Why Amazon is so Hard to Compete Against

Amazon has clearly become an absolute juggernaut. There are likely only a handful of companies today that have the resource and scale to compete with Amazon directly. But most of the companies that do have the resources to compete generally don’t operate ecommerce platforms, leaving the field mostly wide open for Amazon to continue to grow unabated.

I have been trying to grapple with the question of why it has been and continues to be so hard to compete against Amazon. Yes, Amazon has incredible scale, enormous cash flows, excellent assets (e.g. Fulfillment advantages as detailed in my post, Supply Side Advantages of Fulfillment (by Amazon)), but Amazon didn’t always have these advantages. And many of the competitors that Amazon has bested had either similar or even greater advantages in the early days.

For example – scale. A decade ago, Amazon was a tiny minnow compared to the Goliaths of brick and mortar retail. Even today, Amazon is still smaller than Walmart. Scale alone is not what made it hard to compete against Amazon, though it is what makes it even harder to compete against Amazon today.

Same with cash flows. Amazon may have more cash than it knows what to do with today, but its cash flows were materially weaker a decade ago. And certainly the incumbents like Walmart would have been much better positioned from a cash flow perspective to pursue Amazon’s strategy than Amazon was.

The easy explanation would be mismanagement at peers, but that seems like an incomplete explanation to me. After all, EBay wasn’t exactly poorly managed and had an internet lineage just like Amazon. EBay even had greater reach to boot, yet is now mostly an afterthought.

All of these advantages played a part…and ultimately Amazon’s differentiated strategy and perspective on retail helped them pull away, but I believe that one of the biggest reasons why competitors failed and continue to fail against Amazon is because they are never actually competing against Amazon but rather against Amazon’s past.

At any given moment, the observable parts of any company is a summation of decisions – strategic and financial – made some time ago. For most companies, the gap between those decisions and what you see is probably not large because many companies are unfortunately run to a fairly short term time horizon. However, for a company like Amazon, the gap is massive, especially since Jeff Bezos prides himself on thinking 5-10 years out.

From the perspective of a company like Walmart or Macy’s, they likely see Amazon as a large ecommerce platform with wide selection, fast delivery, and a sticky Prime loyalty program. But what they believe they are competing against (and observe) is nothing more than Amazon’s past! And likely the version of Amazon as it was strategically decided 5-10 years ago. Consider that Amazon launched Prime in the US in 2005. Amazon’s competitors are still struggling to compete against Prime with a competitive offering today, but Prime was likely decided far in advance of 2005. Even if competitors were to catch up, they would only be catching up to the Amazon of yore. The Amazon that exists today, the Amazon for which today’s strategic decisions affect, is the true juggernaut that competitors need to beat, but they won’t even know what they are truly up against until it becomes obvious a few years from now.

I think this is the key reason why Amazon is such a formidable competitor, and it is all enabled by years of advance planning. Competitors have a hard time catching up because by the time they know what they are up against, they are already years behind. Even formidable competitors like Google and Microsoft have been blind-sided by AWS, so it’s not just retail where Amazon successfully employs such a strategy.

In order for any company to successfully compete against Amazon would likely require recognizing this asymmetric form of competition and taking a leap of faith to position competitively against the Amazon of the future as opposed to the Amazon of the past. What does the Amazon 5 years from now look like? That’s the true measure of competition.

Supply Side Advantages of Fulfillment (by Amazon)

I wish I had spent more time analyzing Amazon in earnest years ago. But late is better than never. I’ll console myself with the fact that e-commerce penetration in the US is still <10% of all retail sales…and relative to that statistic, even the word “late” seems a bit premature.

Having spent a number of months learning more about Amazon’s history, assets, business model(s), and philosophy, one thing I’ve realized is that Fulfillment by Amazon (FBA) affords the company immense advantages on the supply side that I think are largely glossed over in mainstream media and investor dialogue.

FBA’s benefits to consumers (e.g. demand side) are very well understood: 2-day delivery and potentially faster depending on the category and geography, but I believe FBA builds as great or even greater competitive advantages on the supply side. These supply side advantages are probably key reasons why an FBA-like strategy will be hard (which does have a meaning that is distinctly different from impossible) to replicate for a follower (e.g. Walmart in the future).

It All Starts With Control

I found it easiest to understand trying to work backwards from 2-day speedy delivery. Amazon didn’t invent 2-day delivery. FedEx and UPS have been doing it faster for even longer and Amazon does rely on partners for last mile delivery. Both UPS and FedEx have been offering overnight delivery for decades. So what are the benefits to doing fulfillment in-house? It starts with control.

