough water and oxygen, the dormant fungal spores will germinate, grow and precipitate calcium carbonate to heal the cracks.”

Dating app Tinder is launching an interactive streaming video where the choices you make can match you with potential partners on the platform. It seems like dating apps are increasingly becoming social networks, so it’s no wonder Facebook is trying hard to get into the dating gig. In Japan, people use Tinder to find others to help them practice different languages. As one SITALWeek reader pointed out to me, it’s yet another move toward the gamification of dating, and I wonder if it’s a factor in the delayed Millennial marriage trends?

OpenAI had teams of AI agents play hundreds of millions of games of virtual hide and seek. After 25M games, “hiders learned to move and lock the boxes and barricades in the environment to build forts around themselves so the seekers would never see them”; and at 100M games, the seekers found ways to breach those forts. This back and forth escalated for some time and demonstrated many emergent and unexpected behaviors.

In case you missed it, check out our new long read on the evolution of the trillion-dollar food industry. I also just recently came across this detailed look at delivery economics with tons of data and interesting insights from the founder of restaurant CRM software provider Thanx.

Walmart opened its first healthcare supercenter with “primary care, dental, optometry, counseling, laboratory tests, X-rays, hearing, wellness education and behavioral health” all in one location. As we discussed in our new piece on the evolving food industry, Walmart is well positioned to take share in grocery, especially with their $98/yr unlimited delivery plan, and perhaps they have a shot at becoming a winning platform for healthcare as well.

CVS and its subsidiary / joint-venture Surescripts stopped doing business with Amazon’s Pillpack prescription delivery company. This is an embarrassing sign that the incumbent pharmacies are scared enough to risk monopolistic “refusal to deal” government action in order to stop the competitive threat. Surescript is already being sued by the FTC for illegally monopolizing the e-prescription market. Raise your hand if you find the current experience of going to a drugstore for a prescription a real joy in your day...anyone? (We wrote a bit about this issue of standalone businesses like drugstores struggling to become platforms a year ago.)

But, Amazon is not looking so innocent either: as the WSJ revealed this week, the company changed its search algorithm to favor its own products. What Amazon did is very similar to how all of retail operates, especially a company like Walmart. Walmart sees what sells well, creates a private-label version, gives it preferential shelf placement (like a “search result” in a store), and undercuts the brands all while pressuring brands to also lower their prices. Many stores get 10% of sales and a higher percent of profits from private label. Drugstores do the same thing with private-label OTC drugs. What feels a little more manipulative with Amazon is the importance of top placement in the often-lengthy search results, and the presence of the "buy box", which creates a more restrictive consumer experience than when we physically scan shelves as we walk through a real store. Investors are left wondering if the increased appearances of a yachting Bezos on the society pages is correlated with questionable decision making at Amazon. It was encouraging, however, to see the company step up their environmental focus and order 100,000 electric delivery trucks from Rivian this week. Rivian expects to have 10,000 of those vehicles on the road for Amazon by 2022.

And, speaking of manipulating search results, this recent survey shows that 68% of liberals, 67% of conservatives, and 71% of independents are in favor of breaking up Internet platforms to stop prioritization of their own results and content. A slightly lower percentage was also in favor of breaking up platforms if it meant more competition broadly. The questions in the survey appear somewhat leading; the company has a reputation for doing legitimate surveys, but I am unable to track down the methodology. Politicians on both sides are already in favor of moving against big tech. This is not straightforward from an investment perspective because regulatory capture or breaking companies up can cement monopolies. As we said in our recent tech reg papers: it’s likely governments won’t inflict a lot of harm, but they could cap the upside to these businesses.

This week FedEx stumbled on its outlook. They blamed the economy, but I can’t help but wonder if it’s also the broader factors we’ve previously discussed in SITALWeek. FedEx might be looking to Google’s drones to help it out, but it probably won’t be enough to offset the rising competition in the delivery world as the center of power shifts from global logistics, which are now table stakes, to technology platforms with vertically integrated customer relationships. We like to ask: if a company were to disappear overnight, what would the impact to the world be? Here is an excerpt on that from SITALWeek #205 back in August:
“FedEx ended the rest of their relationship with Amazon this week. It’s widely expected that Amazon could soon offer a broader delivery service, allowing anyone to use their logistics and delivery network for packages. Although FedEx can still partner to deliver for many other shippers, the reality is that, if FedEx disappeared overnight, within a few months the system would re-equilibrate as competitors hire drivers and lease trucks. In the US, it’s not clear why we need UPS, FedEx, Amazon, USPS, and a host of regional carriers and on-demand couriers all visiting each house every day.”

This FT article makes a flimsy bear case on Netflix. The article cites Damodaran, a professor of finance who tries to precisely predict the future by calculating the equity risk premium down to the 2nd decimal point (spoiler: he can’t, nor can anyone else). Whether you are a bull or bear on Netflix, at least checkout more-informed views on the company’s debt and other misunderstandings like this analysis from Matthew Ball on REDEF. And, this article from Matthew is great as well. (Oh, and I have an article on ViacomCBS where I discuss my thoughts on the proliferation of streaming apps.)

Viacom CEO Bob Bakish did a good job articulating the strategy around the merger with CBS in this CNBC interview. Viacom also announced a partnership with BritBox in the UK that I thought was smart for both companies as well as securing the rights to Seinfeld for its cable networks (like Comedy Central). Meanwhile, Netflix’s CEO discussed how inflation will keep rising for creating content, and Netflix only has 5% share of video viewing today. And, this week Disney reached a carriage deal with AT&T/DirecTV after the video provider lost over 300,000 subscribers due to the CBS blackout last quarter proving the drop off in traditional video subscribers remains manageable, favoring the content owners.

In other streaming news, in a smart move Comcast is making it’s Flex digital set-top box available free to data subscribers. The shift to streaming is just a re-bundling opportunity, plain and simple. In the past, Comcast made money in video by bundling content and owning the customer relationship. Digital streaming has shifted the power permanently to the content creators and owners, who can now go direct and own the customer. But the customer (or at least me!) needs a single user interface with functional universal search. No one even comes close to providing a good customer experience across apps today – not Roku, not Amazon, not Apple, not Google, not anyone. Hulu and Disney+, with the reselling of premium channels like HBO, gets you about half way there, but the UI is still mediocre. Maybe Comcast will fail at this as well, but we need more companies trying to bundle apps with a single UI + universal search across platforms for the benefit of consumers.

You might ask: what's the difference between a content owner distributing their app through a digital bundler like Comcast Flex, Roku, Amazon Fire, Apple, etc., compared to selling their channels through a package on Comcast, DirecTV etc.? Data, data, data, and pricing. The content owners can strike new digital distribution deals for their apps and content that allow them to control data on customer viewing and marketing. And, they can set app pricing and revenue splits that more accurately reflect actual consumer demand. So, again, this is a "have their cake and eat it too" shift in distribution whether they go direct or through a digital gatekeeper.

The attacks on Saudi oil facilities were a combination of unmanned winged planes and cruise missiles. The widespread press reports of a “drone” attack were a bit misleading. That said, the risk of cheap swarms of drones that could be operated together with explosives in attacks is concerning. Recently Lex Fridman interviewed Penn professor Vijay Kumar on drones, and I found the podcast insightful.

This week in facial/image recognition news: a woman in China can’t pay for anything after a nose job; UK police have arrested 58 suspects since 2017 using facial recognition tech; private investigators and repo men have built their own database to track you by pooling data collected as they drive around. And, in lighter machine vision news thanks to cows' unique markings, it’s easy to track them around the barnyard: new platforms are emerging to keep tabs on cow behavior and diet to improve overall animal health.

Qualcomm is acquiring its RF joint venture in a bid to integrate the radio chips into a single 5G package. This move could be a threat to incumbent filter and RF-chip makers like Broadcom, Skyworks, and Qorvo. But, it might also be an attempt to create an integrated and easy-to-adopt IoT 5G system on a chip. In other words, this might be to expand the market for 5G more quickly beyond phones.

The irrelevant patent troll IBM, which I consider leftover flotsam from the 1900s, has filed yet another suit against a tech company that is actually innovating. In this case, IBM says they invented "using computing power to analyze the quality and desirability of a geographic area and list-based searches that let users see the results on a map that fits within their screen", and Zillow needs to pay up. This is the second notch in Rich Barton's IBM lawsuit tally – IBM also went after Expedia, a company Rich co-founded.

What would a modern payment network look like?
In terms of value, cash, check, and debit are roughly 45% of the payments market in the US. About 34% is ACH or automatic electronic payments, 17% is credit cards, and the rest is mobile and miscellaneous (e.g., prepaid) as of 2017. Credit cards are mainly for rich folks: households that make less than $25k/yr use credit for 7% of transactions compared to 33% for those that make over $125k/yr. Debit is mainly for young folks – accounting for 48% of transactions for the under-25 age group, but only 16% for people 65 and older (source). I worry that the current credit card monopoly tech stack is an unnecessary tax on payments and the economy. But, let’s put that credit card debate aside for now and assume credit cards will stay on their current growth trajectory (because, in 21 years of professional investing, I’ve never seen stocks so universally loved, defended, and idolized as Mastercard and Visa, and I’ve lost my will to debate them).

Instead, let’s look at the 45% of the cash/check/debit payments that is no- or very-low fee. This transaction group is also 63% of actual transactions (more frequent usage for smaller amounts vs. credit). Instead of turning the several hundred billion dollar tax on payments into a trillion dollar tax, as credit cards continue to take share from cash, there is a real opportunity to create a much bigger win-win outcome for merchants and consumers.

What would be the highest non-zero-sum, or win-win, payment replacement for cash and checks? Here’s what I think it would look like: payments would be free to merchants; the actual cost of transacting would be paid for by data. Consumers would be rewarded with a loyalty program if they opt-in to sharing their valuable data. Reliable merchants would get their money right away. Data would also be leveraged to provide user friendly and transparent credit to consumers and merchants alike. This type of product would be easily doable today and would create enormous value for merchants, consumers, and the payment platform that pulls it off. It wouldn’t have to be exclusive of credit cards, but it’s likely that the monopoly payment stack would withhold their cards from such a competitive platform.

