Greetings all. Hope everyone had a good holiday. Yes, it’s been a minute, but I’m sitting on a grip of half-written posts so I figured I ought to get the momentum going again and bang them all out before the end of the year. Today, I have the first of a trio of posts circling around the same socioeconomic-theory-of-everything I’ve been dabbling with over the past year. Plus, a 2023 round up with a post-mortem on my predictions, with predictions for 2024. Then, if you’re lucky (and I’m feeling brave), I’ll publish my analysis on the complicated drama in the Middle East. But for now, let’s return to everyone’s favorite topic: margin. Does it matter?
MEV Too
Inflation is peeling back, reportedly on its way back to 2%. The Fed is may have the soft landing it was looking for, and it doesn’t appear that anything broke on Main Street (all that was lost was lowly Tech jobs). That being said, after a long, hard summer of poor consumer confidence, companies are making less net income (margin) across the board. Not enough of a blast to warrant widespread panic and layoffs, but enough for stakeholders to sit up and take notice. The can has been successfully kicked down the road for future Us to deal with. Thanks, present Us!
How is it that we all increase prices yet complain about inflation at the same time? It’s a perpetual Musical Chairs or Prisoner’s Dilemma where everyone keeps ratting on each other until the music stops and some Deus Ex Machina in the form of a CPI print tells us to stop.
How is it that we had such “debilitating” inflation without a massive catastrophe? Because price increases reveal the true purchasing parity between consumer wealth cohorts (hint: inequality is up). Increasingly, there is no incentive for businesses to target those with low purchasing power. All of the margin is captured in marking up items to people who can afford to pay for it. In a great article about how Apple charges 17 different prices for the iPhone, ranging from $499 to $1599, Nick Kim describes how “Apple is not interested in giving consumer surplus to customers willing to pay a higher price”.
Smart businesses systematically target the high (or wanna be high) net worth individuals, because that is where all of the purchasing power is, and that is where they can extract maximum value. There are very few businesses, like Walmart and Amazon, that are able to ignore this extraction process with Bezo’s Law (your margin is my opportunity), and race to the bottom of pricing to provide mass value to the consumer. This mass targeting proposition is not scalable for the majority of businesses in the world. Your local hardware store doesn’t have the ability to sell to customers in New Delhi, and SMBs make up close to 50% of GDP in America.
So are we supposed to extract value? Or race to the bottom? Does margin matter? What if we are looking at it all wrong?
Earlier this year we discussed how money matters definitively, from a physical and psychological aspect, but there is also a spiritual aspect where money doesn’t matter at all. We can call this surplus above desired status (SADS, lol), for which everyone has their own place on the spectrum. Put a pin in that.
We have been experiencing economic crashes more frequently, entirely due to the fact that investors get out too far over their skis with risk, allowing themselves to be sold on the promises of growth. In my least-liked post of all time, I made the comment that status is growth, growth is status. GDP has become more and more anchored to financial services and derivative valuations. The reality is that the asset these funds are selling is nothing more than the prospect of growth. The elusive ghost of future margin.
In fact, this simple concept accounts for the entire investment market. Trillions and trillions of dollars are moved around every day on this premise. We are paying money now for the promise of future growth, the bigger the promise, the more we will pay in a premium. As promises become undone, or otherwise become clear that they were impossible to obtain, people start losing the premiums that they paid. As the famous Keynes quote goes “successful investing is anticipating the anticipations of others”.
What can be done about this? Should anything be done? Isn’t this just basic discounted cash flow analysis and risk versus reward?
In one of my first articles, I talked about how everything is a valuation, and that in search of more and more alpha (a.k.a. growth, a.k.a. anticipation) to sell, Financial Assets Peddlers (FAP’rs) are looking further and further into the future for promises of cash flow. They joke in the market is that everything is already priced in. If that is the case, and the market is always in perfect equilibrium, the only thing you can sell is the literal unknown. The unknown is risk, and as you’ve probably heard countless times over the past year or so, is that in a ZIRP environment, risk doesn’t seem that risky. So instead of a traditional valuation on revenue multiples, you were seeing upwards of 2-3-10 times greater, simply because the promises of margin were greater and greater, like the same story your drunk uncle tells every holiday season. This is all due to the incentive of FAP’rs to make their own nut. But who is to blame them? They are simply following the same desire of instant gratification that inflicts all of modern society, and therefore use any means necessary to sell growth to acquire status.