But before we get to that, I discovered there’s a whole universe and art to product delivery. So some background might be helpful.

Shipping Models – Dropshipping vs Fulfillment

I’ve never dabbled in merchandising/retailing until my recent experiments selling on  Amazon Marketplace, Ebay, and Shopify. Hence, I didn’t even know there was such a thing as dropshipping and how that differs from fulfillment, but the differences are large and important.

Starting with the most basic model (e.g. what Ebay started with) where inventory is owned and controlled by the seller – When a transaction occurs on the platform, the seller sends the inventory. This could be some used trinket or old iPhone in your garage, which formed Ebay’s legacy image of being a “used goods” platform. Simple enough. Under this model, inventory is only handled by the seller. The platform never touches the inventory.

Then there is something called dropshipping, which divorces inventory storage from the seller as well. These are the resellers that are buying cheap inventory from China and reselling it on Amazon or Ebay, etc. But big department stores like Macy’s also rely on this method as well. When a transaction goes through, the seller relays that order to the manufacturer / supplier (e.g. a factory in China) and has that manufacturer ship the product to the end buyer (or ship it to the seller that then forwards it to the buyer). This effectively reduces inventory handling and storage for the seller because the seller becomes more of a middleman. Under this model, the platform never touches the inventory, and the seller might also never touch the inventory depending on how the supplier leg of the process is set up.

Bigcommerce.com has a wonderful piece going over the details of dropshipping, including this helpful image:

One thing that is interesting with the dropshipping model is that it can be a service offered by the platform as well. For example, Shopify offers dropshipping services as does Mercadolibre, the Alibaba of Latin America. When offered by the platform, the platform handles the shipping details. The seller simply has to get the manufacturer to deliver the product to the local dropshipping drop-off point.

Then there is fulfillment. Under this model, inventory is stored and handled by the fulfillment partner (which is also the platform in the case of Amazon FBA). The moment a transaction happens, the fulfillment partner (e.g. Amazon) handles and ships the inventory. The seller does not need to do anything post-transaction. The only obligation for the seller in terms of inventory is pre-transaction…how to get the inventory from the supplier to the fulfillment partner.

Also from Bigcommerce.com:

Back to Control

For FedEx and UPS to accomplish fast delivery, it’s essentially a three step process:

  1. Quickly / efficiently take the package from the drop-off location to your long-haul network (probably airfreight if cross country). This process should take just a few hours if done efficiently.
  2. Transport the package to a location close to the final destination. This is probably done by air overnight if distance is far.
  3. Once the package is close to the final destination, do last mile delivery. This process probably takes just a few hours.

In toto, 2 day delivery is not difficult with enough scale and at a price. An efficiently honed operation like that of FedEx and UPS can reliably do one day delivery.

The key word is efficiently. Whereas FedEx and UPS and Amazon are all efficient, without fulfillment, Amazon can’t reliably offer 2-day delivery on 3rd party merchandise because there is no guarantee that the seller will be efficient in handling the parts of the process they are responsible for. Without fulfillment, Amazon does not have control over the inventory, and therefore the process is only as efficient as the weakest link.

What about dropshipping? As mentioned, Amazon could offer a dropshipping model that effectively gives them control of the shipping and handling process, but the passing of that control from the seller to the platform only happens post-transaction. The core difference between a dropshipping model and a fulfillment model is when the platform gains control of the product – under a fulfillment model, the platform has effective control of the product before the item is sold, while dropshipping model only transfers control once the product is sold. The moment the product is sold, the 2-day count down starts immediately…despite the efficiency of the combined Amazon/USPS/FedEx/UPS network, the seller does have to play ball and immediately get the package to the delivery partner at the local dropshipping drop-off point within a short period of time. Any delay (e.g. the seller didn’t read their notifications quickly enough) means the 2-day promise is potentially toast.

With Control Comes Cost Efficiencies

There are several awesome benefits to having control of the inventory, and a number of them are related to reducing system delivery costs.

Let’s start with a baseline example where the seller handles the shipping process (like how it usually happens on Ebay). Transaction occurs, seller sends the item. Unless the seller is high volume, they likely do not have sweetheart deals with their shipping partner and thus pays retail shipping price, which tends to be high.

Under a dropshipping model, the dropshipping partner can group together the volumes from a large number of merchants, and hence negotiate volume discounts. The same goes for a fulfillment model. 

