Internet – Washington Square Capital Management

That Internet in your pocket is disrupting the world.

By subir | September 10, 2013

We don’t often write about individual companies on our blog since we feel all investments need to be considered in the context of a portfolio and an investor’s objectives. We will be making an exception here, since we’re gong to discuss the evolution of an industry where the pace of creative destruction has been frantic, and it’s futile to write about these trends without mentioning the companies and products that embody them.

The FT published a letter one of us wrote about how open-source development has impacted smartphone evolution. Open-source tools and systems are the foundations for the current generation of mobile devices. The two dominant operating systems for smartphones, Google’s Android and Apple’s iOS have open-source roots. Most people will recognize that Android is a Linux build, but iOS which is a Darwin variant, and therefore a direct descendant of BSD (early open-source Unix). That Apple does not license iOS is largely irrelevant, an engineer who has worked on Unix systems will find iOS a warm, fuzzy, familiar environment. As long as Apple and Google don’t stray too far from this well-understood environment, future generations of internet engineers will find few barriers to developing for its devices and systems.

It’s not just about operating systems though. Companies that build commodity, widespread platforms, whether software or hardware have come to realize that openness is a virtue, and often a necessity. Their platforms are tool-benches which are only as useful as the tools or applications that external developers create for them. Integrated Development Environments and core development tools for internet-enabled applications tend to be relatively open and community maintained as well. The list is extensive, but includes Linux, Apache, Eclipse, MySQL, Python and other tools that are part of the essential plumbing and growth of the Internet. Virtually every Internet startup we know of begins life with a Linux installation running Apache, often a cost-effective virtual machine at Amazon’s AWS or countless other providers.

What Apple unleashed with the iPhone wasn’t only a device that appealed to consumers and looked beautiful; of more significance to its future trajectory was that the development platform is similar to Mac OS-X, so large numbers of developers could quickly learn to write applications for the device. Where prior generations of phone app developers struggled to understand a carrier and phone-maker’s system, with an occasionally tweak to low level network infrastructure like WAP, iPhone developers were on familiar ground, within an environment that looked pretty much like a trimmed down OS-X, and with similar development tools. This is what made the explosion of apps on the iPhone so rapid. Android has been able to compete only because it’s largely Linux and apps for it are written in Java, both of which are even more widely adopted and used amongst Internet developers.

Microsoft is only in the running because someone at the company had the good sense to kill Windows CE and commit to a common platform for desktops and mobile devices, combining the development communities. Perhaps surprisingly for the platform providers, content is king, and that is where they need to differentiate themselves. Traditional media (music, tv, movies) is owned by traditional interests and will generally seek to be platform agnostic and available everywhere. The differentiating factor is new media created by a younger creator and applications created by enthusiastic communities of developers. Nurturing these and adapting to their needs will be the path to success for the platforms. As an aside, if you agree that smartphones are computing devices, since smartphone shipments overtook PC/Laptop shipments last year, it’s only a matter of time before the most widely installed operating system on the world’s computing devices is no longer windows but some Unix variant.

Meanwhile, within the space of a few years, stalwarts of the early phase of consumer mobile telephony and computing have had near-death experiences or been devoured by firms they would not have considered competitors a few years prior. Motorola, Palm, Ericsson, Qualcomm and now Nokia fell on their swords or came perilously close to doing so. Blackberry, which seemed unassailable even four years ago is facing an existential crisis. Revenue streams and margins that seemed robust were eroded with frightening speed.

We wonder of course, about what happens next in this industry. The first lesson for investors is that the product cycle in mobile technology is immensely quick and margins compress with dizzying speed. In our view, no company in the mobile computing world has a business model that we say with confidence will support strong or even positive margins seven years out.

What we do know is that hardware is quickly becoming less of a differentiating factor. Most current smartphones have roughly equivalent hardware. Nokia might have a slightly better camera, Apple may have a better display, and HTC may have the best low-light camera around, but that is not enough to make a difference. Most consumers will not notice the difference. And that means smartphone hardware makers are going to find the next few years tough going.

The platform vendors, Apple, Google, perhaps Amazon and with some luck Microsoft, are better positioned. They should be able to retain income from media purchases on their storefronts (iTunes, Google Play, Amazon Kindle) and can continue to develop additional streams of subscription-like income. The ubiquity of mobile phones with rich data ability should mean strong revenues for mobile network equipment makers and services since infrastructure worldwide will need to go through a few upgrade cycles over the next decade (and Nokia may well find a second life as a business in that space).