Side note: we could use status/alpha/growth all interchangeably here, but I will try to keep it within the standard colloquialisms that we all use.
The problem is that we want the status in the current day and aren’t willing to wait 10 or 20 years for the real margin to show its face. Cryptocurrency saw this play out in its own sped-up microeconomy. As soon as a new, unregulated financial instrument is introduced, it is the natural tendency of humans to exploit that via rampant speculation and fraud. Everybody wants their money now, and tasty management fees are that much tastier on top of higher AUM (assets under management).
However, if we collectively agreed and changed our minds to rid ourselves of our dopamine addicted brains, we could start to form (or convert into) sustainable economies with low inflation. Sustainable in this sense is not in regards to some ambiguous ESG platform, but to a society that doesn’t continuously over shoot it’s skis.
The future is in small businesses, not in terms of revenue, but in terms of company size. Employed with a plethora of AI tools available to turn non-technical people into technical people, it is possible for the businesses of the future to be run with <50 people and still rival some of the biggest businesses in the world. Think the original group of Instagram founders, not selling to Facebook, and scaling all on their own by exponentially increasing their engineering capabilities through AI. Maybe they never hit a billion users, but they each maintain equity, and make exponentially more money. All of this increases competition, decreases inequality, and drives down prices.
This missing puzzle piece to this opportunity for sustainability is to create a business that has both status and is minimally extractable from the consumer. Think Apple, but if all the phones cost $499.
We have seen brands like this pop up in many industries. In fashion, small batches of denim are created and are of designer quality, but because they are sold directly to the consumer you can get them for half the price of a designer brand. In the world of atoms, this is difficult to scale up, which restricts supply, and drives up demand, price, and thus status. In the world of bits, zero marginal costs, and massive built-in distribution networks, a small team can scale quite quickly. Without the need for VC dollars, they won’t have a board breathing growth targets down their neck. The newly unlocked ability to scale more efficiently reduces the need to pursue growth to achieve status. Status is achieved through the massive margins made by a small group of contributors. They don’t have to sell future promises of that margin, because it is so great they can willingly dilute it themselves. And the question becomes, how much money needs to be made to satisfy the status itch for these individuals?
The newly unlocked ability to scale more efficiently reduces the need to pursue growth to achieve status.
Younger generations, as they gravitate towards more authenticity, are hip to the game that designer brands are marking up the price specifically to extract value due to status. But you can have your cake and eat it too. The real ESG and DEI protocols should be minimal extraction.
The small company of the future, with a small amount of employees, can provide a valuable product or service to the world and accomplish two things. One is not extracting value from the consumer, who is going to be increasingly aware of manufacturing cost margins in relation to status. The other is by having such a small employee base the revenue is able to be shared with the employees creating better retention, motivation, morale, reducing turnover, and actually creating a community or even a small family around a common goal. Right now we call these businesses “lifestyle businesses” because the goal isn’t to extract as much value as possible. It’s to basically print money and chill and live the lifestyle that you want to live with minimal effort. Right now in Silicon Valley, or even the economy writ large, there’s a bit of a stigma against the lifestyle business. This is because it’s a signal to others that you aren’t constantly hungry, and you aren’t of the tribe that says enough isn’t enough and you aren’t signaling status by constantly striving for growth.
This concept may seem in some ways anti-capitalistic, but there is nothing in the rules of capitalism that says you must extract maximum value from your consumer base (Bezo’s Law provides the case study). To be clear, I am extremely pro-capitalism, but to make a crude analogy it’s like a parasite sucking nutrients from its host. If you extract all the value out of the host, there’s nothing left to eat. This is what’s happening in the economy as we try to increase prices and parity with our competitors under the psychological guise of inflation. You can be a minimally extractable company and still be extremely capitalist. In fact, by not being maximally extractable you are increasing the probability that you reach more customers, and that the customers you do reach come back, because they feel good about not getting ripped off, and they have more cash in their pocket to spend on you.
