The Scaling and Profitability Trade-off: Venture Capital's weakest link! — Transcript

Hi, welcome back. In this session, I'd like to talk about one of those fundamental questions that every business has to answer, which is should you try to get bigger as a business or should you try to build a business model that delivers profitability? I know, I know sometimes the two go together, but sometimes there's a conflict. You have to decide which one to put front. I'm going to start this session by looking at a tweet. I try as best as I can to cut people's slack on social media messages because I know that those messages are often the context of a chain of conversation that you're not seeing or they delivered in anger. But this tweet I could not resist. It was from a legendary VC Vote Coastla and it starts with a statement that profitability is an admission of a by a company that it's lost that they have no place to invest and that you can either generate profits or assets. There's a kernel of truth there but the but the way the tweet was stated makes it sound

like every business should try to scale up and that profitability should take a backseat. So what I'd like to do is actually address that and this is not meant to be a critique of Mr. of course who I you know who I respect but to talk about the core message of scaling versus profits because the implicit message that that scaling is more important than building a business business model that generates [clears throat] profits is more the rule than the exception in the venture capital community. So as I look at that choice, I want to look at the question of which businesses does it make the most sense in to scale up first and then try for profits. And in which businesses should you go for a business model right away rather than try to scale up. So let's step back and think about the question of scaling versus business building. And the best way to think about this choice is to think like a founder. You're a founder. You've come up with a business idea. the business idea actually works. You've tested a

market and the question you're facing is should you take the startup that you have that has promise and build a business to take advantage of the market that you have the niche market the product you have focusing on financial health and profitability. That's one choice. The other is should you take a more ambitious route of taking the product or service you've come up with and scaling it up first and worrying about profitability later. In other words, scaling up takes takes precedence over profitability. So what should you go for? Now rather than give one categorical answer here, let's look at each of those choices. Let's start with scaling. When does it make sense or what kinds of businesses does it make sense to even try to scale up? The first is it's nice if you're a small company in a big business. It's very difficult to think of how you scale up. You're a small company in a small market. First, the first is the bigger the market you're going after, the more you can scale up. Now, of course, the way you

describe yourself as a business can often define what kind of market you face. Now, about 10 years ago when I was writing about Uber for the first time, I said if you think of Uber as a car service company, the total market it can go after, it's much smaller than if you think of it as a logistics company, which includes delivery and moving. So sometimes the way you frame your business can determine market size. It's also nice if the market you're going after is growing because then you can grow with the market and not have to do the more difficult thing of taking market share away from others. I think of Apple and Samsung, you know, 2010, 111, but they were able to grow almost effortlessly with the market because the smartphone market is growing as people flip, you know, switch from, you know, flip phones to smartphones. That's no longer true. So, that market is kind of leveled off. So, market size matters, market growth matters. The industry structure of the industry you're in also

matters. What am I talking about? Industries have a natural structure. Some of them end up being splined with multiple players each of which has a small market share. Other industries tend to be concentrated with two or three or four big winners or maybe even one winner take all. In which of these groupings is there a greater chance of scaling up? There's a contradictory component here. The the the market that is that is concentrated is a market where you can get much bigger but only if you're a winner. So maybe it's a low odds scaling up choice, but markets which are concentrated tend to attract scalers much more than markets that are splintered.

Capital intensity. What am I cap talking about? I'm talking about how much capital you need to invest to get bigger. If you're in a business where that capital investment is big and takes time, it'll take you longer. It's more difficult to scale up than if you can scale up without that capital investment. Again, let's use Uber as as an example. One reason Uber was able to to grow much faster than a traditional car service company is because they didn't own the cars or hire the drivers, they were able to add a city almost effortlessly. The same can be said about Airbnb versus hotels. So, capital intensity matters. Customer inertia plays a role. Why? Because if you're an entrant into a market, you're trying to attract customers away from traditional from their traditional companies that that serve them. And if you're in a market where there's a lot of inertia, customers are unwilling to move, it's going to take you a lot longer, more difficult to scale up. That's why it's often easier to scale up in businesses

where customers are younger, less attached to their brands and and and and products than in businesses where you have older customers. Or it's also easier to scale up in young businesses like software than older businesses like education. And final component in whether you can scale up is how much your business depends on you or a small group of people to make it work. And let's take an example. Let's suppose you're a skilled carpenter. You make the most amazing furniture in the world.