We need to look elsewhere though for the next generation of disruptive business models enabled by the Internet in our Pockets. Fast and cheap connectivity paired with ever more capable devices is quickly turning every waking moment into an interaction between online and offline inputs. We now see the value we believe now shifts to content providers, creators and geo-location based services, this is where we expect to see the next generation of stand-out businesses emerge. GPS mapping software was in some ways the beginning and location-aware advertising is already here. In many places, Yelp is becoming the go to source for recommendations. Foursquare could arguably have an even more powerful business model if it could manage to convert itself into a effective loyalty program or customer relationship management application for small and large businesses, but first it needs to get past badge fatigue. Uber and its ilk will transform the taxi industry in most large cities. A new generation comes of age every year that is far more comfortable living life on its phone. They will steadily move their wallets to their phones (Google Wallet, Paypal) just as they have their social interaction (Facebook bought itself a couple of lives by purchasing Instagram). Companies that figure out how to curate useful content and tools for smartphones should prosper (Twitter, Evernote, Dropbox, Pandora, Spotify, Flipboard). Yahoo, if it plays its cards right, may be able to capitalize on Flickr and Tumblr to rejuvenate itself. They may also want to revisit their roots since curated content will be part of the future of mobile computing. The broader message is that content is king, and content created by an enthusiastic community of creators is what’s needed to build and maintain an engaged audience.

This meld of the physical and virtual worlds has been a long time coming. Regular readers may remember our post on Facebook, Cypherpunk and Psychohistory which referred to Neal Stephenson’s prescient novel Snowcrash. Augmented reality is coming soon, which is why we do not scoff at Google Glass or other wearable computing devices like smart-watches. We will see ever more portable interfaces into the virtual world, and there will be applications for many of them.

It’s not just Middle-Eastern dictators who have learned to respect the power of the computer in your pocket, so will less political entities whose lifestyle and business models rely on things staying the same.

Facebook, Cypherpunk and Psychohistory

By subir | February 27, 2012

One of the more notable financial news stories of the year so far is the decision of social media heavyweight Facebook to go public (an event we alluded to in our top 10 themes for 2012). The question on everyone’s mind is whether a potential $100 billion market valuation is appropriate for a company that had roughly $1 billion in net income last year. It wouldn’t be the first tech company to trade at a three digit P/E (we’re looking at you salesforce.com), but it would be the largest. We are going to leave the valuation question aside for a moment and think in broader terms.

In our view, there are a few factors to keep in mind when considering the lofty growth expectations that surround Facebook.

Fewer, poorer, new users: At 845 million relatively regular users, Facebook already has the cream of the crop when it comes to potential consumers. The economic elite — by far the most attractive consumers — are, for the most part, already on Facebook. The next billion users will have less spending power, and will not consume as many of the digital goods Facebook wants to sell them, nor will advertisers pay as much for access to them.

With the exception of China (where Facebook is banned), the network has no other large upper-middle class markets it can tap into. Since the next billion Facebook users will have more modest means and this could be a tricky cultural and business shift. Facebook initially set itself apart by limiting usage to select colleges. Over time it has successfully expanded availability to new demographics (older users and international users) . But its user base has always been the more affluent segment of each market.

By highlighting this, we’re not trying to diminish the broader value of an open social network and its ability to connect people and create opportunities for them. We hope Facebook continues to be another powerful Internet tool available to a person of modest means to foster deeper connections, expand their horizons and develop themselves. But we do recognize that social networks by definition will mirror divisions in societies, and certain virtual spaces will be more attractive than others to specific groups.

User disengagement: There’s a chance Facebook jumps the shark and usage drops. Despite its meteoric rise in recent years, Facebook operates in the notoriously fickle world of social media, where users may tire of a particular platform and seek out the next hottest thing (let’s not forget Friendster or Myspace, once robust social networking communities before Facebook came along). While Facebook has done a phenomenal job building its user base and cornering the social media market, there are other platforms out there waiting to swoop in should there be a misstep (Google+), or capitalize if users ultimately decide they prefer to segregate their status updates (Twitter) from their picture sharing (Instagram) and location data (Foursquare).

In addition to the possibility of competitors poaching away market share, there is also a question as to how users will interact with the platform going forward. We already see a divergence in the frequency with which men and women use Facebook. Women use Facebook much more regularly than men do. Over time, we could see photo-sharing and instant updates lose their novelty value for certain users who then disengage from Facebook.

Advertising could be ineffective on Facebook: It’s tough for an advertiser to grab a Facebook user’s attention when they are competing with photos and updates from their nearest and dearest. Ads on Google search are powerful revenue generators primarily because the user is searching for something and the ad is related to the search. A Facebook user, on the other hand, is visiting the site because they wish to see photos or updates of their family and friends. An ad on Facebook generally disrupts the user-experience.