There is one area where fulfillment ends up costing more than the dropshipping model – storage. Under the fulfillment model, the provider needs to build out a lot of warehouses to store the products before they are sold. So the natural question to ask is whether this cost is worth the additional control that you get pre-transaction. And the answer is actually a very resounding yes!

Although storage costs are higher, you get additional cost benefits that you wouldn’t get otherwise under a dropshipping model (and, again, the cost benefits I list below come on top of the tighter control that you would have over delivery timelines).

One of the cost benefits come from the ability to group items. Let’s consider a hypothetical scenario of 5 sellers selling collectively 5 items (or one item each). We will call them A / B / C / D / E. These 5 sellers sell their items to 3 buyers that we will call X / Y / Z. Buyer X purchases an item from A and B. Buyer Y purchases an item from C and D. Z purchases the item from E.

  • Under our baseline example where the seller handles the shipping, the 5 sellers make a combined 5 shipments. A needs to send their item to X. B also needs to send to X. C and D needs to send to Y. While E needs to send to Z. 5 different shipments.
  • Under a dropshipping model, we still have 5 shipments, but there will likely be a volume discount since the dropshipping partner will handle the shipping.
  • Under a fulfillment model, you only have 3 shipments! Since the fulfillment partner has control of the inventory pre- and post-transaction, the fulfillment partner (with an efficient enough process) can group together the items from A and B and put it into a single shipping package before sending it off to X. Same with the packages for Y. The cost advantage of this grouping is low when volumes are low, but likely significantly exceeds the cost of storage when your customers are purchasing with high frequency.

So not only do you have greater control of inventory under a fulfillment model vs other models, you also get the benefits of volume discounts and a more efficient shipping process through package grouping.

Storage Cost Arbitrage

FBA is not free of charge. The cost of using FBA covers not only shipping costs but also storage costs. Although I don’t have concrete numbers to back-up, I believe the storage costs for Amazon are likely lower than that for their merchants because Amazon Warehouses are likely located in non-prime real estate locations and obviously negotiated on a much larger scale. FBA likely embeds a cost arbitrage on the storage side whereby it is cheaper for a merchant to store and ship items via FBA than to store items in-house and then use a dropshipping partner. I don’t have concrete numbers to back this up, but intuitively this makes sense to me and will be a project for some other time in the future.

But it Gets Better – Inventory Commingling

Whereas all the items I listed above are probably still likely fairly well understood, inventory commingling is probably more arcane, but an incredible advantage and this advantage only accrues to the fulfillment model.

What inventory commingling refers to, is the ability to mix ownership of items in storage. For example, you have two sellers that are both selling the same trinket and they both have 10 items each in storage under the fulfillment model. With effective control of the inventory, the platform essentially has 20 trinkets to handle as it wish until it is sold.

Why does this matter?

Because it also magically leads to lower costs! And this is possible because geography comes into play.

Let’s consider the two sellers with 10 trinkets each and consider their geographic distribution. Let’s assume one is located in California and another is located in New York. Under the fulfillment model, the trinkets are pre-shipped for storage at the local fulfillment warehouse. For the Californian seller, this is in California. And for the New York seller, it is in New York.

Now let’s assume there is a buyer in California that happens to buy the trinket but buys it from the New York seller because the price is better (buyers don’t consciously consider where the seller is located as long as it gets to them in the expected timeframe, e.g. 2 days).

Under the seller direct shipping model and dropshipping model, the trinket essentially needs to go from New York to California in a very short period of time. That is costly. A bit cheaper with volume discount under the dropshipping model but still costly. Under the fulfillment model, inventory is commingled. The fulfillment partner can send the trinket from California instead! The shorter distance means not only lower cost, but the time to do that delivery is also shorter. I believe this is a key reason why Amazon Fulfillment is starting to gain enough scale to do same-day delivery. 

Of course, over time this process will lead to a geographic imbalance of inventory, but that is easily remedied by shipping the excess inventory from New York to California in our above example. But wouldn’t that negate the cost benefit eventually? No, because this rebalancing process can be done over time on a longer timeframe. Shipping and item from New York to California by train over a week is much cheaper than having to airfreight it overnight to stick to a 2 day delivery promise.

Sorcery!

The Competitive Advantage that is Hard to Copy – It’s All Because of Working Capital

Given all of the advantages I listed above, it’s shocking (to me) that fulfillment isn’t more of a priority for both traditional retailers like Walmart as well as other global ecommerce platforms. JD does this in China, but Alibaba is barely starting to explore this angle. Same with Mercadolibre in Latin America.

