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  • Writer's pictureNicholas Pihl

Competition is for Losers

This post is my notes and reflections on Peter Thiel's talk, "Competition is for Losers." I think this is possibly the most impactful video I've seen in the last two years. Not that the concept of dominating a small niche is totally new (thanks largely to Thiel's other content), but because this was a "come to Jesus" moment for me where I decided to start making some changes in my business.

I was so busy taking notes and synthesizing while listening that I had to hit pause about 30 times. This 40-minute talk took me about 2.5 hours to get through, including a repeat listen. I've distilled my key takeaways to about a 10 minute article.

A common question for business owners and entrepreneurs is "what market are you in?" Most small businesses will respond to that question fairly broadly, not wanting to turn away a potential customer. Entrepreneurs seeking venture capital will make the same mistake, but for the purpose of demonstrating a large opportunity worth pursuing. In each case, the mistake is the same. They're trying to compete in a huge marketplace, one that attracts (or is already packed with) dozens (if not thousands) of well-equipped competitors. These incumbents often have established networks, proven track records, superior economies of scale, huge marketing budgets, and abundant access to capital.

New businesses have none of these advantages. As such, they should never go toe-to-toe with such behemoths. Perhaps that's obvious. But less obvious is what to do when you have a number of equals alongside you, all pursuing the same market. Can you beat them? Maybe. Maybe your service is better. Maybe you're smarter, or a lot harder working than them. Maybe you can parlay this small advantage into larger success simply by grinding long enough to develop more of a competitive advantage as you go along. Maybe.

But does that sound fun? Does that sound like something with a high likelihood of fantastic success and minimal risk?

How should you think about the value of your business?

Thiel offers a really interesting framework here. He argues that there are basically two metrics, X and Y, that are completely independent of each other. X is the value you provide to the world through your product or service. Y is what percentage of that value you capture as profit. For scientists, Thiel notes, X may be extremely high. But Y is almost always zero. Consider Jonas Salk, inventor of the polio vaccine, a revolutionary cure that has affected every single human being on the planet. He not only saved lives, he reduced the number of lives that were impaired by the long-term effects of polio. Famously, he made no money from this invention.

Thiel refers to airlines as a another example in which X is high, but Y is low. The ability to travel anywhere in the world in less than a day is a huge boon for humanity. Yet, all the companies exist in a state of near-perfect competition with one another, and so, over the last century have earned aggregate profits of roughly $0. Mostly due to bankruptcies, and recapitalizations of equity.

Conversely, Google dominates the market for search-based-ads with about 60% market share, and is massively profitable. But is search-advertising more valuable for the world than air travel? Hard to say, but I'd lean toward no. The takeaway here is that value produced (X) and value captured (Y) are totally unrelated to one another. And for a business to be profitable, you need both.

Thiel then establishes that there are basically two types of business. Those that exist in a state of perfect competition, which are profitless, and those that are monopolies, which earn outsized profits. He notes that he very rarely sees any businesses that exist anywhere between those two extremes. It isn't obvious to me whether that's a function of how the larger world works, or whether it's a feature of the venture capital ecosystem he inhabits.

Also of note, I personally don't see monopolies are particularly bad. The notion that they can extort consumers is, I think, largely overstated. When companies abuse their power, they usually shorten their longevity by making it easier and more attractive for new entrants to usurp them. Monopolies, as Thiel describes them, are organizations that are providing value that is an order of magnitude better than their competitors, and who have the means to continue building on that lead. Building that lead means getting more efficient internally and delivering more value externally. Short of lobbying the government to create regulatory barriers to entry (which I object to), or the government accidentally achieving the same result through regulations which are proportionately more onerous for smaller companies (which I really object to) I suspect most of this activity is perfectly acceptable.

How do you create a monopoly? Start with a really small market. Thiel references how Ebay dominated by creating many small, individual markets for collectibles like Pez dispensers and beanie babies. And how Amazon started with just books, in which they had a huge inventory advantage over physical retailers. And how Facebook started at Harvard, and reached 60% market share in 10 days. Had any of them tried to jump ahead directly to the companies they've become today, they would have failed to achieve the critical mass that let them become successful at that scale, and then at successively larger and larger scale. But only after dominating that original small market.

Pursuing massive markets has the opposite effect. Globally, energy is roughly 8% of GDP, which works out to roughly a $6.8 Trillion market. Clean energy is a clear win for humanity, but who are their customers? Everybody? And who is their competition? Again, everybody. Thiel notes there was a massive clean tech boom in venture capital from 2005-2008 in which every entrepreneur and their mother was using graph of the global energy market as proof of the opportunity available for their company. This ended badly for the founders and their investors. Each of the companies trying this approach were a minnow in a vast ocean. They didn't even know who all their competitors were or how they were competing against them. They expected people to pay more for energy because their product was special (to them).

I'd extend this explanation to the reason that many small businesses are basically unprofitable. Once you back out the salary the owner pays themself for doing the work, they often end up with a negative number on the true profit and loss statement. In other words, they're subsidizing their business with free labor, and are not earning a true profit. I absolutely encourage hard work, but be smart about it. Don't let your business consume the rest of your life. Your business will take everything you give it, but will only repay you to the extent that you are doing something differentiated. I've talked to a lot of business owners whose stories will back me up on this point. Don't doom yourself to a world of cutthroat competition by trying to be everything to everyone. Working harder solves many problems, but it doesn't solve this problem. Working narrower does.

Thiel quotes the opening line of Tolstoy's Anna Karenina, "All happy families are alike, each unhappy family is unhappy in its own unique way." But he then clarifies that it's the opposite for business. "Each one earns a monopoly by solving a unique problem. All failed companies are the same: they failed to escape competition."

Once you have that small market defined, how do you dominate it?

