It is always fun to read a book that is useful for investors and entrepreneurs/businesspeople. Nick Gogerty’s The Nature of Value covers a lot of ground—below I quote and highlight some of the most useful lessons and idea from the book. I also met Nick last week, and it helps that he is a very nice and smart guy.
VALUE, IN THE SIMPLEST sense, is the human perception of what is important. As such, it is subjective and context dependent.
I have to remind myself often that market prices are a collective opinion or perception, and that the only sustainable advantage in investing is finding perception (price)/reality gaps. The book talks a lot about changes in the perception of value, and how quickly a hot technology can fade away, its value diminished.
Evolution…favors the energy efficient.
all things can be considered dissipative structures—that is, all forms evolve for energy to flow through at increasing levels of efficiency. We will see that the study of evolution across economic and ecological domains is actually the study of dissipative structures adapting over time and through selective processes.
I love Peter Thiel’s definition of technology which “to do more with less.” This is a key lesson for the entrepreneur (companies like Uber and Airbnb--efficiency machines--best exemplify these ideas), but also for businesspeople. Companies tend to add layers of bloat over time and must constantly fight this slowly accumulated business baggage. It’s very hard to innovate as companies get older and older. Gogerty continues:
Innovation, as suggested, is both a giver and a destroyer of value. The entrepreneur—and society—sees innovation as a positive option that can potentially deliver new forms of value. But innovation expressed outside one’s own firm is a negative option viewed from the firm’s perspective. A competitor’s positive option can kill other firms. This negative optionality is unpredictable and extremely difficult to avoid. The allocator must guess the scope and scale of negative options that may be created by others. Firms with well-known fat margins can become negative option magnets, attracting entrepreneurs.
Negative options look like radical innovation to existing competitors. James M. Utterback, an MIT professor of innovation, has done in-depth innovation research and said the following about radical innovation and corporate death. A product’s life could end quite suddenly with the appearance of a radical new competing product that invades and quickly conquers the market. Not many firms have the dexterity to retool their capabilities in order to survive successive waves of innovation. Over the life of a product, few of the firms that enter the market to produce the product survive. Firms holding the largest market share in one generation of a product or process seldom appear in the vanguard of competition in the next.
This means that, surprisingly, no technology leader managed to hold onto the lead in the next iteration. For an investor in the technology sector, the leading firm must provide incredibly high returns on equity due to the short value-creating life span. Innovation-led companies are often severely overpriced, with little regard for the forces of negative optionality that lead to short life spans. Looking at the big picture over time makes this obvious. Focusing on today’s single “lottery ticket” firm ignores the silent negative options held by others.
One of the best finds in the book is a list of ten aspects of innovation made famous by the Doblin Group. If you work at a business or plan on starting one, going through this list is very valuable. Check it out here. You want to be unique in as many of these ten ways as possible. Having just one or two advantages probably won’t cut it:
Businesses that rely on a single unique capability for market share or margins are highly vulnerable to negative optionality (we explore businesses like this in chapter 6, in the discussion of “hero products”). Many technology firms fall into this category, and thus are weak candidates for sustainable value creation and capital allocation. Paradoxically, many of these firms are mispriced at high earnings multiples.
This story about Mark Twain reminds me of the cautious tale of automobile companies (which consolidated from more than one hundred to three major companies). Someone with a crystal ball about future technology might still fail to make any money from their knowledge of the future because competition is so fierce and it is hard to pick the winners!
History is filled with famous lottery ticket betters. The author Mark Twain was an early venture capitalist. He correctly saw the potential of the early typewriter, and invested in it. The typewriter flourished as a smash hit product for over a century, but the particular firm Twain bet on didn’t last long. Twain lost so much money he was forced to go on a global speaking tour to recoup his losses.
I also found lots of subtle references to the idea of shareholder yield investing (which is a preference for disciplined capital allocation).
Investors should beware, as well, of firms that are pushing innovation simply for the sake of innovation. This is usually nothing more than costly activity, driven by fear, masquerading as productivity. Bad innovation like this happens all the time, and is endemic at firms where analysts, boards of directors, and shareholders insist on “pushing the envelope” and keeping up with R&D initiatives regardless of the return on invested capital (ROIC). Activity like this may push share prices up in the short term, but it does not create value.
A typical organizational response to the cluster death process is to fight to the last penny even as it destroys shareholder equity, which is perversely considered more noble than quitting and handing back shareholder capital.
Allocators should seek long capability-cycle processes with fast, efficient cash flow turnover cycles. Expanding on the biological metaphor, bet on a slow, stable niche and a stable, quick-learning species within that niche that survives and thrives relative to others.
Our research shows that these ideas are right. Companies paying down stakeholders (buybacks, debt payback) significantly outperform those issuing new capital.
Finally here are some fun fast quotes from the book. I highly recommend it.
Remember Henry Ford’s saying that many people missed opportunity, because it showed up dressed in overalls and looked like work. [I always thought this was Edison, but forget it, he’s rolling]
Having the best product doesn’t matter. Efficiently delivering the best perceived user experience is what determines survival.
A cheap ticket on a sinking ship is never cheap enough to make the ride worthwhile. [i.e. a value strategy can probably be improved using other metrics—avoid the absolute worst quality can help in some situations…more posts on this in the future]
I suggest books like this once per month to members of the book club, you can sign up here.