The Opportunity Next Door
What You Know vs. What You Own; Or, Adjacencies and Uncommon Profits
Three stories:
Once upon a time, there was a milkshake machine salesman in Chicago. He kept getting calls from restaurants around the country who wanted to buy a milkshake machine “like the McDonald brothers have in San Bernardino, California”. He flew down to investigate and found a busy hamburger joint with eight of his machines. He realized that this new fast food concept might have a better future than the milkshake machine business, and he eventually bought out the McDonald brothers for $2.7 million. Today, McDonald’s is the leading fast food chain in the world, worth over $150 billion.1
Once upon a time, there was a young power company executive in California. The electric power market was slowly deregulating, and based on his experience in the industry, he believed there was a bright future in trading electricity electronically. He bought an electricity trading platform for $1 (plus the assumption of debt), and managed to get some major players to use it by giving up equity to participants, who wanted an alternative to the leader at the time, Enron. Enron collapsed, and not content to stop with electricity, he bought other commodities and financial product exchanges, converting them to electronic trading, culminating with the acquisition of the NYSE in 2013. Today, IntercontinentalExchange (ICE) is one of the most valuable financial services firms in the world, worth over $60 billion.2
Once upon a time, there was an executive at a personal computer company who believed computer graphics were the future, and tried unsuccessfully to get his employer to acquire a leading computer graphics player that was up for sale. Soon after, he was fired from his job, and he decided to buy the company himself for $5 million. The company, a carveout from LucasFilm, was renamed for its main product at the time, the Pixar Image Computer, and its sale to Disney for $7 billion twenty years later made him the largest shareholder of Disney and one of the wealthiest men in the world. He also went back to his former employer and had some success there too.
As a byproduct of the unique lives we lead, we are bound to pick up some unique insights into the world that few others have. As it turns out, the most lucrative way to use those unique insights is usually to get into a different business entirely.
Ray Kroc was a middle aged man who had spent his life selling paper cups and milkshake machines; initially he wanted McDonald’s to expand so he could sell more milkshake machines, before he was forced to conclude that the real money was in owning and expanding the fast food chain directly. Jeff Sprecher could have built more power plants, as he had for over a decade, but he had the insight that the real opportunity was using what he knew about electricity to digitize the trading business, and once there, he realized there were other trading businesses ripe for the same treatment.
No matter how hard you work, your income will always be limited by the field you’ve chosen. Therefore, it is worth it to stop every so often and think about whether it makes sense to switch fields entirely. As Warren Buffett puts it, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”
This insight has broad applicability as career advice, but it is equally interesting to study as investment advice. The most valuable companies are usually those that start in one field, and use what they learn to invest in, acquire, or build a winning business in an adjacent, much more lucrative field.
Let us revisit the list of the hundred most valuable companies in the world as of June 2020, from a prior edition. To recap, since a few large firms with high returns drive most of the returns of the total stock market, we can get a sense of what drives total returns by just looking at a handful of the most valuable companies. In the case of the top ten (excluding state-controlled Saudi Aramco), virtually every single company either made a large share of their fortune by moving into an adjacent business, or were themselves the adjacent investment that made a fortune for another company:
Apple ($1.568 trillion market cap): Apple built their most valuable businesses internally, but their acquisition of NeXT for $429 million in 1997 was a pivotal step, as it brought them the basis for OS X and it brought back Steve Jobs.
Microsoft ($1.505 trillion market cap): Microsoft’s first business was a BASIC interpreter, but they successfully got into operating systems and applications through both internal development and acquisitions. One key early step was the acquisition of DOS from Seattle Computer Products for $75,000.3
Amazon ($1.337 trillion market cap): Amazon started by selling books, CDs, and DVDs online, and early on they developed the ability to provide infrastructure as a service to their internal development teams. Their key insight was that they could use what they had already built to provide the same service to external clients over the Internet, which they did in the form of AWS.
Google ($953 billion market cap): Google acquired Android for only $50 million and YouTube for $1.5 billion; both businesses are huge parts of Google today, certainly worth well over $100 billion each.
Facebook ($629 billion market cap): Facebook acquired Instagram for $1 billion in 2012; it is likely worth over $200 billion today.
Tencent ($599 billion market cap): Naspers was a South African media company looking to diversify into China when they invested $34 million for a 46% stake in Tencent. This is almost certainly the most successful minority equity investment of all time; their stake is worth over $200 billion today. Naspers recently spun their stake off into its own holding company, Prosus, which is the 58th most valuable company in the world by itself.
Tencent itself is the poster child for this whole idea, having leveraged the power of WeChat in China to build an empire encompassing gaming, payments, and equity stakes in almost everything inside and outside of China - even a 5% stake in Tesla.