Who could pull this off? When we are paying in cash, we are usually there in person, so a smartphone-based system with no physical cards of any kind would seem to make the most sense. Certainly Apple, Google, Amazon, and Walmart in the US are large enough and interested enough to create this alternate payments platform, but government regulation is going to be tricky for those companies as they expand into adjacencies. PayPal has already rolled over and gotten into bed with the establishment, so I’d count them out. Square and Stripe could give it a go, but are also largely beholden to the established card system. Replacing cash with something better than debit and credit cards is just one of the many fun thought exercises in the payments landscape, which is ripe for digital disruption.

Miscellaneous Stuff
Disney CEO Bob Iger’s new memoir The Ride of a Lifetime has arrived before his actual retirement, which he keeps postponing. This excerpt in Vanity Fair covers his relationship with Steve Jobs and the Pixar acquisition including this interesting comment: “I believe that if Steve were still alive, we would have combined our companies, or at least discussed the possibility very seriously.” I am eager to read Iger’s book as soon as it's released this week, and I will greatly miss his stewardship of Disney when he finally retires.

This line in from a NYT interview with Iger reminds me of the ancient Confucius idea of wu-wei, or trying not to try: “[Iger’s] book makes clear how much effort went into his effortless demeanor.”

Iger also comments on the last-minute decision to kill Disney’s acquisition of Twitter in that NYT article: “I like looking at my Twitter newsfeed because I want to follow 15, 20 different subjects. Then you turn and look at your notifications and you’re immediately saying, why am I doing this? Why do I endure this pain? Like a lot of these platforms, they have the ability to do a lot of good in our world. They also have an ability to do a lot of bad. I didn’t want to take that on.”

At the end of that NYT interview Maureen Dowd did a rapid fire “confirm or deny” with Iger which yielded this:
Maureen Dowd: “Your biggest position in your personal stock portfolio is a Netflix short.”
Iger: “Very false.”

Google’s quantum computer was said to have performed a calculation in three minutes that would require the world’s most powerful silicon machine 10,000 years. It seems likely the calculation was designed specifically for the quantum computer and has no real-world value. Just a reminder – we are still in the ‘BS phase’ of quantum computing; maybe someday, in the distant future, they might be functional with some real-world value, but not today.

Stuff about Geopolitics, Economics, and the Finance Industry
Bill Gurley took banks to task again this week over IPO mispricing – citing an average 30% discount that favors investors over companies (Twitter thread). Having participated extensively in the IPO process for 20 years, I agree there is room for improvement. The very small number of shares floating at the time of IPO makes it difficult to balance finding long term holders while also assuring there is ample liquidity in the stock. That said, there is also a lot of opacity and lack of good, market-clearing “price discovery” for private investment rounds. In many cases, private companies are leaving a LOT more money on the table by underpricing themselves in VC rounds as compared to their IPO rounds. IPOs will always be a lower cost of capital compared to VC rounds (which can sometimes have costly rights associated with them), which argues for going public sooner rather than later (there are many more benefits to going public sooner as well for employees, marketing, recruiting, culture, etc.). That said, young companies have a wide range of outcomes, and whether doing a VC round or an IPO, they are going to have to give something up to investors for that risk. While there is no reason the mega Wall St. banks need to be involved to the extent they are now, some of them can be quite helpful in the IPO process (especially all the thoughtful bankers that read SITALWeek!). I recommend private companies use banks to get to know public investors well before the IPO process – then they can “pick” their investors by communicating, operating consistently, and underpromising such that they can out-deliver expectations over time.

I’ve been getting questions about whether I think the US is headed into a recession. My answer is this: invest always like you are already in a recession, then it won’t matter whether we have one or not. That means invest in adaptable companies that will do well over the long term and create opportunities out of short-term problems. We cover those characteristics in detail in our Complexity Investing paper (chapters 2 & 3). So, it doesn’t matter that more investors think a recession is coming than any time in the last 10 years (38% now believe) or that Gundlach thinks the US is going into a recession and it will be “a long time before it goes back to the high of October 2018.” Nobody knows – the economy is a complex adaptive system that defies predictions of nearly any type.

Trump understands the value of Taiwan, and that is increasingly important in the US-China trade war, which is highly unlikely to have a resolution. As I’ve said in the past, we are simply in a long period where the cost of doing business with and in China is rising.
“At this point, we can only guess what President Trump really thinks about Taiwan. He has yet to address the public on this issue. But if actions speak louder than words (and tweets), then he must see tremendous value in this island democracy.”

Alibaba and Tencent are refusing to cooperate with the Chinese government’s Baihang credit scoring system by holding back the data from their users' financial transactions. It’s a notable rebellion as the Chinese control of the two companies has risen dramatically in the last couple of years.

“The Los Angeles-based real-estate firm [Colony Capital] is a global investor with $55 billion in assets under management. Colony aims to sell as much as 90% of its $20 billion property portfolio of hotels, warehouses and other commercial real estate by the end of 2021, company officials said last week. Colony said it would use the proceeds to buy data centers, mobile phone towers and fiber and grow its digital real-estate investment management business.” Maybe they can sell to Blackstone, which has raised the largest property fund to date of $20B to chase the bubble in illiquid private assets. “The capital ready to be deployed has swollen to over $2 trillion, according to data provider Prequin, driving up asset prices and deal making activity.”

Big Wall Street banks are trying to compete with consultants by selling their research – which professional investors apparently no longer find particularly valuable – to corporations, who, I imagine, are likely to find it of equal utility. This discussion excludes, of course, the great research from the smart analysts that read SITALWeek ;-)

-Brad

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The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

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Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #210

Stuff I thought about last week 9-15-19

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, giant flying reptiles, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

In today’s post: an essay on the rapidly evolving food delivery, restaurant and grocery industries; legislating rideshare labor could paradoxically cement the incumbents position due to regulatory capture; influencing social change with “terms of service”; the complexity of commerce with the Santa Fe Institute; understanding quantum mechanics; the latest neuroscience on the lack of free will; and, lots more.

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Stuff about Innovation and Technology

Congrats to NZS Capital co-founder, and now legendary runner, Brinton Johns for his 27th-place finish in the 100-mile race through the mountains of Colorado!

I had the pleasure of attending the Santa Fe Institute’s working discussion on The Complexity of Commerce this week hosted at Shopify. To give some sense of the actual complexity of commerce, this event was originally slated to be hosted by a retailer that subsequently declared bankruptcy ahead of the event. As the WSJ reported, there were more store closures in the first half of 2019 than all of 2018. The event covered a wide range of topics with presentations from some of my complexity science idols: Brian Arthur, Bill Gurley and Michael Mauboussin. This link for the event has some suggested reading (some of which I’ve highlighted in the past). Here are a few things I found interesting:

• Increasing-returns guru Brian Arthur explained that he expects network effects will continue as they have for decades in tech – creating/sustaining natural monopolies, which should continue with AI. Proprietary data sets and who has access to them are increasingly the most valuable things in tech platforms.

• Arthur reminds us that regulation always comes to the Wild West, but that is can take decades. The “Dickensian” period of the Industrial Age in Britain took 30 years to be addressed and even longer to fully get under regulatory control (100 years?).

• Arthur suggests we are in the “distributive age” where it’s not about GDP (which is a weak measure of progress) and jobs, but maximizing access to the economy for the most people, i.e., intelligently distributing the wealth of the economy.

• Stitch Fix CTO Cathy Polinsky and SurveyMonkey COO Tom Hale both discussed the importance of humans and AI working together to improve algorithmic outcomes. You can read more about Stitch Fix’s AI efforts in this article.

• John Hagel from Deloitte suggested we could see infrastructure layers of the economy continue to concentrate, while products and services could continue to fragment into more and more niches. I’d take this one step further to say the massive infrastructure layers like AWS seem to be enabling the fragmentation itself.

• There was a fair amount of discussion about the increasing role of search as a gatekeeper in commerce. I think this applies not just to search engines, but e-commerce platforms as well, which increasingly serve ads to buyers. At some level, if the infrastructure layer is consolidating more, then it will be possible to put a higher and higher tax on access to it (see article below on clothing brand Everlane's impossible cost of acquiring new customers).

• There was some good discussion on regulatory capture cementing current platforms, but also potentially paralyzing or slowing them down (See more on regulatory capture below in the gig worker paragraph).

• At the event, I chatted with Alex Komoroske about his views on complex systems, which you can find in this essay: algorithms that have emerged from technological progress are increasingly optimizing for the wrong outcomes because they maximize for attributes that mattered during the scarce resource period that drove human evolution, but can be dangerous in times of abundance.

Nearly 150 CEOs sent a letter requesting action from government on gun control. In SITALWeek #195, I discussed Salesforce.com’s decision to stop selling their e-commerce platform software to gun sellers in the US:
Salesforce is telling its retail customers to stop selling automatic and semi-automatic rifles or they will be blocked from using their software. Cynically, I could argue this is motivated by limiting their own liability (e.g., if Salesforce’s Demandware e-commerce software was used to sell a weapon subsequently used in a crime). However, maybe it’s more than that, or maybe it could be more. With simple “fair use” policy changes, the handful of cloud software platforms underpinning the entire economy could globally influence social change. Marc Benioff, Satya Nadella and a few other tech leaders could set policy and dialog for the world based on their end user agreements. Once you think this through, it's not a question of "how could they justify this?", but instead “how could they not?”
Given the number of tech companies that signed the letter, I would provocatively ask: if a tech company has a specific view or goals concerning social outcomes (whatever those may be), would it be more effective to drive change by changing your terms of service to explicitly promote that outcome? This should be considered legal behavior under refusal to deal rules. For example, if you want to end ocean pollution (I’m looking at you Benioff!), then incentivize your customers to eliminate single-use plastics from their products. Or, perhaps a little more extreme: if your company wants action on guns, guns are made of steel, so don’t sell software or hardware to the steel industry.

If you missed our recent appearance on The Stock Podcast, you can listen here (or iTunes link) or read a PDF the transcript here. I want to briefly expand on one topic Brinton covered in the interview: he mentioned that there are a handful of companies in the semiconductor supply chain that, if they were gone tomorrow, would send the world back in time and grind the economy to a halt. One company mentioned in that vein was ASM Lithography, which enables every single advanced processor, 5G, and AI chip made today. The world now runs entirely on these chips. Without them we’d go back in time 10-20 years. More broadly, this test is very useful for estimating the value of a company: if a company disappeared, what would happen? To give a provocative counter example to ASM Lithography, what if Facebook were gone tomorrow? Besides the obvious loss of $500B invested in its shares, it’s not clear the world would be significantly different by the end of the week. This is of course true of many consumer-habit companies like Facebook or Coca-Cola, two companies that exist by exploiting evolutionary mechanisms for gossip and calories. This doesn't mean Coke and Facebook won't be bigger 20 years from now, it's just an interesting exercise on the utility of a business. (Eventually, if the negative health consequences are big enough, habits can change with education.)