Competitors like Walmart and other retailers that don’t offer fulfillment likely don’t realize that fulfillment has a massive first mover advantage on the supply side, not just the goodwill that you accrue with buyers on the demand sideAnd this is all because of working capital.

Retailers generally have low margins and managing cash flows are a particular challenge because inventory days are quite high and business is seasonal. A retailer like Macy’s or JC Penney has to turn cash into inventory months in advance and then will have to spend months to turn that back into cash. In short, working capital is high, and working capital can both be life blood and poison.

In a world without fulfillment, ecommerce is a fantastic channel for managing working capital. It brings additional customers without much additional working capital. For example, consider a small local merchant with a physical store in San Francisco. The store already has inventory. That inventory can be listed on Ebay or a Shopify page, and when it sells, you just ship whatever inventory you already have in the store.

We can also consider another example where the merchant is purely online. One set of inventory, but that one set of inventory can be listed across Ebay, Shopify, Alibaba, Mercadolibre, Amazon, etc. One set of inventory, many sales channel. Effectively, we can create shadow/duplicate inventory in an online world. Of course, the merchant would have an issue if all of the items sold at once, but that doesn’t usually happen.

But the whole equation changes when fulfillment comes into play. Because that inventory is now under a non-neutral platform’s control (and not necessarily the seller’s control). With that inventory sitting in a specific non-seller-controlled warehouse, it becomes much harder to duplicate inventory online across a number of websites. In effect, the inventory held in storage becomes captive to that specific platform. And since working capital is a very hard problem for retailers, it limits their ability to sell across a large number of online channels. This creates incredible lock-in, and I think this advantage is largely glossed over by the mainstream media and investor crowd that assume that a well-funded competitor like Walmart can just walk in and fulfillment. Walmart may be able to build out a fulfillment network, but good luck convincing merchants to hold inventory in both a Walmart warehouse as well as an Amazon warehouse. 2x more inventory = 2x bigger inventory management problem and more cash required.

Conclusion

Fulfillment is clearly beneficial on the demand side, but has a lot of supply side advantages as well. It all comes from the ability to control the inventory. That control helps reduce shipping times, which is what consumers are most focused on, but also significantly reduces costs for the entire system.

More importantly, I believe fulfillment has first mover advantages and creates lock-in because merchants have limited ability to fund working capital. The first player to offer fulfillment effectively ups the working capital requirement on subsequent fulfillment competitors. The bar goes up and becomes that much higher.

Bitcoin and Cryptocurrencies – The Mother of All Bubbles

Two months ago I wrote The Bitcoin “Penny Stock”, detailing what I believed were the conditions that created Bitcoin’s incredible run through September. Although the piece sounded cautious given Bitcoin’s 30-40x 1 year return up until that point, I noted that the prevailing conditions allowed far more than that, perhaps another 50-100x. I highly recommend reviewing that piece since I continue to believe those conditions remain true.

Since September, Bitcoin has more than doubled from $3.5k to nearly $11k. Bitcoin is all the rage now, even more so than before as evidenced by media, institutional, and retail attention.

Bubblish? Very likely, but this bubble will be unlike any other bubble in history for one very simple reason – Bitcoin (and crypto) are global assets, and this will be the first global bubble in history.

Consider the list of previous bubbles: US residential property, European peripheral residential property (e.g. Spain), dotcoms and telecoms in the late 90s, Japanese real estate and equities in the 80s, etc.These were massive bubbles. But despite their size, they were localized in nature. The vast majority of people buying US real estate were Americans. The vast majority of people speculating on Spanish real estate were Spaniards. The vast majority of people speculating in dotcoms were Americans. This is because the assets were localized and regulations made it hard to invest cross-border. This limited the amount of speculative capital that could flow into the assets. This is largely untrue of Bitcoin and cryptocurrencies. The amount of speculative capital that can flow into Bitcoin is larger than any other pool of capital observed in history. Bitcoin speculators are/can be from every country. With that in mind, why should we be surprised by $400 billion of crypto assets that have likely decoupled from reality? If the whole world is in on this, the hockey stick likely hasn’t even turned upwards.

In the 90s, Microsoft alone was valued at $800 billion. The combine value of dotcoms was probably greater than $10 trillion. And that was fueled largely just by American money.

There is no parallel for what is happening. Be amazed, and perhaps be greedy while you can, but be scared. This could be the first true global bubble.

The Bitcoin “Penny Stock”

For almost a decade, Bitcoin has periodically captured the attention of the public. Sometimes for its technological potential, sometimes as an object of ridicule, but often times for its boom / bust cycles that have fueled the limitless imaginations of speculators.

