Value creation comes from vertical growth

PayPal founder and venture capitalist Peter Thiel recently described the two competing economic paradigms for growth. These are:

  • horizontal growth or globalisation (sharing the same pie out between more people); and
  • vertical growth or technology (increasing the size of the pie by creating new markets).

Thiel describes technology as something that "moves the needle from zero to one" versus globalisation, which simply propagates existing ideas from 1 to n.

With characteristic acuity, Thiel identifies the key driver in value creation as the opportunity to create a monopoly, essentially what Warren Buffet would call a “defensive moat”. Such businesses have a sustainable competitive edge that provides clear strategic differentiation or operational outperformance. The edge could be a first-mover advantage that generates dominant market share, unique experiential knowledge like a trade secret or the impact of a marketing and promotional strategy that leads to enduring brand loyalty. Frequently the edge is accompanied by legal protection in the form of a patent, trademark, registered design or copyright. 

The alternative to such a monopoly is unfettered competition. This inevitably leads to diminishing profit margins of the type seen in commodity businesses where competitive advantage is driven by cost of production and economies of scale. 

These initial thoughts may be summarised as:

Value investment = (technology + intellectual property) = a monopoly

Vertical growth comes from the margins

How new markets are created is something that has been written about extensively. Aside from the structural, legal and social prerequisites for growth, the creative process that brings new ideas into existence requires iconoclastic thinking.

Perhaps the most eloquent essayist on this topic is Paul Graham, whose phrase “the power of the marginal” describes the difficulty experienced by incumbent industry leaders in being truly innovative. It is 'eye of the needle' stuff and not revelatory – we probably all accept that Big Pharma/Tech/Media is culturally and operationally inflexible. However, Graham also points out that the numbers of people who operate at the margins are far larger than those who own the centre. He also explains that the margins are full of people who are less dogmatic and less afraid of failure. As a result, innovators at the margin are more inclined to be truly radical and the migration of new entrants from the margin to the core has never been more rapid.

To put it another way, big blue-chip companies live by focus groups. These may be implicit ("what would the board say?") or explicit ("eight out of 10 cats prefer it").

This will not be popular with those in the fast-moving consumer goods industry, but the strategic problem with focus groups for real innovators was elegantly articulated by Henry Ford when he said "If I'd have asked my customers what they wanted, they would have told me 'A faster horse'."

Why innovation is different today

Every generation thinks that they are differentbut this decade may one of the few that can claim it. Innovation is happening at an exponential rate and as Ray Kurzweil of Singularity fame is fond of saying, human beings are not evolved to understand, let alone deal with, exponential anything.

A case in point: the Apple-1 was hand-built by Steve Wozniak in Steve Job’s parents’ spare bedroom in 1976 and was sold for $666. A mere three years later, when Jobs was 24, Apple was already a much-hyped pre-initial public offering candidate and, in exchange for the right to buy 100,000 shares of Apple for $1 million, Jobs was granted an audience with the brain trust at Xerox PARC. Jobs watched with barely contained wonder as the Xerox Alto personal computer was demonstrated to him and he saw for the first time a graphical user interface (GUI) controlled by a mouse. In his private 'eureka' moment Jobs immediately saw the value of this innovation and he was stunned that Xerox had not commercialised it; but he also realised that the Alto was far from the finished article and he knew that he could reinvent it.

The Apple Macintosh was as much like the Alto as Homo Erectus was like Neanderthal man. Take mouse design as an example. Malcolm Gladwell describes how Dean Hovey of IDEO fame built the iconic one-button Apple mouse. Unlike Xerox, whose highly engineered, multi-button and rather temperamental mouse was made with precision tooled ball bearings, Hovey worked with deodorant rollers to create a low-tech product that did not stick when fluff jammed it up. The Apple mouse, GUI and other aspects of the Macintosh were divergent superior evolutionary branches of the personal computer. Jobs built simpler, cleaner, with greater utility and more intuition. But he could not have done it without the Alto’s inspiration and the open-ended budget that funded it.

Xerox PARC, like Bell Labs, was R&D heaven. Unlike a university, the researchers had no teaching or publishing responsibilities, they could just invent and were funded to do so. But without commercial constraints the products were over-engineered and expensive ego projects that pioneered technology without regard for any envisaged popular use. The researchers were often disruptive, stubborn, idiosyncratic and unmanageable (a familiar sight to anyone who has worked in academia). Such a pool of talent could only be supported only by a multinational with an effective monopoly, which could afford the luxury of indulgent genius.

The capital and patience to support this type of innovation ecosystem is fast disappearing from today’s markets as it fails to deliver and barriers to alternative approaches are lowered.

Pharmaceutical companies have slashed their multibillion R&D budgets as the gravy train of blockbusters dwindles and the US Patent and Trademark Office and the Food and Drug Administration get picky about patent life extension. Instead, they are turning to collaborative R&D models, co-development deals, smaller, focused but high margin markets, repurposing older drugs across new diseases and, of course, M&A.

The biggest investor in R&D for many years in the cellphone industry was Nokia. However, outside of its formidable patent portfolio it is no longer in the handset business. Industry R&D spend is alive and well (Samsung alone spent $10.4 billion in 2013), but many of the most interesting innovations around capacity management and battery life, for example, are being developed by smaller companies or those in different industries. 

If the rivalry of Intel and ARM/Qualcomm for dominance of the microprocessor industry has demonstrated anything, it is that an ecosystem business model can outcompete a vertically integrated one even when it started with an effective monopoly. Across all industry sectors with very few exceptions (perhaps Google and Apple), big R&D is giving way to more nimble, less Capex-intensive, open-sourced and collaborative R&D. 

Innovation still matters and it is still being done, but it turns out that it is being done very differently.

Chris Donegan

This article first appeared in IAM magazine. For further information please visit www.iam-magazine.com.