Online retailer Everlane said that the increasing cost of paying online ad platforms to acquire new users has made it so no online business can be profitable. Is the increasing toll taken by search, social and other online ad networks stifling innovation? Government regulation appears to be catching up to this risk.

As food consumption habits radically transform in the coming decades, the biggest loser might be grocery stores. As food-delivery platforms platforms vertically integrate with cloud kitchens and white-label brands, offering subscription packages with routed and scheduled meal deliveries, it’s possible delivery might become cost competitive with home cooking for some households. Grocery stores operate on razor-thin margins that are already under attack from e-commerce. The dramatic transformation of the trillion dollar US food industry would also change the type and mix of restaurants that survives and could even re-write the food supply chain. Checkout my long read on the death of food consumption as we know it.

Speaking of food, here is a great example of the creative destruction happening in the restaurant space: diet brand Whole30 is launching a delivery-only restaurant in Chicago in combination with Grubhub to cater to customers looking to improve their health. It’s not a stretch to think such a business could launch a subscription service with scheduled and routed meal deliveries, perhaps even subsidized by health insurance or employers.

Walmart looks to expand their 26% share of grocery sales in the US by expanding their unlimited delivery service to 50% of the country by year’s end. The service costs $98, which is vastly cheaper than the time/cost dedicated to driving to the store and pushing a cart around.

For gig economy workers, is job security more important than flexibility? As expected, California passed legislation this week that would require companies like Uber and Lyft to reclassify contract workers as full-time employees. Gig companies have plans to fight the legislation on multiple fronts, from saying that drivers aren’t core to the business to advancing ballot measures to reverse the legislation. It seems to me that more and more people are choosing to enter the gig economy (36% of US workers according this Gallup report), and there is a competitive market amongst dozens of gig economy companies for these workers. The legislation is based on the assumption that gig workers are currently underpaid and being taken advantage of. There is room for improvement of benefits and pay for gig workers, but I am not sure this legislation would achieve a net improvement. Uber said recently that this type of legislation would force drivers to work full time for only one rideshare company, which (contrary to the legislators’ apparent intent), would be a boon for Uber and Lyft. Think about how hard it would be for new entrants in rideshare/delivery to hire a large network of drivers if they are all locked into one existing platform? It could also consolidate market share as drivers choose to work for the largest platform. This lack of competition would be bad for both consumers and workers. Drivers would have fewer on-demand companies competing for their labor. Perversely, legislation could make everyone worse off except the largest gig companies themselves due to regulatory capture; we touched on this concept in our two tech regulation papers, and, as other smart folks like Bill Gurley have recently pointed out:
“Perhaps the key reason Silicon Valley should be wary of U.S. regulation of big tech is that it will make it that much harder for the new startup to disrupt said incumbent.”
Lyft’s co-founder John Zimmer discussed the issue at the Deutsche Bank Tech conference this week:
“...independent contractors, the way labor law is written, if you want to provide benefits to a small portion of your drivers, you then turn all your drivers into employees, which isn't the best thing for society because if you flip all the way to employees, you only get a certain type of worker, and in our case, 91% of our drivers drive less than 20 hours, 76% of our drivers drive less than 10 hours. And so going full-fledged employee mode, while there would be some pros and cons for us, the con being additional cost for a certain subset of workers, the pro being you'd have a different amounts of control where you could ask drivers to work specific shifts at specific times. So in some ways, it will be easier to manage the marketplace. But then you would hurt the majority of the drivers that are doing this on a more supplemental income basis and don't want to work shifts.”
I’d like to see all gig economy companies focus on building long-term, sustainable businesses with prices high enough to support fair wages and benefits while continuing to provide more value to all of their constituents. Regulation, as it’s currently looking, could make everyone worse off.

NVIDIA’s AI chips are often criticized by competitors for using too much power compared to custom alternatives. The company’s chief scientist countered in this interview that NVIDIA’s Tensor Core for deep learning is just as efficient as custom chips, and the 10-20% difference in GPU power overhead is offset by not having to fetch data back and forth. NVIDIA also isn’t yet seeing the need to jump on the chiplets bandwagon (the new trend in chip design, which allow you to go vertical and stack different chips in a single die). It seems that NVIDIA, with the millions of CUDA programmers, remains poised to own the network effect for AI. Related: chip giant TSMC is pushing hard to keep Moore’s Law on track for decades to come with 2.5 and 3D structures.

The long tail of streaming video, in aggregate, is now consuming more bandwidth than Netflix at 12.8% of bits vs. 12.6%. As I’ve said in the past, the media industry is in a “have your cake and eat it too” period where the rising value proposition of content and direct-to-consumer subscriptions can more than offset cord cutting. And, the market isn’t 100M+ US households, it’s billions of smartphone users globally. I discussed some of these points in my recent essay on ViacomCBS.

Further highlighting the lack of non zero sum in the music streaming business, Spotify, Google, Amazon, Sirius, and others protested a move to pay songwriters and composers more money. Apple, the sole proponent of the move, had this to say:
“Apple doesn’t think it makes sense for [songwriters] to be dependent on the business success of the services that use their music. They should get a consistent, predictable, and transparent per-play rate, and then it is up to the services to run the most innovative and efficient businesses possible for which they can recoup the upside.”
Companies like Spotify are effectively trying to arbitrage between what music is worth, i.e., what singers and songwriters should receive for their art, and what people are willing to pay for it. Right now, that proposition seems to be upside down: people aren’t willing to pay enough to support the art and provide margin for the distribution. Here is Spotify’s argument, which I will leave without comment:
“With lower royalty rates, we can develop a better product, and if we can develop a better product, more people will be willing to pay, the market will expand, and the total value to the entire ecosystem will grow.”

Thanks to tech advances and declining costs, every city in China could be solar powered at grid parity today without subsidies.

Apple’s new lineup of 4G iPhones announced this week could cause the company to lose share in China.

Miscellaneous Stuff
Even physicists don’t totally understand quantum mechanics, but if you want to learn why that is the case (and get a shot at understanding it yourself), checkout Sean Carroll’s latest book Something Deeply Hidden. Sean’s last book The Big Picture is one of my top-recommended books to people that ask me for suggestions. I am about one third of the way through Something Deeply Hidden, and if you want to try to understand the implications of Quantum Mechanics, it’s the most approachable book I’ve come across. Spoiler: Sean is a big proponent of the “many worlds” interpretation of quantum mechanics (and so am I, or should I say so are we...me and my infinite copies...well at least I hope I mostly agree with myselves!). Sean, a professor at Caltech, an external staff member at the Santa Fe Institute, and a physics advisor on Marvel movies, explains in this Wired interview: “We see tables and chairs and people and planets moving through spacetime. Quantum mechanics says that there are no such things as tables and chairs—there’s just something we call a wave function.”

Citing a seven-year-old study and unpublished work, a misleading Atlantic article this week muddied the waters regarding the point at which we are consciously aware of what the brain wants us to do/think/say. The article brings to mind this old joke: Do you believe in free will? Of course, I have no choice. The idea that we could be fully aware of the activity in our brain before we are consciously aware doesn’t pass any kind of logical or real-world feeling test. Importantly, the Atlantic article only cited studies concerning brain signals related to motor movement; a more recent study showed “the outcome of a free decision to either add or subtract numbers can already be decoded from neural activity in medial prefrontal and parietal cortex 4 s before the participant reports they are consciously making their choice.” In Sapolsky’s Behave, he goes through some of the things beyond our control that nonetheless unconsciously impact our behavior, including: “blood glucose levels; the socioeconomic status of your family of birth; a concussive head injury; sleep quality and quantity; prenatal environment; stress and gluticocorticoid levels; whether you’re in pain; if you have Parkinson’s disease and which medication you’ve been prescribed; perinatal hypoxia; your Dopamine D4 receptor gene variant; if you have had a stroke in your frontal cortex; if you suffered childhood abuse; how much cognitive load you’ve borne in the last few minutes; your MAO-A gene variant; if you’re infected with a particular parasite; if you have the gene for Huntington’s disease; lead levels in your tap water when you were a kid; if you live in an individualist or collectivist culture; if your a heterosexual male and there’s an attractive woman around; if you’ve been smelling the sweat of someone who is frightened. On and on. Of all the stances of mitigated free will, the one that assigns aptitude to biology and effort to free will, or impulse to biology and resisting to free will, is the most pernicious and destructive.” (p. 597-598).

75 million years ago, North America had 500-pound flying reptiles with 30-foot wingspans. Discovery and analysis of a partial skeleton of a new species, dubbed Cryodrakon boreas or “frozen dragon of the north”, sheds new light on the evolution and behavior of the pterosaurs (which are “among the most popular and charismatic of all fossil animals”).

As we learned in the Hitchhiker’s Guide to the Galaxy, the answer to the ultimate question of life is 42. Mathematicians have finally solved the sum-of-three-cubes problem for the number 42 by harnessing the capacity of 500,000 idle computers around the world. The answer for x^3+y^3+z^3=42 is x = -80538738812075974 y = 80435758145817515 z = 12602123297335631

Stuff about Geopolitics, Economics, and the Finance Industry
Morningstar reports that passive funds are officially ahead of active in the US at $4.27T vs. $4.25T (note: earlier, they incorrectly reported that this crossover happened back in May).

Chinese influence over US companies continues largely unchecked. JP Morgan, whose CEO Jamie Dimon is one of the posterchilds for The Business Roundtable effort to go beyond shareholder value, has instructed all staff to not recognize Taiwan’s sovereignty and democracy as the bank looks to do more business in China. I guess lying is one way to go beyond shareholder value, just in the wrong direction. Also this week, Secretary of State Pompeo spoke to the Motion Picture Association of America, urging them to resist the rapid rise of Chinese censorship and creative control of the US movie making process.
“In exchange, Pompeo asked MPAA executives to stop bowing to Chinese censors. China is eroding Hollywood's freedom by setting the terms of the content of movies, as studios compete to have their movies accepted among the limited number of movies China authorizes to be shown in the country each year.”
(Richard Gere would probably agree, as he believes his support of Tibet has blacklisted him in Hollywood; Apple also recently canceled a Gere series for Apple TV+ despite winning a heated bidding war for the project.)