Cryptocurrency displayed this dichotomy of ethos perfectly. On one hand, the entire purpose of it was to have a currency that was not controlled by the government, and allowed the less fortunate to participate in unique types of wealth formation. But on the other hand, you had massive speculation that flipped the entire industry on its head in an unregulated market. Bad incentives were allowed to run rampant. MEV is actually a crypto term used to describe miners who manipulate block orders to extract transaction value. By contrast, there are protocols that extract only what is required out of a transaction to run itself. In any exchange of goods between buyer and seller that is conducted over some sort of platform with an intermediary, the intermediary is going to take some value out of the transaction to cover their cost as they have infrastructure and marketing and headcount they need to pay for. A properly decentralized protocol, however, can exist to serve only the purposes of its clients. It runs on electricity, so the costs are not zero, but it can take exactly the cost that it requires, and leave the rest of the value for the consumers or participating parties. Bezos’s Law applied to bits. It sounds socialist in the surface, but it is deeply capitalist to inject competition into the economy. Humans can buy into any protocol, supporting it with their money and being rewarded if and when the protocol provides value to a greater number of people. There is no bad actor that is allowed to increase the amount of extraction that the protocol takes.
Applying this crypto protocol analogy to a human company, it might sound like a nonprofit. I am indeed describing a business that provides a product or service, and takes only what they need to survive. Or rather, achieve their desired level of status, wherever that lies on the spectrum. But nonprofits operate differently, and I would argue much less effectively or efficiently.
Nonprofits require donations to provide their service, which means they are not really part of the competitive environment. They are a marketplace in that they connect benevolent donators with end user recipients (via provided services), but they are maximally extractive, because there is not an efficient market price for the services they provide. They simply get as much money as possible, and spend it with no oversight, acting as a sort of opaque middleman. In contrast to the transparent protocol, the incentive structure can easily become misaligned. This is why we have bureaucratic bloat in school administrations, government, and nonprofit organizations. One only has to to look to OpenAI to see that once Elon stopped funding the non-profit, they had to sell a product to produce cash flow, which put the non-profit in the unenviable position of sitting on top of a massive for profit business with the ability to change the world.
It would actually be more beneficial for these nonprofits to turn a profit, but be minimally extractive. I realize there are many, many types of nonprofits, and it’s difficult to match the buyers and sellers (for example a wealthy billionaire and a Third World country). But there is a whole value of supply chain in between them where the money is transferred into goods and services and allocated to specific target areas.
I see many of the companies as being socially progressive, but not inherently capitalistic, something that most people probably agree are mutually exclusive. The same people who say that fiscal responsibility and social liberty are two different ends of the spectrum and not compatible because to be socially liberal you must extract value from one side of the spectrum and redistribute it to the other.
This does not have to be the case and minimally extracted value companies provide this middle path. They are in a sense philanthropic capitalistic organizations that can compete despite their small size (due to tech enhancements) with large multinational corporations, by providing the same status and quality in product or service at a close enough price to retain consumer adoption. Software has always had an MEV business model because of its zero marginal cost to service n+1 customers. This is what has generated so much of the wealth that’s in the world today (just look at the companies that make up the S&P). As smaller, AI-powered teams start to compete with the big boys, they can choose to take less money, either topline via not needing VC growth dollars, or bottomline margin in not needing to pay for 10,000 employees. This is the spiritual part of money that probably sounds completely absurd to many hard-nosed growth seekers. Knowing that enough is enough, that they will have sustainable personal status long-term by not extracting value from their customer, and not allowing competitors to sneak in and undercut them. It also provides more value to the employee, which is always someone else’s consumer on the other side of the equation. If more people get paid in today’s dollars, there is less incentive to take risks for future dollars.
This can happen in brick and mortar as well, but again it would take a collective consciousness effort on the part of society to realize that future growth is unpredictable. Slow growth compounding over time is more resilient. What’s in front of our face in community is more important than future optionality, and a shift in mindset that growth does not have to be status is a cure to all sins.