By Noah Jessop
“This time is different” — a refrain too-often heard in Frontier markets. Seeking sanity, people often resort to metrics used to measure an investment in other mature markets, like food or other commodities. But these metrics are bad heuristics for quantifying the fundamental shifts happening at the frontiers of the global economy.
Let me explain:
The Market
When Warren Buffett bought a controlling interest in Kraft-Heinz, it looked like a classic case of value investing — a struggling, yet venerable brand that could be reinvigorated through modern management techniques. For example, the deli meats were manufactured in a Wienermobile-era factory and a Black Forest ham might have to ride up and down in an elevator multiple times on its journey from piggy to packaging. Forget advanced Japanese manufacturing techniques, they barely had an assembly line. That’s the kind of easy improvement a “contrarian with a calculator” likes to back. Quickly, the weekly output of the factories increased by 17%, putting Buffet into the black on his investment. The transaction was heralded as a masterpiece of market efficiency.
But while profits soared, the market softened. Consumer demand for processed cold cuts was falling as the demand for grass-fed, heritage breed, and other highfalutin meats grew like a growth hormone-infused Holstein.
Value investing is a good strategy in stable markets, and it has worked wonderfully for Berkshire Hathaway, but it’s important to remember the value mindset is a tactic — and like all other tactics, there are good times and bad times to deploy it. Applying it in the context of early-stage tech is almost always a mistake.
Tech commentators are quick to call out when startup multiples seem too optimistic to ever be reunited with an underlying notion of value. By some account, this is a fair criticism. Imagining that the cold cut market would triple in size over the next few years is ludicrous. Conversely, imagining the same for Amazon, Facebook, and Google in their early years would have been mind-numbingly conservative.
Venture economics aren’t predicated on easily modeled 20% gains, but the unlikely 2,000X returns — which tend to only exist on the frontier.
The Frontier
What’s the Frontier? New technology, new industries, new methods, things that:
- Don’t resemble anything else built before, e.g. a hosted crypto wallet like Coinbase, or;
- Are a newer, better versions of something in a rapidly maturing market e.g. a social network as the internet becomes fully-deployed, like Facebook.
Value-minded pundits are quick to note that the multiples paid to companies on the frontier are out of whack with “real” assets. But the rules are different on the Frontier. In order to pay the current multiples demanded, there has to be a fundamental bet on something far bigger: a future cash flow of truly unknown size.
Perhaps this cash flow will come from a yet-unknown business model, as was the case in the early days of Google, or from the disruptive potential of an asset, like GM’s acquisition of Cruise. William Janeway — studier of risk capital and longtime venture capitalist — draws a line in the sand rather elegantly: “if an investor can determine what the mature cash flows may become for the investment, it’s all for naught.”
The fact that a potential investment has stratospheric multiples carries little information. These multiples are just an indication that the market believes that there might be a remarkable future for the venture but comes with no guarantee of certainty. But that doesn’t make them bad bets.
The Trap
The trap that many smart investors stumble into is mixing these two distant worlds. They seek safety within the Frontier, finding what they believe to be “sane multiples” or taking well-trodden business models applied to the new world. But this, more often than not, the most dangerous bet to make: one gets exposure to plenty of new market risk, while likely capping the overall upside. Short of a true “picks and shovels” offering (a “Market” business with a large unserved market on the Frontier), a diversified investor would be far better splitting their exposure between “safer” or more established assets and playing for true volatility around the frontier.
Investors and entrepreneurs alike should know: are they playing in the Market or the Frontier? If the latter, they ought not to swing big — for the future is unknown. And up for grabs.