The FT reports on “Fear and oppression in Xinjiang: China’s war on Uighur culture”.

The Pentagon worries about US reliance on China for prescription drugs. "Basically we've outsourced our entire [drug industry] to China," retired Brig. Gen. John Adams told NBC News. "That is a strategic vulnerability."
"We can't make penicillin anymore," said Gibson. "The last penicillin plant in the United States closed in 2004."

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

Evolution of the Meal

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The Evolution of the Meal

If you traveled into the future and brought a newspaper back in your Delorean from the year 2029, what headlines might it contain? With the dramatic wave of disruption coming to the restaurant, delivery, and food supply chain over the next few years, it might contain a story about the death of the grocery store. Americans now spend more money eating out than at grocery stores, so in some sense, the familiar grocery store facade is already beginning to fade like the image of Marty McFly in a family photo.

Besides former Kroger CFO Michael Schlotman, does anyone like going to the grocery store? He made this rather outrageous statement in 2017 as the CFO of Kroger, the world’s largest grocery chain: 

“Part of me refuses to believe that everybody is just going to sit at home and everything is going to be brought to their doorstep and nobody is ever going to leave home to do anything again,” Schlotman said. “I mean, humans are social animals and we thrive on interaction with one another. The good news is food is one of the things that’s at the center of social interaction today.”

Is grocery shopping a social interaction? Is there a single person reading this who wakes up in the morning with a big smile on their face and says “Yes! Today is grocery shopping day, and I’ll get to see all my friends!?" I am sympathetic to people who shop at grocery stores and cook at home, whether it’s for budgetary reasons or simply because they enjoy cooking. In our house, we cook from scratch over 300 nights a year. We go to the grocery store twice a week (more than the 1.6 average American weekly visits), and I’m too embarrassed to say how much we spent at Whole Foods last year. 

However, I think this situation is all about to change. I might not have the year right (as people like to say “Brad is not always right, but he is always early!”) - it could be faster, it could be slower, but the entire trillion-dollar food chain from agriculture to brands to restaurants and grocery is going to completely change. It could make the disruption we’ve seen in retail and media look incremental by comparison. At NZS Capital, we don’t like to predict the future, but we do like to assess whether certain outcomes could be considered a broad view or a narrow view. It seems like a fairly safe bet that the range of outcomes is dramatically widening for food consumption. 

The Size and Impact of the Food Industry

Americans are officially spending more on eating out (including sit-down, takeaway, and meal delivery) than cooking at home. Since March of 2019, food and beverage purchased at restaurants and bars has been pacing ahead of food and beverages purchased at retail stores (using the actual sales, which is not seasonally adjusted). There is an incorrect, but often cited, Quartz article stating that this transition happened back in 2015, but they used an overly-narrow definition of grocery stores, which missed some retail food and beverage sales. If you seasonally adjust the data, as you can see in the following chart, the crossover is happening as we speak. 

This chart comes from the Census Bureau’s monthly retail trade data, which are frequently used by the market and economists. There are other ways to look at food consumption in the government stats, and it’s easy to get confused. Food and agriculture amount to 5.4% of US GDP, or $1.05T, in 2017, when measured by its value add to the economy. This figure includes agriculture, retail, and service businesses like bars and restaurants. It also includes alcohol and tobacco (tobacco appears to be about 10% of the $1T). Another angle is household spending: in aggregate, US households spend 13% of their budgets on food, including eating out and cooking at home. Spending a growing portion of food budget outside the house does not imply people are eating more meals out than they were 10 years ago. Indeed, the number of meals eaten outside the house has been relatively stable at 4-5 meals/week over the last decade. There appears to be two main drivers of the crossover: inflation in the cost of eating out, and an important demographic shift from Boomers to Millennials. So, let’s dive deeper into this shift away from groceries and cooking at home.

Demographics and Meal Preferences

Personal consumption, which includes money spent on food, is 68% of the US economy. Consumption jumps from $48k/year when people are 25-35 years old to a high of around $60k/year at age 45-54, and then falls to $34k at age 75 and older (source). People at or beyond retirement age also simply consumes less food, and may eat, on average, fewer meals in a given week. This age-related consumption data is relevant in light of the significant demographic shift happening in the population. 

Currently, about one third of Baby Boomers are in retirement, but the remaining two thirds will enter retirement over the next 10-15 years, with the youngest Boomers turning 65 in 2029. Behind the Boomers is Generation X, which is about 10% smaller (currently 66M), and thus will almost certainly have a smaller overall impact on the economy (vs. Boomers during their prime consumer years) between now and when Gen X begins to leave the workforce in a decade. Behind Generation X are the Millennials, who are a little larger in number than the Boomers. 

The data on Millennial food habits are mixed; however, we do know that Millennials are getting married and having fewer kids later in life than previous generations, so, at least for now, there are more households with fewer mouths to feed on a fixed budget, which expands dining options (e.g., so that convenience and time savings can be taken into account, as discussed in the next section). I think we can also agree that this digital-native generation is more comfortable adopting the expanding options for meal delivery; anecdotal evidence (e.g., from the cities with a large meal delivery service presence) supports the notion that Millennials are driving the increase in dollars spent eating out, and on meal delivery in particular. To summarize, the crossover in more money spent on meals outside the house than grocery appears largely driven by a shifting consumer base, as retiring Boomers leave their high-consumption years and the larger generation of digital-savvy Millennials enter theirs. In other words, it’s a generational shift in eating habits.

Profit Anatomy of a Meal: Grocery Stores

How expensive is cooking at home vs. eating out for US families? The average US household (2.5 people) spends around $4000 a year ($77/week) on groceries. There are a few estimates that people eat out 4-5 times a week. Let’s say a family eats at home 16 times a week for an average cost of ~$5/meal. I would guess significantly more money would be spent on dinners vs. breakfast/lunch, so a typical dinner might be $10-12 for the average family ($4-5 per person). The top third of income-earning households spend $5200/year on food at home and $2600 eating out compared to the bottom third, who spend $3380 at home and $867 eating out (2014 data). Given that more affluent households tend to eat out more frequently, the $5200 could break down to an average of $7-8 spent on each meal prepared at home (similarly, I would estimate a typical dinner might be $12-15 per family, or $6-7 per person).  

What about the other less tangible costs of grocery shopping? The average household makes 80 trips a year to the store. With drive time, gas, and time spent pushing a cart around, that’s probably an additional cost of $800-1,000 a year ($1/meal for the average household). I used $10/hour for lost time in that estimate, and I think it’s valid to say that time is an increasingly scarce resource for many households, especially Millennials busy building careers and families. Walmart recently expanded availability of their $98/year unlimited grocery delivery subscription. For the average family, that works out to savings of about $1 per trip to the grocery store! What about the time it takes to prepare meals (for those people who don’t view it as an enjoyable hobby!)? In some ways the current paradigm – driving to the store, pushing the cart around, checking out, driving home, putting groceries away, preparing and cooking a meal, cleaning the dishes – is analogous to how most households operated 150 years ago – maintaining livestock and backyard gardens, canning their own produce, sewing their own clothes, etc. – in that the system seems overdue for a phase shift in outsourcing and optimization; ‘going grocery shopping’ could fast become an anachronism just like going to a department store. 

Grocery stores as large-format, big-box retailers began to rise in numbers in the 1930s and 1940s, with the 1950s and 1960s considered to be the golden era of big grocery stores. The number of conventional grocery stores has declined from 26,828 in 2011 to 26,148 in 2018, with an accelerated 1.5% drop last year. To what extent did grocery stores come into existence because of the suburbanization of America, the ubiquity of the automobile, and other cultural trends? With the rising popularity of ridesharing/on-demand rentals, could declining car ownership make grocery stores less relevant and more inconvenient for some households? Is grocery shopping a cultural trapping left over from the social engineering experiment that gave us the nuclear family and Leave it to Beaver family values?

The Information Age and the advent of online ordering is fast making grocery shopping a choice rather than a necessity. A lot of perishable and non-perishable items can be fulfilled through Amazon Prime or other delivery services (like the $98 Walmart unlimited grocery delivery subscription I mentioned above). Fresh produce, a key product many shoppers say they want to hand pick themselves (maybe they haven’t heard of Amazon’s AI that inspects produce for freshness!) is only about 1/3 of grocery sales for Kroger. As such, smaller “neighborhood market” type stores focused on fresh produce and prepared meals could be one surviving concept. At the other extreme, big-box stores that combine grocery with other revenue sources, like Walmart (which already has 26% of US grocery) and discount “dollar” stores, may continue gaining share in grocery spend. 

Grocery stores operate on razor-thin margins. Kroger made 1.5 pennies for every dollar spent in their stores last year. That’s right, a 1.5% reported net income margin. And, a lot of profits at grocery stores are from payments made by brands for shelf placement and in-store promotions. Even more profits come from pharmacy and gas sales. Food itself seems to be a tricky and very-low-margin business for grocery stores (does selling food even make money on its own?). It will only take small changes at the margin to tumble the grocery store industry given these existentially-low margins. Kroger currently has over $14B in net debt with a ratio of 2.8x debt to EBITDA – it’s a slippery slope.

Profit Anatomy of a Meal: Eating Out and Delivery

Let's turn our attention to eating out (dine-in, takeaway, and meal delivery) and look at the revenue and profit table of various food transactions using a few examples. Using public data from McDonalds, on an average dine-in or takeout/drive-through meal for two people costing around $12, a McDonald’s franchise could expect to earn around 15% ($1.80). For Domino’s, a franchise owner can expect about 15% (~$3.50) from a Large Pepperoni Pizza that costs $18 plus $4.49 in delivery fees (again, excluding any tip involved). For a higher-end chain restaurant like Cheesecake Factory, a tab for two people at $60 (excluding tip) nets around 17% (~$10) in profit. Chipotle Mexican Grill also had operating margins around 17% back in 2015 (before the company stumbled due to food contamination issues). So, there seems to be a fairly narrow range of mid- to high-teens percentage operating profit, whether restaurants are fast food or sit down. Food and labor are a big component of costs; however, advertising, franchise fees, and fixed location overhead add up as well.

