#166 - The Erosion of Modern Moats

Merry Christmas and Happy Holidays to everyone! I hope everyone has a blessed and productive 2022. My New Years resolution is to reassert discipline over every area in my life - diet, spiritual, fitness, financial, etc. I need a reset!

What are you focusing on in 2022?

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Last week I read a great whitepaper by NZS Capital titled Complexity Investing.

This document is the distillation of their entire investing framework into 46 pages and centers around two concepts: resilience and optionality. NZS defines resilient businesses as:

"In the world of business and investing, Resilient companies are less optimized for maximizing immediate returns and more focused on the ability to adapt and evolve to changing conditions – able to quickly recover from or capitalize on extreme events"

and optionality in business as

"a large potential payoff resulting from a relatively small investment. Power laws are no secret to venture capitalists. They know that the majority of their investments are going to amount to nothing, but they also know that a few are going to make up for all of their disappointment and then some."

These twin pillars aren't necessarily new to modern business thought, but what really got my juices flowing was this part of the paper on competitive advantage in the 21st century:

"As transparency and the velocity of information sharing increase in the world, it will become increasingly challenging for companies to extract positive sums from their customers. While traditional investors seek businesses with ‘high barriers’ and ‘wide moats’, we believe this practice is misinformed. A barrier or moat today becomes a vulnerability tomorrow. Rather than create large barriers (which often turn out to be temporary and/or artificial), companies should focus on maximizing NZS."

Where NZS (non-zero sumness) is defined as:

"A company that operates a platform focused on creating value for all participants, including itself, is creating large amounts of NZS. Specifically, when companies create significantly more value for their ecosystem than for their own treasury, the win-win positive spiral is optimal."

In other words, when companies prey on their customers in a parasitic manner, with the increase in velocity of information dispersion, their life span as a business will greatly shrink. With the abundance of information only growing in scope, it is more important than ever for businesses to create win-win scenarios. In NZS's mind, this is the only thing that matters:

"in other words, they create so much long-term value for their customers that it’s very hard for a competitor to come in and change the game. Many companies can get away with obfuscating and extracting more value from their customers in the short term; but, in the long run, evolution and information sharing win and new disruptive forces emerge. Michael Porter’s famous “Five Forces” of competitive advantage need to be re-examined in this framework (see Chapter 4 – Competitive Advantage: A New Framework). Companies should want to create win-win scenarios for suppliers and customers – not extract too much value from either. Pricing power could actually be a bad omen in this framework... While there are still pockets of information hoarding to be found throughout the global economy, these could largely disappear over the next decade as the vast majority of the world’s population gains access to real-time information through low-cost smart phones, tablets, and wireless networks. Porter focused on profit first and product/ customer second (or in some cases not at all)... 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."

This all brings me to the question of how more abundant information affects real estate markets and investors. The old adage with real estate is that it's all about location, location, location. It's really the only competitive advantage for what is mostly a commodity asset, coupled with your basis in the property. If you can acquire or build for less than the competitor next door, all else equal (market rents, opex, capex, etc.), you will generate higher returns relative to your local submarket competitors (this leaves out supply and demand for simplicity). But if everyone knows the going price of everything, where does alpha come from?

To summarize, every listing gets 10x the eyeballs as it once did, and in the current stage of the market cycle where even off-market deals don't get much of a discount, focus shifts to creation (development) of new assets that are unique in location and cost roughly the same as existing assets (adjusted for depreciation in some cases and in others not at all). When all information becomes public and widely distributed, the only information that isn't public is that which is between the developer's ears - the vision for a piece of land or existing asset. Creativity coupled with operating chops will be the last vestige of alpha as information becomes more and more of a commodity in a frictionless world.

How do you think information abundance will affect real estate markets and investing going forward?

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Another question I'm thinking about this week: What is the metaverse and does it matter? I.e. is it just virtual reality or immersive online games or is it something altogether different?

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Links:

Why Peter Thiel searches for 'reality bending secrets' (David Perell)

Commitment in a distracted world (David Perell)

The west's race to secure water (Bloomberg)

Demographics drives labor participation, inflation, demand and much more (John Burns)

Lex Fridman interviews Norman Naimark on Hitler, Stalin, Mao, and Absolute Power

The story of FTX, the crypto derivatives exchange (Acquired)

Seven Deadly Sins; Seven Lively Virtues (Father Robert Barron)