Since the start of this year, Bitcoin and alt-coins have once again captured the attention of the public.

market-price-(usd)

Not only has Bitcoin risen dramatically in price, potentially minting hundreds of millionaires and possibly a few discrete billionaires, the blockchain, alt-coins, and ICOs appear to be carrying us at light-speed into a radically democratized and de-centralized future.

I’m not here to speak to the technological appeal of blockchains — for which there are many — as there are many more qualified minds that can do that better than I can.

However, I do have news for you:

Bitcoin’s meteoric rise in price year-to-date has more to do with the technicals and conditions normally found in penny stocks than likely any long-term fundamental factors. 

Before you immediately dismiss the rest of this post because you suspect my argument is for lower prices, I will be upfront and tell you that that is not the case. I have no particular view on whether cryptocurrencies will go up or down. My goal is simply to discuss what I believe has been the primary driver of upward momentum and leave it for the reader to assess whether these conditions will continue favorably or potentially reverse. Having observed the rise of many penny stocks, I have seen few that don’t eventually come crashing back down in dramatic fashion when the conditions that made the rise possible cease to persist.

The Anatomy of a Penny Stock Shooting Star

Most penny stocks never amount to anything. But occasionally, a few rise and rise and rise in dramatic fashion. Sometimes up to thousands of percents within a few days or months.

For example:

HGENCVSI

Every penny stock shooting star begins with a similar set of conditions: Limited information, micro market capitalizations, and extremely low liquidity.

All of these factors come together to maximize the chance that a / any penny stock can be easily manipulated to trade on everything but fundamentals.

Fundamentals are usually the enemy of penny stocks since most of these have no long-term successful business models. What they might have are seductive stories – potential to change the world, potential to transform society, and the most seductive story of all, the potential to make you very rich very quickly. Limited information creates the right environment to nurture these stories because whatever information you can get becomes definitive. The siren song these stocks sing are already powerful in and of itself, but even more so when there are no other credible voices of caution.

Micro market capitalizations further nurture this environment because it usually keeps professionals away. By virtue of having a small market cap, it is nearly impossible to make meaningful amounts of money for the professionals (e.g. shorting), and thus many that could see through the risks of penny stocks are not engaged. Retail investors also popularly assume that many long-term winner once began as penny stocks:

Investors who have fallen into the trap of the first fallacy believe Wal-Mart, Microsoft and many other large companies were once penny stocks that have appreciated to high dollar values. Many investors make this mistake because they are looking at the “adjusted stock price,” which takes into account all stock splits. By taking a look at both Microsoft and Wal-Mart, you can see that the respective prices on their first days of trading were $21 and $16.50, even though the prices adjusted for splits was about eight cents and one cent, respectively. Rather than starting at a low market price, these companies actually started high, continually rising until they needed to be split.

-Investopedia, The Lowdown on Penny Stocks

But the most important one of all – low liquidity. It is through low liquidity that penny stocks gain their immense volatility. As money pours in (or out), low liquidity guarantees that trades will easily move penny stocks like a leaf-blower through a forest floor.

Why Some Penny Stocks Soar While Others Languish and are Simply Forgotten

Many retail investors have limited ability (or perhaps desire) to conduct research on companies. Many retail investors are simply chartists. But to become a shooting star, penny stocks need a story. Although the most seductive story of all is always the same – you can be rich very quickly – even speculators usually demand a story that has some semblance of fundamental long-term potential.

Because of that, many penny stock shooting stars begin with a sponsor that formulates this story and sells it to potential speculators. These sponsors are the ones that get the flywheel going. Story formulation is not the hard part, but how do you convince speculators that there is potentially a lot of money to be made? The easiest way is to show that a lot of money has already been created, but don’t just sit there or you will miss out on all the rest! By targeting low liquidity penny stocks, a sponsor can buy a meaningful amount of stock initially, which drives up the price because of the low liquidity. This creates the initial gains that will eventually draw in other speculators. Once the flywheel is in full motion, the sponsor will quietly sell down the initial purchase at a handsome gain, leaving speculative followers with the aftermath.

This is known as pump-and-dump:

The same scheme can be perpetrated by anyone with access to an online trading account and the ability to convince other investors to buy a stock that is supposedly ready to take off. The schemer can get the action going by buying heavily into a stock that trades on low volume, which usually pumps up the price. The price action induces other investors to buy heavily, pumping the share price even higher. At any point when the schemer feels the buying pressure is ready to fall off, he can dump his shares for a big profit.