Now, let’s take a look at delivery through a service like Uber Eats (Uber fees aren’t completely transparent, but the following estimates are approximately correct). Typically, there is a $3-6 delivery fee and a 10-20% “service fee” for orders over $10. If I order a pizza from a local restaurant, for example, it might cost me $16 for the pizza plus $5 delivery fee plus $2 service fee (~$23). Uber Eats also charges the restaurant a 20-30% commission. This commission is said to be much lower for chains like McDonalds or Starbucks, which Uber is using to drive customer adoption and generate a larger network effect for their platform. In total, Uber would take ~$11 ($7 from me, $4 from the restaurant) in revenue for the pizza delivery, which, in 2018, drove an average net revenue across all Uber Eats business of 10% after paying drivers. Another example with Uber Eats and chain restaurant PF Chang’s yields the following: a $55 tab might drive a $5 delivery fee, an $8 service fee, and $14 commission for a total of $27 to Uber. It seems like there’s a lot of money extracted in these transactions, which suggests that there’s opportunity for a more efficient system. Looking at China, we know that it is certainly possible to achieve a high degree of system optimization; according to this FT report, there are 338M delivery-app users in China, and Beijing alone sustains 1.8M meal deliveries a day.

From the restaurant’s perspective, by partnering with Uber Eats, they can run higher utilization of their fixed-cost facility while saving on advertising and service labor. For most well-run restaurants, delivery should drive higher absolute profit dollars up to the point that it causes a location to sacrifice on service or wait times for patrons who come to eat at the restaurant. In some ways, delivery is a shift of the labor burden from a restaurant's own waiters to the delivery people of Uber and others. In some cases, it might be the same employees who are choosing to work as delivery drivers (and, I don’t mean to ignore the significant labor issues that the rideshare and delivery companies are facing – it’s a critical issue that is going to require higher wages and more benefits). Restaurants are grappling with increasing employee turnover, which is very costly in terms of downtime, training, and manager attention, not to mention customer service. Panera recently explained they lose 100% of their employees a year in restaurants.

From a convenience and potential cost-savings standpoint, it seems like delivery may be at the early stages of a massive rise in popularity; however, could delivery ever be competitive with the cost of cooking at home, or will it be stuck serving only the most affluent households? And, if delivery were to take off, would it be accompanied by environmental costs like more wasteful packaging and traffic congestion? How much share would delivery need to take before grocery stores would fold like Sears, K-Mart, and department stores? If delivery becomes more popular that sit-down restaurants, how might that change the restaurant landscape? Let’s take a look at all of these questions next.

Cloud Kitchens and Subscriptions – the Asteroids Hurtling Toward the Food Business

The above analysis on restaurant and delivery economics is based on the current, status quo restaurant landscape, but let’s take a look at the relatively new phenomenon of cloud kitchens. Cloud kitchens are centralized food prep facilities that allow multiple types of food or brands of food to be prepared efficiently for delivery. Uber is currently investing in their own cloud kitchens as well as partnering with others. In a cloud kitchen, you can have your own brand of “Luigi’s Pizza,” street tacos, gourmet burgers, etc. – the situation is analogous to private label brands in grocery stores – and the sky’s the limit. And, space in cloud kitchens could also be leased to brand-names, like Taco Bell or Starbucks.

With cloud kitchens, there are numerous opportunities for cost savings: 1) the real game changer is lack of overhead for prime real estate locations with sit-down or take-out facilities; 2) staffing is much reduced (especially if you have automated kitchens with robot sous chefs!); 3) virtually no advertising needed to support a restaurant brand; 4) food ordering and delivery point-of-origin can both be centralized; 5) kitchens could be shared to maximize utilization by time of day.

What benefits can the cloud kitchen off the consumer besides passing on a percentage of cost savings? I can think of a few: 1) food could be systematically prepared and packaged in a delivery-friendly way to keep it fresh; 2) typical “grocery” items, beverages, and (depending on state laws) alcohol could be bundled with food delivery; 3) Cloud kitchens could specialize in fare such as kosher, gluten free, vegan, organic, etc.; 4) centralization would enable multiple food brands or types in the same delivery order (great for families with picky eaters!); 5) subscription services. 

With regard to subscription services, I think there are huge opportunities for all ecosystem participants. Uber is currently testing a $25/mo subscription that includes free delivery (that $3-6 fee discussed above) as well as discounts on car rides, or scooters/bike rental across their platform. Let’s have some fun exploring some possibilities: what if there were a bundle for five dinners a week for a family of four with a set delivery window? Bundles and schedules would drive the cost to deliver down to a couple dollars per house, similar to what last-mile services like UPS achieve. What if insurance companies and employers got involved to subsidize meals to treat conditions such as offering 10 heart-healthy meals a week or meals with nutrients balanced to help those predisposed to certain medical conditions? Indeed, diet company Whole30 launched the first delivery-only restaurant with Grubhub in Chicago for customers interested in the strict food regimen. Would these options be more broadly appealing than going grocery shopping?

Vertically-integrated cloud kitchens, bundles, subsidies, schedules, and routing combine to drive the flywheel for Uber (or whoever else takes this strategy in the US or other countries – I could easily see Amazon leverage its massive Prime membership base, Whole Foods kitchens, and Amazon delivery service to offer a Prime Meal bundle) to generate a huge user base to densify their cloud kitchens. With one (or two) winners serving a given geographic location, the advantages of centralization, along with scheduling, could also greatly cut down on the number of drivers out on the street. 

Are there other potential environmental benefits to cloud kitchens? What if, in addition to delivery, the driver also picked up last night’s food packaging for wash and reuse? What about increased vertical integration? Many big restaurant and grocery chains are already heavily involved in the agriculture side of their ingredient supply chain. Why wouldn’t a chain of cloud kitchens vertically integrate farming? Warehouse-sized kitchens could dedicate space to hydroponic fresh ingredients and maybe even lab-grown meat down the road. This type of on-site sourcing would significantly decrease the need for food transportation and packaging. With all the environmental costs of factory farming, food transportation, waste, trips to the grocery store etc., it seems plausible that vertically integrated food supply chains, prep, and delivery could be a greener solution, or at the very least no worse than the current system. 

The appeal of cloud kitchens seems fairly overwhelming. If only a small fraction of the population – 5%? 10%? – switch to cloud kitchens for the majority of their meals, would that be enough to tip the scales and start a cascade of grocery store closures? 

It leads to the question of just how many restaurant locations are needed to serve the immediate need for food (such as drive-throughs), how many for special occasions, how many for social gatherings etc.? If cloud kitchens and delivery bundles take off, it’s possible we will see far fewer restaurants of all types and a major composition change of those that survive.

What happens to those trade promotion dollars if food consumption shifts to delivery subscriptions? What happens to pharmacy sales (9% of Kroger’s 2018 sales) as Amazon enters that market with same-day prescription delivery? What happens to gas sales (12% of Kroger’s 2018 sales) as cars go increasingly electric and higher fuel efficiency?

Brand affinity, or nostalgia toward food brands, could become more important. For example, a Starbucks in every cloud kitchen could more than make up for lost business elsewhere as consumer preferences change. Recently, fast food has seen a resurgence in popularity with clever Millennial marketing combined with delivery. 

We can only speculate as to how cheap it could get to deliver a meal for a typical middle- or upper-class household. But, hopefully, by walking through this potential dramatic shift in the preparation, sourcing, and delivery of food you can start to see what’s possible. Could vertically-integrated cloud kitchens with subscriptions, bundles, subsidies, etc. deliver food for a few dollars a meal? It seems with the realm of possibility over the next decade or two.

Conclusion and Outlook

My intention in this thought piece is to be provocative. The truth is I don’t know what will happen to grocery stores and restaurant sales over the next 10-20 years – no one does. But, what we do know is that the range of outcomes is widening dramatically. I also have no idea who wins the delivery market. It seems likely to be a couple winners taking most, similar to ridesharing or cellular service. At NZS Capital, when we see a situation like this with a widening range of outcomes, we expect the unexpected and we act like good Bayesians – maniacally consuming every new data point as objectively as we can to tilt our credences one way or the other. We do know that the world is becoming platformized. That means Informational advantages are taking over from Industrial Age advantages. What investors previously considered moats are becoming vulnerabilities. Consumer needs are changing and increasing. Therefore, long-term focused management teams that have a culture of adaptability who can either become platforms themselves or plug into larger platforms without losing their economics will find a way to survive. Most importantly, we will be looking for companies that have the most friendly platforms that drive the most win-win, or positive non-zero-sum outcomes for consumers, drivers, food providers, animal welfare, the environment, etc. I think that is likely to be a vertically-integrated delivery network with cloud kitchens. It strikes me that there is potential out-of-the-money optionality for Uber (Uber Eats had $3.39B in bookings Q2 2019 and adjusted net revenue growth of 56%), but there is a lot that can happen between now and then, so it’s anyone’s guess.

When I was a young analyst nearly 20 years ago, I covered a discount retailer called Ames. Folks in New England might remember the name. A portfolio manager asked me “does Ames have a reason to exist?” I thought the question absurd at first. Of course they have a reason to exist – they had billions in sales and millions of customers. So, I set out in a rental car on a tour of New England, stopping at every Dunkin Donuts along the way, visiting Ames stores (this was before Google Maps!). Guess what? They didn’t have a reason to exist. There were plenty of Walmarts, K-marts, Sears, etc. to sell stuff cheaply if Ames went away. I then spoke to their suppliers, who were pulling all of their vendor financing, which crippled their inventory supply chain. And, that was it. Soon after, Ames filed for bankruptcy. Ames was a canary in the coal mine; a decade later other discount retailers, and then department stores, would also learn they had fewer reasons to exist. Department stores have seen a 30% drop in sales over the last two decades and thousands of locations have closed.

Similar to what we’ve seen in retail over the last 20 years, I would argue most grocery stores – as they are conceived today – and many restaurants simply won’t have a reason to exist in the future as the Information Age consumes yet another legacy industry that isn’t fulfilling the changing needs of consumers.

All this said, for anyone who is a fan of Demolition Man, we all know that Taco Bell will win the restaurant war!

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #209

Stuff I thought about last week 9-8-19

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, wireless human implants, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback.

In today’s email: If you have more berries, will you get more bears? Apple doesn’t worry about security exploits if they are only targeted at ethnic minorities; peer to peer networks used by protesters could soon be implanted under your skin; emergent behavior is a missing ingredient everywhere from investor predictions to climate change models; the NYT explains how a war over Taiwan could start; the fear bubble rises as a record $150B of corporate debt was issued last week; Brinton's 100 mile run, and lots more below...