You've started a business. It's succeeding. Can you scale up? Well, if your skill is not easily transferable, it's difficult to scale up. You can say, well, I can train people to do what I do. And you can try. In fact, um, the best examples you have of of key people being able to scale up is the is a cooking business where some master chefs Gordon Ramsay, Wolf Gang Puck, have fran have franchised their margins to different degrees of success and been able to scale up. So all of those things play into whether [clears throat] excuse me whether you can scale up.

Already you can see that in some some businesses are more structured to scale up than other businesses are. Now let's talk about how this plays out. These are three very broad categorizes you can make in scaling up. I'm not going to say one is better than the other. They're just different. If you're in a business, if you're where there's very little inertia and very little capital needed, it's a big business and it's a consolidated business, you can scale up almost overnight. You're a quick scaler up. If it takes you longer to break in, there's more capital intensity, stronger competition, it can take you a lot longer to scale up. Now, if I just gave you choice, would you rather scale up quickly or rather scale up slowly? You're saying, "That's an easy one. I'd rather scale up quickly."

There's a catch though. It it's part of what I talked about in the context of life cycle. The businesses where it's easy to scale up are also businesses where it's difficult to stay at the top. And when you scale down, you scale down quickly. So already, you know, you can see the genesis for my argument that the classic 21st century company is a fast scaler. The classic 20th century company was a slow scaler. And to argue that one type of company is better than the other misses the point. There's a third choice though which is not to scale at all. You are facing a small market. You have localized competition. There's a key person involved. Customer inertia. Maybe it's better for you not to scale up at all. And let's put that on the table.

Scaling up is not always the best option. So that's the scaling choice. Let's move to the business model choice. The best way to think about what drives business models is to break down what profits that a business model delivers and where those profits come from. First, it comes from what you make per unit that you sell. It's called it's unit economics. What does that measure? It measures the difference the price you charge for the next unit you sell minus the cost of making that unit. Already you can see that unit economics vary widely depending on the business you're in. If you're a discount retailer, your unit economics are not great because you're buying pro, you know, you're buying your products from manufacturers, marking them up 6, 7, 8, maybe 10%. And that in a sense is your gross margin.

You're going to have a tough time breaking through it. You know, in contrast, if you're a software company, the next unit you make cost you almost nothing. And if you can sell at a high price, unit economics are great. So you take the unit economics, price per unit times cost of making that unit. You multiply by the number of units you sell. That's where the scaling decision comes in. That gives you your gross profit. From that you subtract your other operating expenses. What what will that include? Your SGNA, your R&D if it's a fixed goal, any fixed operating expenses. That's where economies of scale kick in. If you have economies of scale, here's what you should see. Those operating expenses, those fixed operating expenses should grow at rates which are lower, preferably much lower than your growth in revenues. So here's what's happening. You sell more units, you make a profit per unit, the contribution per unit, you subtract your operating expenses. As you get bigger, you can see that your losses get turned to profits, your operating income.

There's a final component here. To get that growth, the scaling up, you get to sell more units, you might need to invest capital. So, if you have a capital intensive business, you're building factories, investing huge amounts, you can make money, but not enough money. Now, that might sound like a greedy thing to say, but if you're investing a trillion dollars in something and making only a billion, billion dollars is a lot of money, but not relative to the trillion you've invested. that is captured with what kind of return you make. Almost every aspect of the business model is in this picture and I think you can see the breakdown as you go through. So as you look at business models and you look at scaling there's a whole set of possibilities that can play out. I'm not going to capture every possibility but I've essentially captured eight possible combinations of scaling and profitability that you can come up with.

