Before we get started I just wanted to highlight a short video Eoin Treacy has made on bitcoin’s trend. A few weeks ago he used his trading expertise to look at the bitcoin chart in a different way, and he predicted bitcoin would hit $7,000. Today, he has another video on where he believes bitcoin is ing next, you can get access to it here.

Yesterday, we looked at how the “power law” was the key to picking winning investment strategies. It dictates that the most of the value of firms in any given market is normally concentrated in the top few names. In inherently concentrated markets, such as social media, that largest single firm often has 50% of the total market capitalisation.

From an investment point of view, it comes down to one key principle: go big, or go home – and that’s why Facebook is grinding Snap Inc. into the dirt. The firm has lost half its value in a year – while Facebook is up by half, in the same period.

Strangely, you may not think of the consequences of this law in the correct way. It’s certainly true that investing in the world’s largest companies (or firms which are destined to become them) can mean your investments perform very well. The difficulty with this approach is that, once it’s obvious that a firm is dominating a sector, much of the value increase is already built into the price.

To explain this another way…

If you could be on horses within a race, then at some point the lead horse would trade at almost zero return. Even if half the race is still to be run, a horse that’s sufficiently far a of the field will be priced as if it has already won.

Accordingly, it’s often a smarter move to focus on smaller niches, but follow the same investment principle. Instead of looking for the Amazon of e-commerce retail, you might look for a specialist sector, in which Amazon is unlikely to compete. Here, you can find new niches, which are ripe for disruption.

For example: while Amazon is currently the world’s biggest B2C ecommerce retailer, it’s unlikely that it would become the number one wholesale supplier to pharmacies. This sector is sufficiently different to Amazon’s core business model to make it an unlikely breakout strategy for the firm. Therefore, looking to back the potential “Amazon of pharmacy supplies” may be a very smart move.

I hope that this relatively simple rule of thumb for investing will help you use your money in a smarter fashion. It’s certainly an approach I’m taking myself – and some of the most successful businesses I’ve previously held a stake in have taken this approach. They’ve dominated by looking to create an early lead, and become the biggest fish in a small pond.

 

Conversely, I instinctively shy away from contested sectors

If there are half a dozen firms all vying for the top spot, I know that my chances of picking a winner are pretty low. Accordingly, my focus is on trying to find firms which have an obvious capacity to dominate, in the first place. This does not necessarily mean I’m looking to back the very first firm entering an industry sector. Instead my focus is on finding early-mover firms, which are clearly capable of dominating.

This strategy is supported by a study by Bill Gross (covered in his TED talk). This demonstrates that the winning companies in recent decades have typically had one thing on their side: timing. Being the firm that comes to market at the right time is the key to dominance. Too early, and your vision is too far a of the market: investors may not support you; and consumers are likely to be underwhelmed by your offer, even if they believe in your vision. For example, I’d love a completely non-polluting electric car – but I’m not prepared to sacrifice my petrol car’s near-instant “charging”, and ubiquitous refuelling network.

Competitor versus Disruptor

Similarly, firms that are too late to market inevitably face a struggle to compete with entrenched players. Once you’re a competitor of giants, as opposed to a disruptor of giants, you’ve really got your work cut out to make that critical number one position. That’s why today’s industrial behemoths often have very long histories. In spite of rebrands and reorganisations, firms like Esso, Ford, Boeing, etc, have histories stretching back many decades – and, in some cases, well over a century. In all likelihood, the established incumbents in any given market tend to remain so, until a genuine disruptor comes along. This vulnerability is a complement to the power law, enabling you to pick well-timed disruptive investments, which have the capacity to dominate individual niches or markets.

In today’s market, look to back firms that have an early lead in disrupting established competitors – but yet are sector dominant. Some great examples of recent winners are Airbnb, Tesla, TransferWise, etc. Behind them are promising upstarts, who may be poised to become the power law winners of tomorrow: Monzo, Matternet, Boom Technology, Bigelow Aerospace, Hybrid Air Vehicles – and, of course, many others. Finding these exciting firms is what Exponential Investor is all about.

How are you putting the power (law) into your portfolio? Let us know – andrew@southbankresearch.com.

Best,

Andrew Lockley
Exponential Investor