Arbitrage is “the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.” Once the arbitrage spread closes, the profit is made and the opportunity no longer exists. According to Austrian Economics, entrepreneurs’ profits “derive from the services he performs in detecting and eliminating arbitrage opportunities, thereby allowing supply and demand for a given good to meet.” By recognizing and acting on opportunities, the entrepreneur moves markets toward equilibrium. So entrepreneurial arbitrage is a low-risk way of exploiting gaps between what the market demands and what it’s being supplied until the spread closes.

There is very little “invention” involved—startups imitate or slightly modify someone else’s idea and only introduce breakthrough products or new business models many years later. This is what Peter Drucker calls creative imitation. The technology and market demand already exist, but the creative entrepreneur understands what the innovation represents better than the original innovators. This also includes packaging current technologies into new business models. Paul Graham calls this an idea that’s “a square in the periodic table”—if it didn’t exist now, it would be created shortly.

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In December of last year, I gave a presentation to a group of investors on the mental models of robustness and generalist/specialist species. Below are some of my findings, along with how these models can be applied to business and investing.

Animal species reside on a scale with “generalist” on one end and “specialist” on the other. Specialists can live only in a narrow range of conditions: diet, climate, camouflage, etc. Generalists are able to survive a wide variety of conditions and changes in the environment: food, climate, predators, etc.

Specialists thrive when conditions are just right. They fulfill a niche and are very effective at competing with other organisms. They have good mechanisms for coping with “known” risks. But when the specific conditions change, they are much more likely to go extinct. Generalists respond much better to changes/uncertainty. These species usually survive for very long periods because they deal with unanticipated risks better. They have very coarse behavior: eat any food available, survive in many climates, use a simple mechanism to defend a wide range of predators, etc. But unlike specialists they don’t maximize their current environment, because they don’t fill a niche where they could be more successful. It’s tough being a generalist—there’s more competition.

An environment with more competition breeds more specialists. Rainforests have huge diversity and competition, and therefore many specialist species.

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It’s good for any investor or business person to know where their company fits when it comes to the progression of innovation. Even if a certain company or product isn’t new, at some point in time the business it’s in was. Throughout history, innovations (whether they be technological inventions or innovations in business model) came about that performed a certain “job” better than the status quo. Most of these innovations didn’t arrive spontaneously — they were built upon or evolved from their predecessors.

The following is a simplified chart/timeline of innovations in the computer industry:

Consumers purchase computer systems, with new innovations or shifts in one component (processors or operating systems) driving innovation in computer design and vice versa. Other components like storage and display also drove innovation but were less important in this context. Most of the above innovations are technical, with the exception of the commodity PC makers (Dell, Compaq, etc.) which were an innovation in business model.

After money was transferred from consumers to computer makers, it went primarily to chip makers and OS developers. Because suppliers like Intel and Microsoft had strong competitive advantages, they had strong bargaining power, and therefore received and kept most of the value.

Retail Industry

The progression of innovation doesn’t just apply to industries as technical and complex as computers. Below is another timeline (dates are approximate) of the progression of the retail industry:

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Instead of further examining where Apple’s current (and future) products fit in on the “innovation scale,” in Part II I want to talk about Apple as an investment, and where its products fit in in terms of investment value.

Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.

One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.

Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.

Apple and the Red Queen Run the Hedonic Treadmill

“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”

So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year.

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Insight: When looking at a company, what type of building is it?

Large companies (with competitive advantages) can be pyramids or skyscrapers. Both are large and have commanding presences. Both have high returns.

Pyramids are strong — you can’t knock them over. Skyscrapers are tall and strong, but they can be knocked over much easier. For a pyramid to be destroyed, it must start at the top, and slowly erode over time. After a while, only the foundation will be left. With a skyscraper, the foundation can be destroyed first, and the rest of the company will go with it.

Wal-Mart is a pyramid. Google is a skyscraper (for now — it seems that Larry & Sergey are in the process of building the foundation up). Berkshire Hathaway is a pyramid. Newspapers were pyramids — however, over the last two decades, they have been slowly chipped away starting from the top. Now, the foundation is about all that’s left.

Skyscrapers can be turned into pyramids over time.  But that requires great management and somewhat favorable circumstances. The time it took to build a company doesn’t necessarily tell you what type of building it is.

You can combine this analogy with Buffett’s moat analogy. Moats are barriers to entry — the wider the moat, the harder it is for competitors and disruptive technology to affect the company. But if the moat can be crossed, you’d much rather have a pyramid than a skyscraper.

Related:

The presentation above compliments my previous post on the systemic causes of the financial crisis. Some of the illustrations didn’t translate well on SlideShare, so to download the original in PDF format click here (6.4MB).