So on one axis you can see I've got no scaling to massive scaling. On the other axis losses or very low profits to very high profits. Let's take what I call lightning in a bottle. These are companies that both scale up quickly and are able to be profitable almost right from the beginning. That's unusual but it can happen. Facebook and Google in their early years were both profitable and scaling up at the same time. I'm going to call it lightning in a bottle because it's so rare. What's more common is companies that take time to scale up and while in at least in the early part of scaling up they lose money. I call [clears throat] these Field of Dreams companies. It's um premised on one of my favorite movies, Field of Dreams. So Kevin Cosner builds a a baseball field in the middle of I think it's Iowa and um the farmer in the next field comes over and said, "What are you doing building a baseball field in the middle of these corn fields?" And one of the most more most more famous lines, movie lines of all time, he says,

"If we build it, they will come." Talking of course about, you know, if we build a baseball field, they will come. Now, early on in Amazon's life when it was a growing online retail company, I described as a field of dreams company. And I did it did it intentionally because for much of its early existence, perhaps the de first decade or so of its existence, Amazon lost money. But Jeff Bezos sold the market on the idea that if we build it revenues, the profits will come. And you got to give him credit. He was consistent that story. He was consistent. The way he acted the case of Amazon, the field of dreams ended with shooters Joe Jackson coming out of the next cornfield. In this case, success. But while Amazon succeeded, there was a dark side to its success, which is the Amazon example got held up to a lot of companies that were scaling up and losing money, saying you can be the next Amazon. Well, let's face it, there aren't too many next Amazons. In fact, when companies scale up and they

can't make money and there is no endgame here where they can make money, you end up with a field of nightmares. a scaled up business with no pathway to making money. Not because you didn't try, because the business model you tried failed somewhere along the way. Now related and an even worse scenario is you start with a broken business model and then you make it bigger and bigger, but you don't fix the broken business model. I've never understood the incentives that cause this to happen.

But when you take a bad business model and you scale it up, you end up with a big bad business model. I mean, that was what I thought when I looked at weiwork at the time it went public is, hey, this is a broken business model. You lease a building for 40 years and you sublease it for 3 months. There is this is a duration mismatch made in hell. And if your answer is we're doing it on hundreds of buildings, my reaction is that's a duration mismatch multiplied by hundreds. That of course crashed and burned but you're big and broken. So those are the four scenarios in the right hand side. Scaled up scenarios.

Let's go to the four scenarios where you don't try to scale up. The first is you stay a niche player and you're a star at your game. huge margins, you're successful, you grow, you you deliver value without even really trying that hard. I mean, I think of the example of Ferrari, a company that has sold cars in the thousands, not in the millions, 9,000, 10,000. I think the most recent year, 13,000 cars, but it serves an edge. Super rich people are willing to pay premium prices. It gets brandame value that allows it to earn extraordinary margin. margins in excess of 20%, you're a niche star.

Now, that's a choice. You chose to stay small and become a star. You have many companies that stay small either because they have no choice. They can't access capital because they want to. They're small wins. What does that mean? They they they don't try to scale up, but they reach a scale where they're delivering enough profits that they earn more than their cost of capital. You're saying that's not much of a threshold to meet. be glad if you're a small winner because the alternative is you can be a small loser. What do small losers do? They make money. So, they're not money losers, but they don't make enough money to cover their cost of capital. You think, why would why won't I shut them down? Cuz you can't get your capital back. Many small losers are trapped in bad businesses. They can't quite get out and they can't quite make it in terms of earning their cost of capital. Then of course your businesses that start as losers and you very quickly they're small losers and their losses get bigger but they don't scale up. So in other words you're you you realize very quickly that this is not a business