Alibaba ($577 billion market cap): Alibaba made the fortunes of two other public companies.
Softbank was a Japanese publisher of computer and technology magazines before it started investing in Internet companies. It invested $20 million into Alibaba in 2000, and even after selling off pieces over time, its remaining investment is worth over $100 billion, helping make Softbank the 90th most valuable company in the world.
Yahoo would invest $1 billion and contribute its China assets for a 40% stake in Alibaba in 2005, the value of which also swiftly soared into the twelve figure range. Yahoo (renamed Altaba after selling the Yahoo business to Verizon) is in the final stages of completing a liquidation to maximize the value of its Alibaba stake for investors.
Alibaba itself has branched from marketplaces into payments (Alipay) and investments in other companies in China.
Berkshire Hathaway ($430 billion market cap): Warren Buffett turned a Maine textile company into one of the most valuable companies in the world purely by investing in or buying other businesses in a wide variety of attractive industries.
Visa ($372 billion market cap): Visa was originally created by Bank of America in 1958, but as it grew, it converted to a cooperative owned by its member banks. It is now more valuable than any of the banks that created it, and in terms of intangible value, it is probably more valuable than all of its original member banks combined. Visa went public in 2008, in time for some of its member banks to cash out shares to cover some of their losses from the financial crisis.
Johnson & Johnson ($366 billion market cap): Johnson & Johnson today is a leading pharmaceutical and medical device company, but it got its start in 1886 making surgical supplies. They didn’t get into pharmaceuticals until 1958, when they began a series of acquisitions to get into that area.
The list goes on; Roche (#14) got into biotech by investing $2 billion to buy 60% of Genentech in 1990; Genentech was valued at $100 billion when they bought the remainder in 2009. MasterCard (#15) is basically the same story as Visa, a network built by its member banks. TSMC (#19) was initially funded by the Dutch electronics giant Philips, which took a 28% stake and agreed to buy its chips.
This is not a recent phenomenon; it extends to the industrial leaders of yesteryear.4 The rise of General Motors was in large part due to the efforts of DuPont, which at the time was a supplier of key automotive inputs such as leather and varnish, and which invested $50 million in GM for a 29% stake. Boeing was founded by a lumber baron who got into the business of manufacturing wooden seaplanes; Boeing branched out so quickly and successfully, it was forced to spin off their airline (United Airlines) and engine manufacturer (United Technologies, owner of Pratt & Whitney) for antitrust reasons.
Henry Wells and William Fargo built two express delivery companies in the 1850s that moved money and goods by stagecoach; the New York company, American Express, got into the more profitable business of moving money by travelers checks and later credit cards, while the California company, Wells Fargo, eventually focused on their San Francisco commercial banking business.
When you invest in a company, you are really buying two assets: Their current business, and the unique knowledge they have about adjacent businesses, which they can monetize by investing the firm’s capital. It goes beyond possessing simple knowledge, however; the best performers also must have the willingness and ability to act on their unique knowledge. This includes having a management team with a deep understanding of strategy and economics and a culture where successful acquisitions and investments will be nurtured and not wasted.
One reason successful investors emphasize the quality of the management team, particularly among growth companies and companies in fast changing markets, is that their ability to allocate capital and win in other fields is crucial to the outcome of an investment. A DCF of an existing business is inadequate to analyze the outcome in a fast changing field where yesterday’s assets are becoming obsolete, but the leading players have a huge head start on building the more durable assets of tomorrow.
A company with investing skill has a huge unfair advantage over other players in their area of expertise. Not only does the company have proprietary data, scuttlebutt, and insight that public investors cannot get, but they also have the ability to swing the outcome of an investment. They can supply proprietary know-how, or they can kickstart a positive feedback loop by being the first major customer, which allows the target to benefit from “learning-by-doing”, and gain credibility that gets them talent, capital and customers.
There are hundreds of fields adjacent to any business. The odds that a business happens to start in the most lucrative of these hundreds of possible fields is very small, and without being in a lucrative field, a business will never be that valuable. Furthermore, every business grows more obsolete every year - it has been a long time since Amazon sold a significant quantity of CDs and DVDs, or Microsoft made money licensing BASIC. It’s much more important to fish where the fish are, rather than get a little better at fishing.
There is a huge difference in profitability between adjacent fields. Below, we have a simplified map of the airline industry, created by the great Michael Mauboussin. (I encourage you to read his whole study.)
Along the horizontal axis, we have all of the parts of the value chain - the airline, the airports, the airplane manufacturer, and so on - where the width corresponds to the amount of capital invested globally. On the vertical axis, we have excess return on capital.
The airlines and airports, with all of their planes and buildings, consume a lot of capital without earning a return, at least for the period of time being shown. There is very little money being made here, at least in aggregate. The real action is in the spiky fields on the far right.