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Stuff about Innovation and Technology

Brinton and I sat down with Nate Abercrombie at The Stock Podcast for a detailed discussion on our investment process, risk vs. volatility, valuations in various sectors of tech, the risk of a war over Taiwan, team process, and more.

Everyone please wish Brinton luck for his upcoming 100-mile ultra race in Steamboat Springs Colorado starting this Friday, September 13th (Friday the 13th!?). The course clocks in at 101.7 miles with 20,391 feet of elevation gain. Brinton is raising money to help fund research for a rare genetic disorder afflicting the child of a former coworker of ours. You can learn more about that cause and support Brinton at this link.

Criminals used a deepfake voice AI to call an executive at a UK energy firm and trick him into wiring $243,000 to Hungary. There are plenty of executives with enough webcasts and YouTube video interviews to copy anyone’s voice these days. Time for secret passcodes and cones of silence?

Starting in California, Tesla will offer insurance to its owners with savings estimated at 20-30%compared to existing policies. The company indicates it won’t be using sensor data to price insurance, but on-board cameras and sensor access could be very important in terms of determining what happened in an accident. And, it’s hard to believe they wouldn’t offer discounts for safe drivers in the future as well. As more and more cars have data, this could be an interesting revenue stream for car makers to either enter the insurance game or sell their data to other insurance companies, including video footage.

The fast food industry is grappling with a significant increase in employee turnover to well over 100% per year. Turnover adds a high cost to doing business given the time to recruit, hire, and train employees, and is likely exacerbated by the shift to on-demand jobs (now more than one out of three in the US workforce) and the falling teen labor participation. The industry is looking to automate with robots and technology, but the more obvious question is: as consumption shifts to delivery from centralized kitchens with private-label food brands, do we need all these quick-serve restaurants staffed with people? The increasing labor turnover problem isn’t unique to restaurants: Vail Resorts reports an increase in turnover from 11% in 2014-2018 to an estimated 16-18% in 2019 with a cost of $15,000 to replace each employee.

After a particularly wet summer in the mountains of Colorado, a neighbor once remarked to me: “with all the berries, there will be more bears this year.” The spirit of the comment makes sense, but I chuckled at the prospect of bears manifesting out of thin air just because there were more berries on bushes this year vs. last year. I see the Berries=Bears growth strategy often touted by management teams, e.g., “if we have more locations we will have more customers.” While this math may be true when you are forging a new industry or selling an innovative product/service, I don’t think this direct cause and effect holds to the same degree in many industries where distribution and marketing is shifting to digital platforms, like restaurants. Domino’s Pizza stock went up this week on management reiterating targets relying in part on growing locations, because, as we know, if you have more pizza, more bears will show up to eat it! Except now, if the bears pull out their smartphones and can choose from 20+ different deliverable cuisines, simply having more locations might not make much of a difference. Or, maybe it will, time will tell in the widening range of outcomes for the food industry.

There is an increasing trend in local wireless communication networks that run node-to-node or person-to-person, but do not completely connect up to existing cellular or WiFi Internet feeds. Protesters in Hong Kong have been using the Bridgefy App, which communicates phone-to-phone via Bluetooth, and thus cannot be centrally spied on. And, in perhaps the most extreme example I’ve seen so far, this humanimplant can be powered wirelessly to “store hundreds of gigabytes of data, stream movies or music to connected phones or computers, act as a server for an anonymized chat room or forum, and smuggle encrypted files across international borders. PegLeg was designed so that anyone who connects to the device’s network can upload or download files to the hard drive anonymously, but this radical openness raises thorny legal questions about who is responsible for the data stored in another person’s body.”

'Automation bias' is our tendency to believe the output of automated systems more than we should. This is one of the problems with handing over nuclear weapon control to an AI system, which has both clear negatives and positives to consider. Hopefully we have learned from War Games, and the system will be well-versed in tic-tac-toe game theory before it’s given nuclear codes.

Google is facing heightened scrutiny regarding mobile searches that increasingly push organic (unpaid) results out of view. Software company Basecamp’s CEO posted his company’s new mobile search ads, which read: “We don’t want to run this ad. We’re the #1 result, but [Google] let’s companies advertise against us using our brand. So here we are. A small, independent co. forced to pay ransom to a giant tech company.” Adding to the troubles, with Google providing more answers and transactions itself (displaying re-formatted excerpts from third-party sites and featuring Google Shopping results), 50% of Google search results now end without anyone clicking away, causing retailers to rethink how they approach search strategies. In other negative Google news, the makers of Brave – my favorite web browser – have evidence that Google has been secretly collecting and sharing data in violation of GDPR, as the FT reports. Lastly, Google is the subject of a new DoJ investigation and multi-state antitrust inquiry.

Apple is mad at Google for disclosing a serious Safari security breach because (to paraphrase the gist of their argument as I see it) ‘it only targeted an oppressed minority in China, and, therefore, none of Apple's affluent Western citizens were threatened by it’. Apple thinks Google shouldn't have scared all it's customers who aren’t a target of Chinese oppression. Apple’s security flaw allowed anyone to silently take complete control of your phone and its contents just by you visiting a website. By redirecting criticism at Google, Apple has sloppily side-stepped the real issue: the possibly life threatening exploit by China, the country where every iPhone is made. Their response, unfortunately, leads one to question Apple's involvement and motivations in the security flaw. Did Apple even notify the people impacted? How do we know China or others didn’t use this same tactic to exploit Western targets?

The drone bubble has gotten its rotors stuck in a bush following $2.6B of VC investments over the last seven years. In all, 25 companies have shut down and 67 have been acquired. This seems like a case of right idea, wrong timing, as we are likely just on the cusp of an explosion of drone use cases globally.

Lyft is entering the car rental market competing with the likes of Turo and incumbents such as Hertz. Currently only available in a few cities in California, the service comes with a $40 credit for the Lyft ride to and from the car pickup/dropoff location. I am not sure if the primary focus is on rentals for riders, drivers renting their cars out when they aren’t driving themselves, or drivers that want to rent a car to drive on the Lyft platform (or, maybe all three of these). It will be interesting to see whether the power of Lyft’s large base of riders and inspected cars will disrupt Turo, which is an excellent product itself with a large head start.

Texas Instruments has a new robot kit called the TI-RSLK that allows students to build a fully functioning robot in 15 minutes. Related: Magic Leap’s new app lets you assemble a dinosaur skeleton, and then watch it come to life in your living room.

MIT has built a working carbon nanotube RISC-V processor capable of running software. This achievement matters in our post-Moore’s Law world because carbon transistors are faster and more power efficient than silicon. There is a long way to go, but it’s a great proof of concept and a testament to open-source semis supporting innovation in the sector.

Amazon doesn’t compete with Shopify because it doesn’t have to according to Jon Reilly, VP global commerce at Publicis. In the past, Amazon made more than one attempt to provide what Shopify does, but given that Amazon wasn’t a neutral platform, it ended up failing on those attempts to provide e-commerce services for small businesses. “The majority of Shopify’s 800,000 customers are small and medium sized businesses, many of which will fail and be replaced by newcomers trying their luck at the eCommerce poker table.”

History has been kind in forgetting Masa’s investment track record, but gamblers sometimes see their luck run out. The 50% drop in the estimated value of WeWork, the drop in Uber, and troubles at ARM (that we’ve discussed in the past) are just some of the problems the Vision Fund faces. A propensity to lever anything and everything is another issue for Masa who is said to be using Softbank to lend $20B to employees to help fund Vision Fund 2 – on top of the $8B lent to employees, including Masa himself, for Vision Fund 1 (that’s $1.4B in annual interest payments!). “Son, who was on the brink of bankruptcy in the early 2000s during the dotcom crash, managed to spin a fortune out of an investment in Chinese e-commerce powerhouse Alibaba - a company which is now worth $461bn. But questions surround his ability to deliver on SoftBank’s mega-investments.”

As streaming drives the recorded music industry to 18% y/y growth, older catalog songs are growing listening even faster than songs from newer artists. In order to drive margins to sustainable levels, streaming platforms need to grapple with this headwind that favors incumbent music labels. As I wrote in Music as a Loss Leader: “Even though more and more people are discovering and listening to new artists, streaming services can’t get away with dropping the catalog. And, it’s a question of frequency – I might easily be able to live without my favorite movie on a video streaming platform, but a music streaming platform without Bob Dylan would be unusable to me.”

56% of Americans trust law enforcement to use facial recognition according to this Pew Study.

What investors can learn from operators and vice versa by Brent Beshore: forecasts are guesses, and guesses are wrong; capital allocation matters.

Miscellaneous Stuff
The dominant model for the economic impact of climate change, known as DICE from Yale professor William Nordhaus, is based on bad math. The Nobel prize winning economist (as SITALWeek readers know, we think economics should fall under the ‘fiction’ category of Nobel prizes) used a smooth quadratic instead of taking into account the potential for emerging properties and tipping points, or phase shifts. If you’ve been reading anything we write on complex adaptive systems, you know that not only will there be phase shifts, we also won’t be able to accurately predict them. Further, complex systems are dominated by chaos, which means small perturbations in initial conditions have wildly varied impacts in the future. Instead of modeling climate as a complex adaptive system, Nordhaus picked a random fudge factor of only 25% to estimate the impact of an event like accelerated warming from ice sheet melting.

And, as the ice melts at a record pace, the race is on to find and preserve the archaeological treasure troveemerging from the frozen ground. If this anthropological topic interests you, I follow two people on Twitter that post many cool finds: Jamie Woodward and Secrets of the Ice.

The airlines are one of the more at-risk industries as a result of climate change. With plane travel likely accounting for at least 5% of warming, the FT reports on the growing number of people refusing to fly. Would this be a far-fetched headline in the future: “Flights Grounded in Emergency Attempt to Stop Rising Temperatures”? At the very least, I wouldn’t rely on the DICE model to estimate the potential impact to investments in your portfolio.

Tim Ferriss helps Johns Hopkins launch a new $17M psychedelics institute to study the positive impact of the molecules on a range of mental disorders with hedge fund managers and tech entrepreneurs (hmmm, did I word that sentence a little awkwardly...oops!). The goal is nothing short of “bending the arc of history.” Pollan’s How to Change Your Mind is a good read on the developments in this space.

