Land Grab

Looking for Future Winners

There is an interesting “winner takes all” phenomenon that frequently occurs in capital markets where a few select individuals companies capture the lion’s share of their respective addressable market.

I first came across this concept from Nassim Taleb’s book “Black Swan.” A simple example is to think about the distribution of album sales in the music industry. Consider annual revenue of a billion dollars in sales per year and 50,000 ‘talented’ artists. In a ‘fair’ world, the typical artist would make roughly $20,000 per year (or simply the average revenue per artist). Some artists could make a good bit more if they happened to be better singers, better song writers, or were even more attractive, perhaps. Others would make a good bit less, but on net, most would hover around the average mark.

That’s not the world we live in. In our reality, a select handful of artists capture 70% or more of the music industry’s revenue while small time artists are collecting pennies per listen on music apps¹. Taylor Swift isn’t one hundred times better at singing or songwriting than the next artist, and yet, that’s how the market values her anyways.

Once you learn about this concept, you start to notice it happening all over the place. NFL quarterback Sam Darnold might be only marginally better than Zach Collaros (the best quarterback in the CFL), yet Darnold’s salary is well over an order of magnitude higher. The same is likely true for Darnold vs Patrick Mahomes.

This concept can be observed in business as well.

Uber and Lyft, for all intents and purposes, both have a product that could be easily copied from a technological standpoint. But any new entrant into this space wouldn’t stand a chance.

And does anyone remember Google+? This was supposed to be Google’s answer to Facebook, and their entrant into the social media space. It was a complete flop.

This phenomenon can be explained by several factors. It could be due to network effects, first mover advantages, flywheels (whatever that is), or providing a marginally better product for the same price (value proposition). Whatever it’s caused by, it doesn’t really matter. All that matters is that it exists.

Enter, the land grab.

Because this phenomenon exists, it makes sense that scaling is priority ‘numero uno’ for startups. The unit economics need to work, of course, but if you’re a founder / CEO, the goal is to capture as much market share as you can as fast as you can…and at any cost.

This poses an interesting question for investors, especially value investors, who live and die by forecasting earnings and earnings quality metrics. At the end of the day, cash flows and earnings are the most important thing, but for most of these companies, earnings and cash flows don’t materialize in the financial statements until much later, leaving them looking hideously unattractive as investments just by the numbers. This makes most of these companies look like nonstarters for the average fundamentals screener.

Amazon operated at a loss for the first 6 years of existence: going public in 1997 and turning its first profitable year in 2003. Even after that, price to earnings ratios made them look overpriced for much of the following decade.

Uber lost money on every ride during most of its early years as the primary focus was on customer acquisition. In fact, Uber’s first profitable year wasn’t until 2023, over a decade after being founded.

Netflix and Spotify also come to mind.

All of these companies operated at a loss for extended periods, often times close to a decade, in the pursuit of market capture.

I don’t want to attempt to make this article “A guide to finding the next high flyers” because finding the next big thing isn’t really a repeatable exercise and I have no delusions that I’ll be better at this than the next newsletter or podcaster. It’s also important that we don’t fall victim to survivorship bias… For every company listed above, there are dozens that followed the same model, and failed.

But I do think this article was worth writing and gives good reason for self proclaimed Value Investors to open up our pool of investable assets (one that isn’t full of only profitable companies with low PE ratios and high ROx metrics).

That being said, I do have some thoughts on what we might look for.

Growing Revenue

This is an obvious one, but I think it’s the most important. If a company is deferring profits in an attempt to capture market share, that market share growth should be reflected at top-line levels. Losing money with stalled revenue would be at the top of my list of bad omens.

Ballooned Advertising Budgets

A massive advertising campaign is a clear signal of market capture efforts (a.k.a land grab). The SG&A line item in the income statement is the place to look here. This is an indication for how deep into the customer acquisition phase a company is.

Advertising is also the first place where a company can cut once they hit a market saturation point. This “found money” flows directly to the bottom line.

Ballooned R&D Budget

A high R&D budget is a clear indicator that a company is working to improve their product. In a world where a marginally better product wins, this is a necessary evil.

And like advertising, once a company “wins” their market and has a mature product, this could be a source of cost-savings later on.

However, there is another side to this coin (see below).

Differentiated Product

If the market can’t be won, the R&D budget can spiral out of control as each new marginal improvement to the product costs more than the last. These products would be classified as commodities, but this often doesn’t become obvious until well after this becomes the case. An example of this would be engineering software. Nastran, ANSYS, Abaqus, Hyperworks, etc. These all may have their strong suits, but none of them really stand out as a clear winner. No company can really demand a premium and they all become trapped in an R&D arms race. Autodesk seems to be a winner in the space just by having a larger, more robust product-set, and some benefits from network effects.

Another example of a successful business (in terms of 2024 stock returns), but weak product offering is HIMS. This is a company that targets the vanity of men, offering generic medications for treating hair loss and sexual performance. They spend half of their annual revenue on advertising, but (in my opinion) these are commodity products. Currently, they command gross margins in excess of 80%. We’ll see if BRAND is enough to maintain that level of profitability.

If you happen to follow my other newsletter, you’ll know that I’m pretty enamored with the solid state battery maker Quantumscape. This is a company that has a current product (prototype) that has marginally better performance than any li-ion battery configuration currently on the market. While this company is still very high risk, it’s also the type of company that has the profile to win their market in the event that they do succeed.

Alternative Valuation Metrics

I’m in danger of sounding like a dotcom manic that promoted price to eyeballs, but I think there are some unconventional metrics that we can actually screen for that could help generate potential ideas.

Some of these might revolve around gross profits. High gross margins could be an indicator of robust unit economics. As mentioned above, once a company wins their market, squeezing marketing and R&D budgets can mean more of gross profits make their way to the bottom line.

Price to Gross Profit could also be an interesting metric to look at. For the reasons mentioned above, current gross profits can be an indicator of what net profits could be. This is better than price-to-sales because we’d be able to compare better across industries. Naturally, this metric misses the capital structure of the business, so it’s important we don’t get ourselves into trouble here.

Advertising and R&D expense as a percentage of gross profits could help filter in companies that have some excess fat to trim. For instance, advertising and R&D expenses make up almost 50% of Spotify’s gross profit. This to me is an indicator that 1) Spotify is still in the market capture / product differentiator phase and 2) eventual cuts to these expenses would be a massive boon to bottom line earnings.

On Valuation

One last note on valuation. I believe the days of simple price-to-earnings screens leading to better returns are long behind us. The heyday for this style of investing came and went with the advent of the internet, when simply having the data offered a competitive advantage.

Earnings are important, yes, they are the most important thing. Earnings are what determine value. But we need to focus more on improving our forecasting prowess, because it’s not what earnings are today or even next year, but what they will be in the fullness of time.

We, value investors, need to adapt. It takes a little creativity to look out 5 to 10 years and try to see how the world will be rather than what it is today. This evolution is necessary if we want to compete in today’s investing landscape.

If you have any good examples of “Land Grab” companies, drop them in the comments! Thanks for reading!

1. I haven’t verified these numbers, but I believe them to be directionally correct from simple observation.