that's going anywhere. So that that's where you cut your losses. Now as you look at those eight possible outcomes you can already see that for every business there is perhaps optimal is a strong word a right pathway based on what business you know who founded them how much access. So as you look at all those choices you can see there's no one choice it's going to apply across all companies. Now as you look at those choices though there's a question worth asking. Are there times where a company has a choice in front of it that makes sense where it chooses not to take that pathway? Put put differently, are there small companies that could become larger? They have the pieces in place but choose to stay small. Conversely, are there small companies that shouldn't get larger that push through and try to become larger anyway? The answer has to be absolutely. Those are the mistakes we see around us in in economies all the time. So let's look at the forces that might cause you to kind of deviate from

the script from that optimal path. The first is what kind of founder are you? There are two choices founders bring to the table that are personal that can drive this choice of scaling up versus profitability. The first is this battle between control and ambition. What am I talking about? Scaling a business almost always means going out and raising capital from outsiders. either borrowing money, which comes with constraints, or raising equity, which means you give up a share of ownership. Either way, you're giving up control. Not just control over capital, but control over operations.

So, scaling a business almost always requires giving up control. And many founders don't like to do it. But many founders are also ambitious. And ambition often means that you can get larger only by giving up control. So, the question is, what kind of founder are you? you're a kind of if you're a founder built around control and that's your key then you're going to be cautious about growing but if you are ambitious you might override that caution and go for growth the second is the choice between you know do you want to be a longived company or do you want to just grow that sounds like an odd choice you're saying I can think of long live companies that grow you're absolutely right it's not always the case but it turns out that there is a bit of a trade-off off between scaling a business and making it I hate this word but I'm going to use it anyway sustainable.

And here are a couple of pieces of evidence to back that up. Now there are businesses out there that have been out around for not just tens of years or hundreds of years but even thousands of years. The oldest business is this Japanese shrine maker called Komo Komogi. I think it's a Japanese company. It's been around was around 1500 years. just went out of business a few decades ago, but it was a small family-owned private business that did one thing, which is Bill Shrine said did it well.

So staying small and staying focused allows you to last a long time. And there's another piece of evidence I can bring to the table. Remember CO wasn't that long ago? And remember all those companies that soared because of COVID. There was of course Mona because of its vaccine. You had Zoom because everybody was online. You had Pelaton because people were buying these exercise bikes at home. You know when you look back at these companies and you ask and you look at what's happened to them, they succeeded beyond their wildest dreams in 2020 and 2021. But if you take a company like Pelaton, you can see that in the long term, they probably damaged themselves. Why? That's as they succeeded, they overreached. They built too many factories. They thought they could get bigger. In many ways, Pelaton has never recovered from its success. So the choices you bring to the table as a founder can determine whether you scale up or go for business models. The second is to scale up. You need capital. Let's

look at the oldest source of extra capital until you get to the last century, the 1900s, and where public markets took off. The biggest source of capital was your own family, which meant that if you start a business and you needed more capital, you went to your family, which creates an unfair process because if you had a wealthy family, you were able to scale up your business a lot more than if you had a family that didn't have much wealth. Well, not surprisingly, some of the largest businesses in the world, and it's still true in many parts of the world are family-owned businesses. Why? Because they had the capital to grow, and the wealthier you went, the more capital you could access. So, family capital was the primary source of capital, and it created the skew in what kinds of companies were able to scale up. Now starting about 70 years ago has always been around but in its institutional form you can say it's it kind of had its roots in the US perhaps 1940s and50s I

mean it's grown over time in fact in this chart you can see the growth of venture capital over the last 20 years and it looks at the number of venture capitalist looks at the the amount they have to invest venture capital has become bigger and more robust and it's also gone global it used to be primarily US It's still the US dominates, but you can see the rest of the world is starting to get venture capital. Now, we're going to talk more about what venture capitalists bring to the table in terms of altering the scaling versus profitability decision, but that's the second choice. There's a third choice, which is you can go for public equity either by bypassing venture capital and going public yourself. That's what the dot companies started doing in the 1990s and other young tech companies have or the more likely scenario is you let a publicly traded company become a lead investor in you invest their capital.