One of the highest of the spiky fields is labeled CRS, which stands for Computer Reservations Systems, the software airlines use to manage reservations. This is a small but very profitable business for the winners; the leading player in the space, Amadeus, is now more valuable than all of the network airlines in Europe combined. The airlines foresaw how lucrative the space would be, and built (and later spun off) the current leaders. Amadeus was formed by a consortium of four European carriers in the late 1980s, and the number two player, Sabre, was built by American Airlines.
There is a deep literature on strategy that tries to explain why most value chains, when mapped, look like the graph of the airline space above: There are a few layers that grab most of the profits, while the rest are lucky to tread water. They have to do with barriers to entry, returns to scale, bargaining power of suppliers and customers, and a number of other concepts you likely have already heard of.5 The reasons as to why this happens are outside of the scope of a short essay, but it is a well known feature of the business landscape. Suffice to say, a smart company stuck in a field with low returns should try to figure out if they can redeploy capital into a field with high returns.
It is good to be in a profitable space, but it is almost as important to get to a large space. Consider the field of technology investing. Sequoia Capital is widely considered the top technology investment firm in Silicon Valley, having backed Apple, Google, YouTube, and Airbnb, among others. In December 2020, Bloomberg reported that the three early stage venture funds Sequoia raised between 2003 and 2010 returned up to 11 times the capital originally invested, an exceptional return. Sequoia’s investors likely made about $12 billion on their investment in those funds.
As of the end of 2020, Warren Buffett’s Berkshire Hathaway, not widely considered to be a top technology investor, has already made nearly $100 billion on its $36 billion investment in Apple made between 2016 and 2018. It is all well and good to be the best, and even better to be the best player in a profitable game; but this illustrates that it is often even more important to play for high stakes.6 There may be riches in niches, but there are even more riches in $100 trillion liquid markets.
Another key factor to consider is if one can be a winner in the space at all. Many of the industries with the highest profitability are very concentrated, often with three or fewer players, with the leader taking most of the profits. For example, in the search space, Google captures virtually all of the profit, and Apple captures two-thirds of the global profit in mobile devices. If the returns in your field mostly go to the leader,7 it helps to have the support of a strategic partner that can increase your odds of finishing #1. Every lucrative field has a graveyard full of companies which tried to compete and failed, and many of them only have survivors that were backed by an adjacent company, as we saw in the CRS example.
There is no guarantee a company will achieve exceptional returns by investing in adjacent spaces; in fact, the general wisdom is that companies do poorly when making acquisitions, and would be better off returning cash to shareholders. A poorly executed investment and acquisition strategy result in what famed money manager Peter Lynch dubbed “diworseification”. (He was writing at a time soft drink companies were buying movie studios.) However, a well executed investment and acquisition strategy will achieve exceptional results consistent with what Peter Lynch was most famous for advocating: “Buy what you know”.
[Further reading: This essay was inspired by topics covered in Byrne Hobart’s The Diff and Marc Rubenstein’s Net Interest, both newsletters that you should definitely subscribe to. This topic is also addressed in Philip Fisher’s Common Stocks and Uncommon Profits, which is always worth a read (or re-read). There is additional reading material in the footnotes below.]
Byrne Hobart originally surfaced this here; for further reading, Ray Kroc’s Grinding it Out is a classic.
Marc Rubenstein has a great write-up here in Net Interest, which you should definitely read, as it has detailed case study of exactly what aspects of exchanges are so lucrative, and how that guided Jeff Sprecher’s strategy.
Microsoft made a $150 million investment in Apple to help save them in 1997; unfortunately, they sold far too soon, and the investment would be worth more than $100 billion today. They also made an early investment in Facebook that they reaped a few billion dollars of profit on.
Philip Fisher wrote about this subject in Common Stocks and Uncommon Profits in 1958, albeit with a stronger focus on the returns a well-managed company in the right field can make from R&D aimed at adjacent markets. Many of the companies he cites as examples, such as Dow, Corning, Motorola, and Texas Instruments, bore out his predictions, and are still market leaders in their respective fields today.
For further reading: Mauboussin’s survey linked here is a good place to start. Also, Warren Buffett’s annual letters, Michael Porter’s Competitive Strategy, Hamilton Helmer’s 7 Powers, Peter Thiel’s Zero to One. If you prefer newsletters, you can’t go wrong with Ben Thompson’s Stratechery.
Venture capitalists are very aware of this, and are holding their investments for much longer, encouraging their portfolio companies to stay private longer, and raising later stage funds where they can put more capital to work. Sequoia famously sold their 1977 Apple investment after 18 months, prior to the IPO; today, Sequoia still owns the stock from their 2009 Series Seed investment in Airbnb.
Second place is a set of steak knives, and third place is you’re fired.