-Investopedia, Pump and Dump

Regardless of how sophisticated you are with the markets, I’m quite certain most people know that pump-and-dumps never end well (unless you are the sponsor or a speculator that recognizes a pump-and-dump for what it is and are able to get out in time).

Drawing Parallels to Bitcoin

So what are the parallels to Bitcoin and alt-coins? Simple, all the conditions that make penny stocks potential vehicles for speculation have been present in Bitcoin and alt-coins.

Firstly, Bitcoins and alt-coins are new areas driven by technology that has not matured and continues to evolve. This creates an environment that is a vacuum for information that is necessary to judge the long-term fundamentals of the asset class. In addition, the amount of technical knowledge needed to understand cryptocurrencies mean that a small subset of people can establish themselves as the de-facto experts on the future and possibilities of cryptocurrencies. Regardless of whether these expert opinions are well-placed or not, they formulate and control the story and overwhelmingly the story has been about the potential for cryptocurrencies to change everything – your life, your finances, government, everything.

Cryptocurrencies in the aggregate recently accumulated a market cap of >$160bn, certainly not micro cap under any definition. However, we should view that in light of the 30-40x growth within the past year. We need to consider the market cap before the rise, and even as recently as October of last year, the aggregate market cap of all cryptocurrencies according to Coinmarketcap.com was as low as $13bn.

Cryptocurrency Market Cap

And as with penny stocks, the most important factor of all – low liquidity. I cannot overstate how important this factor is for understanding why Bitcoin and cryptocurrencies began a sudden rise less than a year ago.

Let’s take a look at Bitcoin trading volumes over the last 6 months (via data.bitcoinity.org):

6m Bitcoin Volume.jpg

We can observe a few spikes here and there, but overall the volumes have been fairly steady. Do note that volumes rose significantly as the recent sell-off intensified in August / September.

But the more informative chart is to see what volumes have done over the past year – you will be shocked:

Bitcoin 2 Year Volume

Volumes absolutely collapsed between December and January. In fact, liquidity nearly entirely dried up.

Where did the liquidity declines come from? Cutting the data another way, we can see which exchanges were responsible for most of the trading over the past two years: BTCChina, Huobi, and OKCoin. These three exchanges were responsible for close to 90% of all Bitcoin trading over the past 2 years, but suddenly the entire volumes of all three exchanges evaporated at the end of last year.

Bitcoin Volume by Exchange

The drop in volumes was due largely to Chinese regulations tightening up the trading of cryptocurrencies. Coindesk featured an interesting article highlighting this dynamic earlier in the year.

Due to the significant decline of Bitcoin trading volume earlier this year, I believe it is clear that Bitcoin’s low liquidity created conditions that are normally only observable in penny stocks. This low liquidity likely allowed well-meaning technologists and venture capitals that are true believers of cryptocurrencies to inadvertently act like sponsors akin to those of penny stock schemes. The buying of cryptocurrencies into extremely thin liquidity created the initial 5x-10x gains that would later bring masses of retail speculators.

Do All Shooting Stars Eventually Burn Out?

Here’s the thing – with penny stocks, the rise usually comes to an end because the sponsor sells out at the top. The sponsor considers when s/he has maximized the number of speculators (or prey depending on how you look at it) that can get pulled in and then will sell out at the top. Sponsors always have an endgame of getting out before the crowd finds out.

I have no doubts that given the extremely low liquidity in cryptocurrencies today, that if the large cryptocurrency wallets (and yes, there are a number of wallets out there are are very massive in size) were to cash out, downside volatility would be as dramatic as the rise we have seen year to date.

The question is how many of the early “investors” in cryptocurrencies believe enough in the long term to not be concerned about volatility and therefore feel compelled to go back into cash / government-issued currency? If Bitcoins and alt-coins were truly only in the hands of true believers, low liquidity could mean that we continue to see these cryptocurrencies appreciate 50x or 100x or even more from here.

The question is, again, are cryptocurrencies in the hands of true believers?

One anchor that many investors / speculators in Bitcoin fixate on is that the number of Bitcoins that will ever be in existence is fixed (currently growing at a small rate but total that will ever be mined is fixed). Yes – this is true, and perhaps one reason why Bitcoin should appreciate relative to the growing stock of government-issued currency. But 30-40x in 9 months? That’s only possible not because the stock of Bitcoins is fixed, but because the tradable float of Bitcoin has been decliningJust ask yourself how many cryptocurrency investors you’ve heard say that they will buy and sit on it and never sell – these coins are locked away and in effect reduce the tradable float. The tradable float is declining every day.