They might call it a strategic investment. The reasons they do it can vary widely. Sometimes they do it because they want to stake in it. This is the way many young you know biotech but farmer companies got their capital is by going to farmer company with deeper pockets or a more mature company getting it to invest in them. So what family wealth, venture capital, public equity. Now the reason the capital sources matter is when you raise money from somebody, you know, and this is quite fair, they what they want you to do enters the process. So as a founder, you got to factor that in, which is no matter what you might want to do with your business, the minute you raise capital from venture capitalists or from public equity, their incentives come into play. you get your cues from what they're looking for. So the bottom line is a a business that gets capital from a family member is going to make

different choices on scaling and profitability than that same business raising capital from a venture capitalist. So that potential for conflict has to be factored in. And here's where I think it makes sense to focus in especially on what venture capitalists bring to the table. There's a lot of mythology about venture capitalists. In fact, there are, you know, there are some people who view them as super investors because the kinds of companies I invest in. And because so much of the evidence we see is coming from a selection bias from successful venture capitalists, we think they do things that I don't think they're capable of doing. So, I'm going to break down what venture capitalists do into five tasks and look at what we assume they do and what they actually do. We assume venture capitalists screen young businesses and they're good at picking out good versus bad business.

They're good screeners. They judge founders products and businesses. Now, I think we um we might have seen too much Shark Tank when we make this judgment because while there are some VCs who are good at gauging founders and businesses, many of them just follow the the rest of the herd. If everybody's investing in AI, they invest in AI. If everybody's investing in social media, they invest in social media. A lot of following the hood. Second, once you've picked a business to invest in, no venture capitalists provide capital. And of course, in return, they demand a share of the business they invest in. We assume at least the collective assumption is VCs can value these young businesses. Otherwise, how would you ask for the right share without valuing it?

The truth is VCs price businesses. They don't value them. What does that mean? They look at what other people are paying for similar businesses. And since these are young businesses, very little in terms of operations, they can scale it to users, subscribers, downloads, whatever that metric is. So, it's not just pricing, but very, very, very rudimentary and simplistic pricing. Third, we assume venture capitalists take small businesses and they push them to scale up, but they make sure that these are the businesses that should be scaling up that provide the additional capital for these business scale up.

Again, that is partially true that additional capital is key to scaling up. But often whether that capital is provided is a function of conditions in the VC market. If you remember after 2022, the VC market completely dried up everybody. Even companies that deserve to get capital didn't get capital. And often when you get capital flows, you know, the existing VCs are just as um focused on protecting themselves by doing what? Introducing ratchets and staying protected when new capital is raised. So it's not this frictionless process, new capital coming and new scaling up. Fourth, we assume VCs are as much advisors. They help build businesses. They know how to build businesses and they will help founders who might be tech, you know, tech geeks to kind of build businesses that they otherwise wouldn't be. I would love to tell you VCs are great at business building, but I'm going to I I I don't think most of them would know how to build a business. They're good at

scaling up or picking the metric that they think will get them a higher price. And this is where we'll talk a little bit more about how VCs win in their own game. how that enters the process of what they're going to kind of put pressure on you as a founder to do. And finally, VCs to make money have to exit their investments. And we assume that they, you know, that they go to companies and they talk about the best time to exit for exit for the company, either go public or sell to somebody else. But the truth again is VC incentives might lead you lead them to push you to exit at the wrong time or to the wrong buyer because that's what gives them the highest returns. Again, I'm not painting I'm not trying to paint a picture of VCs as shallow and bad investors, but they have their own incentives and those incentives might not be congruent with what a founder wants from the same process. So let's talk a little bit about VCs and what I meant when I said VCs price companies.