An issue with Malcom Gladwell’s books is that he tries to make psychology popular, but psychology isn’t hard science, and many of the themes he has put forth fall short of being useful, and often are simply wrong. This Guardian interview touches on some of these issues. If the inner workings of the human brain are of interest to you, I’d recommend Behave by Sapolsky instead of the new Gladwell fiction.

In reading this Techcrunch interview with Ray Dalio about his Principles in Action app, it struck me how rarely, if ever, Dalio attributes outcomes to luck and randomness. At NZS, we view luck and randomness as a fundamental force in success. A synonym for luck is humility, and we place a high value on humility. There are tons of smart and capable people, some of them get lucky, but most of them don’t. When you acknowledge the importance of luck and the unpredictable nature of complex adaptive systems, you are much more likely to hear luck when it comes knocking. In other words, there is a mindset that enables luck and opportunity to not be squandered. In that article, Dalio talks about how great it would be to have Bill Gates’ and Steve Jobs’ algorithms for decision making; however, odds are, those algorithms would be worthless without luck and good timing. Gates and Jobs represent smart and capable business people who were phenomenally lucky. Walter Isaacson’s 600+ page biography of Jobs fails to mention luck once – that simply cannot represent reality. Buffett has always been a champion of the role of luck, and perhaps because he is so cognizant of it, he and Munger always seem to hear luck when it comes knocking. Dalio’s formulaic, pattern recognition approach is exactly the type of analysis we work hard to avoid; when pattern recognition ends up actually working, we call that luck. The key element missing in Dalio’s brand of analysis is emergent behavior, i.e., unpredictable outcomes from the interactions of the system itself. (I am a big fan of Dalio’s economic research and open education efforts – it’s to be respected and emulated; my criticism here is a philosophical one concerning how useful research is in terms of predicting the future given the system complexity and the random role of luck.)

Stuff about Geopolitics, Economics, and the Finance Industry
The author of Creating Shareholder Value, Al Rappaport, questions what the Business Roundtable means by ‘going beyond shareholder value’.
“The Business Roundtable’s message that corporations should become more stakeholder-inclusive and socially responsive is significant and timely. Regrettably, it offers no specifics on how companies should allocate resources, on whether it supports corporate investments in socially motivated initiatives that do not create long-term value, or on how to align incentive compensation with long-term value.”
And, another economist points out that starting with actually paying taxes would be a nice way for corporations to start backing the Business Roundtable’s pledge.

This op-ed in the NYT this week was the first time I’ve seen the risk of war with China over the sovereignty of Taiwan articulated in a widely read publication. The article suggests China could try to destabilize Taiwan by taking down its power grid. Such an aggression would bring global chip supply to a standstill, as 70% of semiconductors pass through Taiwan in the manufacturing process. The global economy runs on those chips. “...in 18 of the last 18 Pentagon war games involving China in the Taiwan Strait, the U.S. lost. Still, that can be misleading, because the war games are much more limited than real life would be. For example, the United States could interrupt China’s oil supplies from the gulf.” For several years, I’ve been talking about the importance of Taiwan as the ultimate pawn in the growing tension between the US and China: the heart of the matter is China’s reliance on semiconductors and, therefore, complete reliance on US intellectual property and Taiwanese chip manufacturing. On a much more positive note, it was surprising to see China back down and withdraw the extradition bill that has caused months of violent protests in Hong Kong. It’s possible that China felt it could not risk a global eye on the rolling of tanks into Hong Kong. Maybe this backing down is an indicator that China will also not pose a military threat to Taiwan in the future. With a presidential election coming in 2020 for Taiwan, voters there are no doubt watching China’s handling of Hong Kong as they choose between candidates that are for and against closer relations with China. It seems as though the decision to withdraw created confusion on the Chinese mainland, where the extradition bill had been marketed as a just law. The government was quick to censor any discussion of the topic as Hong Kong’s leader told a group of business leaders she would quit if she could. Part of China’s propaganda campaign on the mainland is to blame the US: “China’s increasingly caustic accusations against the United States — in state media and official statements — reflect a deepening conviction that support for democratic rights in Hong Kong is part of a broader effort to undermine the Communist Party.”

A record smashing $150B in corporate debt issuance hit the bond market this week including 49 deals in just 30 hours!

Homeowners in Denmark are taking advantage of the country’s negative rates by taking on new mortgage debt. Lenders are working to offer 30 year mortgages with negative rates while making money on servicing fees.

It was funny this week to read back-to-back predictions by two finance industry veterans with opposite conclusions. Jim Paulsen called out the “fear bubble” (I love that term!) saying the market is poised to go up, while 13D Research predicted the US stock market will be “crippled” by a corporate bond meltdown as money is hoovered back from stock repurchases into debt payments. Who is right? For the long-term outlook, does it really matter? Other than having a half-baked view on long-term rates, we just view “macro” as volatility, which means opportunity for us.

Speaking of the fear bubble, high net worth individuals are said to be 28% invested in cash up from 27% a year ago.

And, even more fear: insiders are matching their 2006-2007 record share sales with $600M/day of insider stock sales in August.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

SITALWeek #208

Stuff I thought about last week 9-1-19

Welcome to Stuff I Thought About Last Week, a collection of topics on tech, innovation, science, the digital economic transition, the finance industry, robotic brain worms, and whatever else made me think last week. Please grab me on Twitter with any thoughts or feedback. -Brad

In today’s email: the Apple-Goldman Sachs-Mastercard shows us how the card networks have successfully bullied tech companies away from innovation in payments; the special culture of Redfin; how Hume’s relative view of perception directly informed Einstein’s Theory of Relativity; big companies are joining governments in borrowing at negative rates for the first time; China makes progress on semiconductors, but the US keeps the upper hand in the tradewar. And, lots more below...

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Stuff about Innovation and Technology

Life imitates Sci-Fi: just as production is beginning on the 4th Matrix movie, researchers at MIT have developed a threadlike robot worm that can navigate inside a brain. If you are prone to nightmares about robots tunneling into your brain, don’t watch the video in that link!

This week I went on CNBC’s Squawk Alley and discussed two of my favorite topics: semiconductors and media stocks. Thanks to producer Ben Thompson for inviting me on and host Jon Fortt for chatting with me!

John Rotonti at The Motley Fool wrote this thoughtful framework of ESG characteristics of management teams including some very kind comments and excerpts from NZS Capital’s Complexity Investing and Non-Zero-Sum papers:
“To read more about a new competitive advantage framework based on a company's ability to adapt and innovate, check out the white paper titled Complexity Investing that's taking the investing world by storm.In the paper, Johns and Slingerlend argue that investors need to rethink the allure of qualities like legacy moats, ultra-fast growth, and even pricing power and rather focus on a company's ability to innovate and adapt in the digital age, all while providing win-win situations for the company, its customers, and other constituents involved.”

Speaking of management teams that exemplify NZS (non-zero-sum, or win-win) thinking, this interview with Redfin CEO Glenn Kelman is exemplary of what we look for in CEOs we invest with:
“You have to treat the culture of the company as some kind of living, breathing thing. You're not placing it under a slide or encasing it in amber. You're trying to make it better every year and someone new who shows up has something to add to that, not just something to learn about it. The fundamental trait of this company is humility...The company can be a little bit goofy, there's an authenticity to that. Part of who we are is just an acknowledgement that every company is just a collection of dingbats. A group of flawed human beings. Sweaty, hairy mammals who are trying to figure something out. It goes forward and then back, but hopefully more often forward than back.”
And, while I am praising Glenn Kelman, this blog post – describing his recent stint running product at Redfin – is enlightening, to say the least:
“We spend a lot of time filling one another’s brown paper sacks [with compliment cards]. When I was the age of many of our product managers, I was the brown paper sack, existing purely to get praise.” (This quote probably hits a little closer to home than I’d like to admit!)

On the other end of the spectrum, here’s a management team that seems to embody the opposite of non-zero-sum thinking: Johnson and Johnson CEO Alex Gorsky is currently featured on the cover of the September 2019 Fortune Magazine “Change the World” issue for spearheading the Business Roundtable’s efforts to go beyond shareholder value. However, somewhat embarrassingly, at the same time J&J is appealing a jury award in an opioid addiction case. I don’t pretend to understand the legal reasons why J&J is appealing this verdict, but it certainly highlights the firm’s role in the rampant opioid crisis. As I said last week, broadening the purpose of a company is a major cultural shift, and it's much more easily said than done.

When you swipe your slick, new Apple Card powered by Goldman Sachs and Mastercard, it appears that Mastercard can leverage your data in far reaching ways such as letting Google determine whether an ad you saw online is linked to buying something in a physical store. In other words, while Apple and Goldman have worked to restrict the sale of some transaction data, it may not apply to the Mastercard part of the Apple Card. And, this isn’t just the Apple Card, of course, it’s every bank- or retailer-sponsored Mastercard and Visa card in your wallet. I mentioned recently the less-than-optimal “NZS” levels of credit card system, suggesting that there remains a risk of both government regulation and technological disruption in the future. This type of purchase tracking is another example of a win-lose rather than a win-win with cards. I get nothing from my bank or a card network selling my data; and, in fact, it could have negative consequences in the event of a data breach or improper use by a 3rd party (for example, in most marketing databases I am labeled a “frequent gambler” even though I never gamble because I attend numerous IT tradeshows in Las Vegas for stock research!). The entire transaction chain – retailer, point of sale, merchant acquirer, card network, and issuing bank – is spying on you, as this WaPo article points out, with an eye towards exploitation. A criticism of my view on credit cards defends the ubiquity and convenience of the current card payment system. It’s popular to raise the golden “network effect” defense of credit cards payments. I don’t completely disagree, but the stranglehold of Visa and Mastercard in the US is causing consumers and merchants, notably small businesses, to miss out on progress and innovation, as evidenced by less than 10% consumer adoption of mobile payments in the US despite their widespread use in other parts of the world. We have to question: what has stopped PayPal, Square, Google, Apple, Amazon, and others from creating a new, closed-loop system with lower transaction costs, better user benefits, and friendlier borrowing terms? For the answer, we don’t have to look any further than the CEO of Visa himself for publicly threatening and bullying PayPal:
“For consumers, the difficulty of using credit cards on PayPal was an annoyance, but for payments companies, it was a threat. In the U.S., retailers pay $90 billion every year for payment processing, making Visa and Mastercard fantastically profitable. Visa, whose network processes $10 trillion in debit and credit transactions annually, was particularly frank in its hostility to PayPal. ‘Anyone that’s trying to take your customers and disintermediate you is not a friend,’ CEO Charlie Scharf said at a May 2016 tech conference. Visa would love to cooperate with PayPal, he insisted: ‘The other door is where we go full steam and compete with them in ways that people have never seen before.’ Visa and Mastercard threw resources into developing PayPal-killing digital payments platforms of their own.”
Under the current system, the card networks seem like monopoly abusers that are able to keep companies as large as Apple locked into the archaic US transaction chain that siphons value away from businesses and consumers. I am still swiping my retailer-branded, big-NYC-bank Visa card that is selling my data and exploiting the system, but I sure hope someone is courageous enough to challenge the status quo. Ideally, I’d like to see a company start from scratch with a disruptive system like Facebook wants to try with Libra, but one intermediate step would be a tech platform leveraging the infrastructure of Discover or Amex by partnering or acquiring. Discover and American Express are mostly closed-loop systems, though they still depend on point-of-sale terminals and other parts of the transaction chain, and a tech platform could more easily leverage their infrastructure to innovate a more consumer and business friendly payment option. Absent a disruption, Mastercard and Visa are likely to continue to be good stocks, but I’m left wondering what innovation we might be missing out on? I really appreciated all the pushback on my less-than-positive view of the credit card ecosystem a few weeks ago. I’m a true fan of Bayesian Logic: start with a view, and then absorb all positive and negative evidence objectively – so keep those arguments coming at me!