  • For technology companies, a key characteristic is some sort of proprietary technology that is 10x better than the next best thing. If you are in a high innovation field, that tends to be bad for your business unless you have some embedded ability to keep your own innovation very high relative to competitors.

  • Network effects. These are often very powerful in the long run, but very difficult to get started. You need something that is valuable to that first user.

  • Economies of scale. Unattractive to new entrants due to high fixed costs to enter, and such efficiency that new entrants don't make much money.

  • Branding. Thiel confesses to having no real edge here, but has seen it produce decent results elsewhere.

Even when businesses get it right and try to narrow down what it is that they do, they often misidentify the real market. Non-monopoly companies (those that exist in perfect competition and earn no profits), may wrongly conclude that they are the only fish in their pond. For instance, a restaurant might claim to be the "only British food restaurant in Palo Alto." They ignore the fact that people can drive to other nearby cities where the restaurant has competitors, as well as the fact that nearly all restaurants are just another place to eat. It is still reasonable to attempt differentiation to become more "one of a kind." But owners should be mindful that they ways in which they do that are suited to the real problem that needs to be solved. Should the restaurant out-British the other restaurants on the basis of this perceived uniqueness? Maybe hang a flag outside, pipe in some British music, have all the servers speak in an accent? Does that solve the true problem? Likely not. But maybe they can host cultural/entertainment events, thereby becoming something slightly different from a typical restaurant, and therefore, actually differentiated.

It's also interesting how monopoly companies (which is what you want to be) talk about their position. Usually, they talk down their market share by defining the market very broadly. Google might reference very broad markets, such as global advertising, or even technology as a whole, rather than ad-based-search. This helps to avoid regulatory constraints, as well as mask the attractiveness of their industry for new entrants.

Thiel then takes on the "first mover advantage." He perceives this edge as real, but smaller than you'd think for large markets. This is similar to making the first move in a game of chess, which is worth about a third of a pawn. What you really want to be is the last to market. In chess, the last mover checkmates their opponent. In business, the last mover captures the lion's share of the value. Microsoft Windows was the last viable operating system for many, many years. Facebook, similarly, was the last social network. Google was the last search engine. There were many social networks before Facebook, and there were many search engines before Google. But each of these captured the vast majority of the market.

Because of this dynamic, he notes that it's more important to emphasize durability than growth rate. Most of the long term value of these companies (over 80%) comes many years in the future, due to their growth rate exceeding the investors's required rate of return. As such, it is absolutely vital that these companies still exist beyond year 10, and not have their lunch eaten by yet another new entrant.

Innovation and profitability

Thiel discusses the industrial revolution, in which massive, unrelenting innovations came year after year after year. GDP grew 4-5% compounded for decades, factories sprung up, workers completely changed careers. It's hard to wrap your head around. But throughout this time, no one really made any more money than before. Workers didn't get rich because there was huge competition for jobs. Capitalists didn't get rich because there was so much competition between factories, and minimal differentiation.

But in the second industrial revolution, some companies did start to earn profits. And boy did they earn them. One type of monopoly came from integrating their total supply chain, mastering a huge logistical challenge. This is incredibly capital intensive, and takes a long time to build. Thiel notes that this type of company is something that not very many people have the appetite for today. Elon Musk is unusual in that he has done this with very capital intensive businesses like SpaceX and Tesla. Which really, is interesting because the end product there is not the driving force behind the company's competitive advantage. Tesla has some branding around the superior performance of electric cars, but it is still a car. Even self-driving doesn't strike me as a 10x improvement since you still have to sit consciously in the car. Looking at its batteries, which are key to the car's performance, you don't see a crazy technological gap vs its competitors. Instead, you see a supply chain mastered from beginning to end, in which every little bit of cost is wrung out to bring down battery costs around 30%. Hardly the 10x advantage Thiel references. SpaceX is almost pure logistics.

Thiel discusses the difference between the X and Y factors he mentioned earlier. When he looks at the valuation of technology companies, he sees hugely profitable organizations that are really good at capturing the value they create. They mostly don't have tough competitors, and are worth trillions of dollars in aggregate. These are great businesses.

But, he argues, we shouldn't confuse the value provided with the value captured. Again, these are completely separate variables.

"There are these different rationalizations people give for why certain things work and why certain things don't work. And I think these rationalizations always obscure this question of creating X dollars of value and capturing Y percent of X.

"The science rationalization we're always told is that the scientists aren't interested in making money. they're doing it for charitable reasons, and that you're not a good scientist if you're motivated by money....I think we should be a little bit more critical, we should ask, 'is this a rationalization to obscure the fact that Y=0% and these scientists are operating in this world where all this innovation is just competed away, and they can't capture any of it directly?'

"And the software distortion is that because people are making such vast fortunes in software, then we infer that this is the most valuable thing being done in the world, full stop. People at Twitter make billions of dollars, it must be that Twitter is far more valuable than anything Einstein did."

Competition as Validation, aka Why Do People Choose to Compete?

The only thing scarier than failing is failing alone. We often rely on social proof for the validity of an idea, which inherently means lots of other people have agreed it's a great idea and are pursuing the opportunity. In fact, this is often proof of delusion. "20,000 people each year move to Los Angeles to be movie stars. Each year 20 of them make it." You also see this in market bubbles, whether the 1849 Gold Rush, 2010s crypto craze, 2000's real estate boom, or 1990s dot-com rush. In all of these cases, people were competing with each other for the same outcome, and each of these became disastrously unprofitable for the participants. Meanwhile, there were plenty of other opportunities during these time periods which were not yet widely appreciated, but eventually grew into sizable markets. Levi's Jeans was founded during this time.

"Don't just try things that are new to you. Try things that no one else is doing."

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