Of course, Facebook could use the reams of data it has on each user to suggest a gift for your wife or girlfriend based on browsing or comment history; but this could easily mis-fire and be considered intrusive. Similarly, word of mouth recommendations are very powerful drivers of product sales, and Facebook is an effective medium for friends to share these; but advertisers tamper with word of mouth at their own risk. Our sense is that Facebook has become a virtual family gathering or a dinner party, and overt advertising or sponsorship will always feel slightly out of place at such an event.

On Facebook everyone knows who you really are, even if you’re a dog. All that said, there is one aspect of Facebook that sets it apart from virtually every other website and could end up being extremely valuable. From the very beginning, Facebook has insisted on “real names” and worked to keep anonymous or fraudulent identities off the platform. The result is that Facebook can tie virtually each of its 845 million users to a real-world identity. They have also built an authentication framework on their platform which other sites can use in lieu of asking users to pick new passwords or user ids. Since Facebook has photographs of all your friends, they can be used as a challenge if unauthorized activity is detected. Your ability to recognize your friends, along with Facebook’s knowledge of who they are, combined with a large photo database, makes it very difficult for an unknown attacker to try to hijack your profile. This has meant an enormous shift in the previously anonymous world that the Internet was, and it remains a rare and valuable commodity. It is a service Facebook could charge other sites for down the road. For Facebook, it may be the next big thing. Perhaps bigger than targeted ads.

Further Reading:

The genesis for this post came as a result of a wide-ranging conversation we had recently, and which led us to think about two of our favorite books…

The first is Neal Stephenson’s Snowcrash, a 20 year old book that predicted much of the impact the Internet would have on human society. No one who has ever read that book can underestimate what anonymity can lead to and what power accrues to an entity that can definitively identify 20% of humanity.

The second book is Asimov’s Foundation series, which is what got one of us interested in Economics and reinforced the constancy of human behavior. Some of the conversation about 3-D printing and replicators also brought to mind Asimov’s gem, The Last Question.

Photo credit: Flohuels

2012 Themes: The More Things Change…

By louis | January 26, 2012

Here are our top 10 investment themes for 2012. These are the topics we think will have the biggest impact on client portfolios in the coming year…

1. Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election. With the ongoing crisis in Europe, the Fed would normally be engaging in further monetary easing, but there is nowhere to go below the current 0.00% target overnight rate. In most presidential election years, the Fed is hesitant to make large moves in either direction, to avoid appearing politically biased. That instinct is especially heightened in an election cycle where Fed policy action and arcane monetary policy debates have unexpectedly become contentious, emotional political issues.

2. Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors.

3. Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis. Though it has been over a decade in the making, things have finally come to a head. All the dominoes (Greece, Portugal, Spain, Italy) are lined up, and we wait to see which the two players (France and Germany) will allow to fall before they stop the carnage. We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value.

4. Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. We would not be surprised if the Euro approached parity with the dollar over the course of the year. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed.

5. Blue States/Red States: The US presidential election cycle should be the major story in the US in 2012. US and individual state debt burdens will be the most important topic of debate, as the European sovereign debt crisis plays out in the background. American politicians will have to negotiate some cut in benefits for the charmed baby-boomer generation to ensure the financial burden of these programs in coming years does not doom the economic prospects of their children and grandchildren. This negotiation of a new social compact between the generations is the most important issue of our times.

6. Chinese Math: At the 18^th Communist party congress to be held this year, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required as China moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, GDP growth is slowing as labor costs rise, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels.

7. Revolutionary Times: We were surprised to see the speed at which the political structure of the Middle East has been transformed in a remarkable series of revolutions. Though we have been aware of the demographic pressures that created the basis for these changes, their rapidity has astounded us. As events unfold in the Arab world, something perhaps even more remarkable has begun to happen in Russia. A previously apathetic Russian electorate seems to be flexing its muscle in opposition to a renewed Putin presidency. We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year.

8. Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources. And while we’re talking about oil, we would like to reiterate our skeptical view of gold prices, which we believe would be well under $1,000 an ounce if the political and economic future were not as muddy.

9. Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance). The larger story will continue to be the steady march of the internet into every device and living room, placing a strain on core Internet infrastructure. We heard relatively little about a seminal event that took place in 2011, the last large block of addresses (IPv4 numbers) was assigned and there is no address space on the current infrastructure to accommodate another few hundred million devices. The public discussion has centered around the addition of new top level domain names (like .com, .org), but the addresses that sit behind these are the real concern. A new addressing scheme (IPv6) has been built into most devices for years, but adoption is minimal. We expect this will have to change in 2012, with a few hiccups along the way.

10. Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis. We believe there is still too much supply available and US consumers as a whole will be reluctant to financially over-commit themselves given job security concerns and how many were burned by homeownership in the past few years, despite record low mortgage rates.

Tag: Internet

That Internet in your pocket is disrupting the world.

By subir | September 10, 2013

2012 Themes: The More Things Change…

By louis | January 26, 2012

An important notice