Google is a big proponent of using ethical hackers to find software vulnerabilities. The company has already paid out over $15M in bounties, and is now extending the program to Play Store apps with over 100M downloads. The partnership is with HackerOne – the premier platform for leveraging hackers to safely find security problems in software – which is run by the very thoughtful CEO Marten Mickos. Earlier this year, Google exposed a serious threat in Apple’s iOS Safari browser that allowed for a complete phone takeover just by passively visiting a website. The high-stakes Apple security flaw was allegedly created by China to target Muslim minorities according to Techcrunch.

Despite new chips from Intel and others targeting the AI market, NVIDIA remains dominant due to a combination of chip advancements and the network effect of the company’s superior CUDA programming platform. This lead is being held with a chip that is two years old, but seeing 80% performance improvements due to software upgrades. With NVIDIA’s next-gen AI chip on the horizon, their lead could extend even further.

As chip companies work around the slowing of Moore’s law with chiplets – stacking multiple chips into a single package – complexities are abounding. The industry is several years away from Cadence, Synopsys, Ansys, or others solving the design-and-testing complexities as this Semiconductor Engineeringpanel discusses. “When you put together two high powered chips on top of memory, will the memory hotspot be shifted because of the SoC thermal hotspot? So, the interactions between the dies or the stack is challenging. There are many challenges in addition to thermal integrity such as electromagnetics challenges, capacitive coupling, inductive coupling between the dies.”

Huawei continues to believe it will eventually get by without US semiconductor companies – a claim that I continue to question. This week the company discussed the Ascend AI chip, which was designed by Huawei engineers using US design software, and it will be made in Taiwan with TSMC’s 7nm process using US and European manufacturing equipment. Huawei also has many ARM-based chips, which could be problematic in the future due to US restrictions; thus, Huawei is considering using RISC-V open-source chips, but those also would require US intellectual property to design and manufacture. China has a long way to go to reach chip independence, which continues to give the US the upper hand in trade negotiations.

Yet, there is some progress for Chinese homegrown semiconductors in the microcontroller (MCU) segment of the market. GigaDevice is a Chinese company that has released a RISC-V-based MCU that is pin-for-pin compatible with an ARM-based STMicro processor. Importantly, software running on an ARM MCU will run the same on the new GD chip. GigaDevice’s history in flash memory gives them an advantage in chips like this one, which reportedly integrates memory function. Early applications of the GD RISC-V MCU are thermal printers, multi-touch screens, air purifiers with ozone and motor control, etc. Next up, the company will be adding RF capability such as WiFi.
“GigaDevice believes it has built ‘The bridge with RISC-V’ – a path for companies who have been designing with Arm-based MCUs to quickly make the switch to its RISC-V based replacements. The ‘complete compatibility’ between the two product families should ensure the reusability of the code, the company said, ‘making cross-core MCU selection and design’ very convenient. ‘This is our very leading, unprecedented innovation,’ according to GigaDevice.”

After 30 million people have had their DNA tested, the market has hit a wall. Privacy concerns may in part explain the slowdown that has impacted technology providers, like Illumina, in recent quarters. Ultimately, however, DNA testing was about companies like 23andMe gathering enough data and users to run panels and studies with big pharma while also finding potential drug testing subjects. 30M probably is plenty until we can get some useful results from the data, which, given the complex interactions of genes and gene products, may be a long ways off.

Epic, the maker of Fortnite (which is also part-owned by Tencent), is trying to disrupt the video game marketplace model by only taking a 12% cut of revenues, dramatically undercutting the dominant PC game download platform Stream, who charges 30%. If successful, it’s also a challenge to the typical app store take-rate model, which, if toppled, would be a boon to video game publishers. This move is evidence of the high-stakes, multi-platform war brewing between Google, Microsoft/Sony, Steam, Epic, and others as social and broadcast elements of video gaming become more popular and the market shifts to streaming.

Elon Musk and Jack Ma held a debate at an AI conference in Shanghai last week. The two disagreed on most issues, as Ma is optimistic humans will harness AI, while Musk remains concerned it will be the other way around. However, both agreed one one point: that population collapse is a problematic scenario (something I wrote on in more detail down in the macro section of SITALWeek #206). I also agree with Ma’s view that dramatically shrinking the working week – to around 12 hours – would be enabled by humans working in conjunction with AI (and, I think, would help offset potential problems stemming from a population collapse).

Last Sunday I suggested I’d much rather see Amazon spend money on exclusive premium content or acquire other content assets, and this past week they did just that. The company joined a group that acquired the YES Network (NY Yankees) from Disney.

Let down by increasingly partisan media, teens are leveraging Instagram and other mediums to create news platforms for a younger generation.

Miscellaneous Stuff
Hume is probably the closest Western philosophy came to Buddhism. As Bertrand Russell discusses in The History of Western Philosophy, Hume posited that there was no self, i.e., every time you look, you only find some perception of something, like feeling cold, not ‘a self’ that is cold. And, humans are just a "bundle or collection of different perceptions, which succeed each other with inconceivable rapidity, and are in perpetual flux and movement." I was reminded by this article that Einstein’s theory that proves time is relative was heavily influenced by Hume’s writings. It seems as though we’d be much less likely to have the theory of relativity had this philosopher, who lived 200 years before Einstein, not caught his attention. “Hume’s philosophy of time shows the fundamental relevance of the relation between an observer and a reference object. There is no evidence for absolute, self-existing time. Nor is there evidence for one universal time. There are different times, depending on the observer/reference-object relation. It is not ‘possible for time alone ever to make its appearance’, as ‘time is nothing but the manner, in which some real objects exist,’ writes Hume.”

The brain is a prediction machine and it’s not showing you any sort of objective reality. This Scientific American article is a great overview of the various ways in which objective reality is anything but real:
“Yet we have known since Isaac Newton that colors do not exist out there in the world. Instead they are cooked up by the brain from mixtures of different wavelengths of colorless electromagnetic radiation. Colors are a clever trick that evolution has hit on to help the brain keep track of surfaces under changing lighting conditions. And we humans can sense only a tiny slice of the full electromagnetic spectrum, nestled between the lows of infrared and the highs of ultraviolet. Every color we perceive, every part of the totality of each of our visual worlds, comes from this thin slice of reality.”

Speaking of problems with objective reality, Randonauts are people who think that we are in a simulation that can be glitched by traveling to random places. This scenario raises all kinds of amusing questions about free will: are they really going to random places, or is it all just part of the predetermined simulation? ;-) Likewise, the author paraphrases Schmidhuber: “...what we perceived as randomness was in fact a result of our puny human brains being unable to transcend the sense of perception we’ve been given.” And, as I’ve highlighted recently, usually once the subjects of an experiment find out they are part of an experiment, the experimenters shut it down...so maybe we should all act real predictable for a little while to allay suspicions.

By land or by sea? Newly discovered ancient human remains in Idaho suggest that early settlers to the US came by boat across the sea and then went up the Columbia, Snake, and Salmon rivers more than 16,000 years ago rather than walking across the Bering land bridge thousands of years later.

Targeting the 90B units/year plastic cup market, Ball Corp has debuted it’s much-anticipated aluminum cup (for reference, the current aluminum can market is around 300B, while the plastic water bottle market is 500B units/year). The first ever of its kind, the infinitely recyclable 20oz design will launch at entertainment and sports venues this Fall. The cups are cool to the touch and can carry branded logos.
“Ball’s research shows that 67 percent of U.S. consumers say they will visit a venue more often if they use aluminum cups instead of plastic cups and that 78 percent of consumers expect beverage brands to use environmentally friendly containers in the next five years.”

Stuff about Geopolitics, Economics, and the Finance Industry
The 'roller coaster' nature of Trump’s trade deal negotiations has created a lot of volatility in the market, which is actually great for long-term, active investors. This reminds me of something NZS Capital’s co-founder Brinton Johns said about risk in an interview this week, which sums up nicely how we lick our chops at market volatility: “Most of the market defines volatility as risk; we define it as opportunity.” (I’ll link to the podcast interview in SITALWeek when it posts.)

In lieu of boring everyone with yet another long exposition on declining interest rates, Brinton suggested I post this much more insightful video clip from our time traveling friends Bill and Ted. (But, if you can’t get enough of me rambling on interest rates, you can always re-read last week’s macro section connecting inequality, deflation, government policy and negative rates!)

As bond yields continue their 35-year decline, and Siemens issues the first zero-interest-rate corporate bond (and, it’s priced at a negative yield!), private and public pensions are facing a massive funding crisis, which will likely lead to benefit cuts and riskier investments, including those in the low-liquidity, private-asset market. As we know, when there is any sort of run on the bank for any of these funds invested in illiquid assets, things will get ugly fast.

One of our expressions at NZS Capital is ABCD: Always Be Connecting Dots. The term is borrowed from Danny Meyer’s book Setting the Table. I came across this quote from musician and author Amanda Palmer this week on Twitter that struck a note with me:
“Collecting the dots. Then connecting them. And then sharing the connections with those around you. This is how a creative human works. Collecting, connecting, sharing.”

-Brad

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The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

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