When will this locked up float suddenly come back to exchanges? That will be a terrible moment.

As I mentioned at the beginning, I’ll leave it up to readers to decide on the direction of prices. I have no view. What I have a view on is that Bitcoin and alt-coins have increasingly become like penny stocks.

I’ll close with a quote from Fred Wilson, a celebrated Venture Capitalist:

I know a lot of people who are true believers in crypto and have made fortunes in it. They are “all in” on crypto and have much of their net worth (all in some cases) invested in this sector. I worry about them and this post is aimed at them and others like them. It is fine to be a true believer and being all in on crypto has made them a lot of money. But preservation of capital is about diversification and I think and hope that they will take some money off the table, pay the taxes, and invest it elsewhere.

-Fred Wilson, Diversification (aka How to Survive a Crash)

Beware – even the faith of the true believers may waiver.

The World’s Most Valuable E-Commerce Company

Is possibly going to be Alibaba very soon.

Amazon vs BABA

For a long while following it’s IPO in 2014, investors were highly skeptical of Alibaba. Many still are, but many more are starting to recognize Alibaba’s incredible dominance in China. More importantly, as mentioned briefly in my post Tencent vs Alibaba on the Quest to Go Global, the company stands a fairly good chance of going global.

Despite the rising enthusiasm for Alibaba, the company appears to be underrated. A few examples:

  • As of FY16, Alibaba reported gross merchandise volume (GMV) of $547 billion across its e-commerce platforms. Amazon does not report GMV but estimates peg it around $300 billion.
  • Alibaba had annual active buyers of 466 million as of 2Q17. Amazon does not report annual customer count, but Statista pegs it at ~300 million.
  • Alibaba owns approx. 1/3 of Ant Financial, which is the world’s largest fintech co. Amazon has surprisingly limited interest in fintech.

Amazon is rightly known as an aggressive competitor, but Jeff Bezos once squared off with Jack Ma in China and lost (Amazon was also relatively late to China). Both are now vying for control of India. But their strategies could not be more different: Amazon is essentially carrying out a very similar playbook to the one in the US (superior distribution/logistics + Prime), while Alibaba has gone the fintech route and leveraging that to enter e-commerce.

Will be interesting to see how India plays out since Amazon is determined to not let India slip out of its hands and is currently near pole position.

Predicting the Potential of “New Electricity” by Looking at the Lessons of “Old Electricity”

Andrew Ng (former Chief Scientist at Baidu, Co-founder of Coursera) is fond of referring to AI as the “new electricity”. Similar to how electrification ended up transforming every single industry during the 20th Century, AI is broadly expected to have similar (if not greater) impact in the coming years.

This post by Oscar Li does a great job encapsulating Andrew Ng’s thoughts as shared during a recent lecture at Stanford.

The social and business ramifications are easy to extrapolate / imagine: Anything that you can do now, you can do better with more AI and data. And as the technology that underpins AI continues to improve and the datasets continue to grow, AI will allow us (or machines) to do whole new things not possible before.

If you’re like me, it’s actually quite overwhelming to ponder the full implications of AI. But if AI is on track to transform the world like how electricity did, we should be able to learn some lessons and create some useful predictions by looking at what happened a century ago.

Lessons from Electrification:

  1. Everyone Electrified and then Electricity was no Longer a Differentiating Factor: Today, companies that use AI and data have an advantage over those that don’t. A similar dynamic existed a century ago. Retailers that were electrified had an advantage over those that didn’t. Factories that were electrified had an advantage over those that didn’t. Eventually all businesses either adopted electrification or were out-competed. However, once electrification was fully borne out, it was no longer an advantage. A similar dynamic also played out with air conditioning in the middle of the 20th century where early adopters had an advantage, but once every retailer adopted air conditioning, it became a necessity rather than an advantage.
  2. Electricity Changed How Business was Done But Had Less of an Impact on the “Jobs to be Done”: Electrification allowed businesses to extend their hours of operations, drastically increasing efficiency and productivity. Electrification also brought about new machinery and tools that similarly improved efficiency. In other words, electricity made businesses (and people) better at their craft but had less of an impact in terms of the goals that businesses pursued. Retailers remained retailers. Manufacturers remained manufacturers. Service providers remained service providers. This is perhaps the most interesting takeaway (or contrast) with current assumptions around AI – namely that AI will necessarily lead to “new” products / services.
  3. The New Business Model Created by Electrification was the Electric Utility: Although electrification had large ramifications on how existing industries operated, the only key new business model to emerge appears to be the electric utility to provide the fuel for the disruptive technology (I’m not quite sure if this statement is entirely accurate – if any readers have supporting evidence for / against, please do share). Similarly, how many new business models should we anticipate in the coming AI explosion? It’s clear that AI will be important for existing industries, but how many new types of businesses should we expect? Perhaps a “data utility”, but what else?
  4. Other than Utilities, No One Made Money on Electricity: Once every business adopted electricity, it was no longer a differentiating factor by and of itself. As a result, electrification become purely a cost of doing business. Only utilities made money off of electricity. Can this be extrapolated to AI and data? Will it purely become a cost of doing business?
  5. Electricity Led to a “Cambrian Explosion” in Hardware: Although electrification appeared to merely change how businesses were run, it did lead to many new hardware products such as light bulbs, phonographs, radios, televisions, etc. Turned out that the best way to monetize electricity other than operating a utility was to produce hardware. This was the genesis of General Electric. Perhaps that is also what we should expect of AI.

These are just a handful of lessons. There are probably more that can be added to this list.

Taking these into account, it’s not outrageous to ponder whether AI can truly be monetized if not offered as B2B service (e.g. the utility model) or bundled with hardware (e.g. Amazon Echo, Siri / Google Assistant / Cortana in devices). Are there alternate monetization pathways if neither of these are feasible?

One thing that is an interesting contrast between AI/data and electricity is that AI algorithms and datasets are not commodities like electricity. Every utility’s product is the same. But AI algorithms and datasets are not interchangeable. What are the implications of having non-interchangeable “fuel” for one of the most disruptive technologies of the 21st Century?

Tencent vs Alibaba on the Quest to Go Global

Finally catching up on some reading: Bloomberg published an excellent profile on Tencent and the co’s strategist, Martin Lau. I highly recommend the article as it not only goes through the history of the company, but reveals the type of thinking and mentality that has helped Tencent become one of the most successful companies in the world.

For the uninitiated, Tencent is one of the “BAT” trinity (Baidu, Alibaba, Tencent) that dominate the Chinese tech space. The Chinese are increasingly living their lives in a “digital-first” manner, and as a result, BAT’s influence extends across nearly all aspects of Chinese life in a way that Google, Facebook, Amazon, Apple can only wish (and try to replicate with limited success thus far). All three players operate across nearly all verticals including social, video/entertainment, e-commerce, search, browsers, app stores, delivery, cloud services, payments, finance, and many more. They have gone beyond being just software/service companies to essentially digital lifestyle companies.

Despite the BAT moniker, investors view the strengths of each company quite differently.

Generally, Baidu (the company with search as its core strength) is viewed as the weakest. Unlike Google’s dominance in the US, Baidu has struggled to find its place in China’s highly digitized mobile world were users largely spend their time in Tencent or Alibaba’s walled gardens. Whereas Google has been able to run its search crawlers through the open internet and through the Android platform (majority global share), Baidu does not have the luxury of a dominant mobile platform nor access to the increasingly large amounts of data that is generated outside of the browser.

Of the remaining two, Alibaba and Tencent are generally neck-and-neck. Alibaba absolutely dominates in e-commerce and payments/finance while Tencent owns the incredibly sticky WeChat messaging super-app with a fast growing payments solution. Nonetheless, investors overwhelmingly consider Tencent to be a much stronger business with a 1yr forward P/E of 45x to Alibaba’s 34x despite similar growth rates according to consensus estimates. The difference in perception largely comes down to the fact that investors consider WeChat to be mostly un-disruptable while Alibaba is currently contending with a sizable #2 player in JD.

However, I believe that perception is misplaced especially when we consider Tencent’s and Alibaba’s prospects for going global.

The Bloomberg article mentioned above highlights the challenges that Tencent faces in trying to export its WeChat model abroad:

Then there’s the matter of Facebook Inc. and WhatsApp, which have a huge market advantage pretty much everywhere outside China. Going overseas, Lau says, “is essentially the challenge of every Chinese company. We tried to make WeChat international. The reality was that there were other products in the market already.”

Tencent faces a much more formidable competitor in Facebook as they try to expand abroad, while the global e-commerce landscape is much more benign for Alibaba. E-commerce is much more fragmented on a global scale, and Amazon is nowhere near as dominant on a global scale as Facebook is for social networking.

The valuation gap between the two companies only make sense in a China-specific context. In a global context, why should that gap exist?

Disclosure: I have no direct beneficial interest in Tencent (700 HK) or Alibaba (BABA) as of publishing date and have no intent to initiate a position within the next 48 hours.