There is uh there's a model called you know there are models that people call VC valuation models but that's a misnomer. They're pricing models and here's what I mean. You know the way a VC pricing model works is you take a metric. It could be revenues. It could be operating income. You project it out into a future year arbitrary or 5 years 3 years you know you put a you get to that future year. So you've got revenues in year five. Then you apply a multiple to those revenues based on what based on what other people are paying for companies out there perhaps in the public market. So revenues of 100 million in 5 years people are paying 10 times. Revenues 10 times a 100 is a thous a billion dollars. You got that as your pricing in year five. And then they bring it back to today. You're saying oh they're discounting. Well, technically it looks like discounting, but the difference is they use a rate that has nothing to do with the discount rate.

It's a madeup rate. The rate that they claim they need to make 30%, 50%, 70% and they use the reason I emphasize the word made up is those rates become negotiating tools because remember know for the VC you want to come up with a low value for that business today because you get get a bigger slice of the business. So this becomes a pricing and it's a gaming of the pricing process to deliver the best outcome for VCs. So VCs don't value companies, they price them. And if you look at VC returns over time, this perception that VCs are superior investors starts to come apart very quickly. This is from Cambridge Associates which tracks VC returns over time and they correct for you know the fact that you know there's failure among VCs and there's you know if you don't correct for VCs look better than they should be and if you look at VC returns across 25 20 so basically this is returns over single year 3 years 5 years

10 over almost every single time period let me take the almost over every single time period we These collectively have underperformed the NASDAQ and the two times they've beaten the S&P 500 are no not by much. The average VC like the average mutual fund manager and the average hedge fund manager delivers a negative alpha but we need to dig a little deeper because VCs I think are different from other active investing groups. First is failure in the VC investing business is very much part and parcel of investing on two levels. One is when VCs invest in multiple startups most of those startups fail and across VCs there's a huge failure rate where know multiple VC funds shut down every so failure is very much part of the game. Second when it does work VC investing can deliver superersized

returns. So you see this every time you get a big IPO. You will see some VCs who invested in that company whether it's Anthropic or SpaceX at a fraction of its eventual pricing are making 50,000 100,000% returns from the original investment. So lots of failures and the winners if they're winners tend to be superersized returns. It's called the power law in VC returns. And here's how it plays out. This is from you know but this looks at returns that VCs make when they exit investments and how much of their total returns come from the top 1% of their holdings the top 10% and the rest you know so you go back to the 2005 to 2010 period 53% of the returns VCs made then came from the top 10% the remaining 90% delivered 47%.

And when you get to 2023 to 26, the numbers have really become skewed. 80% of the returns come from the top 1%. More than 90% come from the top 10% and less than 10% come from the rest. What does that tell you? First is the winners carry the VC returns. The second is there lots of losers when VCs invest. This shows up in two places. First is if you look across VC as an investing business there are relatively few winners. It's estimated that a quarter of all VCs deliver above average returns. So basically the the it's the the returns are coming from that top quartile. But here's the good news for VCs. Unlike other dimensions of active investing, mutual funds, hedge funds, where there's almost no continuity, the winner, you can have a mutual fund that does really well this year, but it tells you nothing about next year because there's, you know, there's no continuity year to

year. Same is true for hedge funds and even private equity. Success in v V the venture capital business is more enduring. In other words, winners stay winners. That there are questions to ask about why that is. One reason might be once you become a venture a winner in the venture capital business, remember those huge winners that deliver the 80% of your returns, the top 1% of those startups. It turns out if you're a startup with immense potential, you want to have the bigname VCs, the VCs who've been successful in the past on your roster. So, you often offer them terms you wouldn't offer a no-name VC. So, there's persistence in winning. But as you noticed, this skewed towards the winners is getting worse over time. The top 1% delivering 80%. I mean, you're getting more the more topheavy these returns become, the closer this entire process is getting to gambling. That's something that we need to think about in terms of how this will evolve over time.

So that lead in let's talk about changes that have happened over the last two decades where I think this tilt I mean because already you can see this choice between scaling and profitability VCs entering the business and becoming more topheavy has skewed towards scaling but there are two other developments that I think we need to bring into the game to understand why scaling has become even more it's everything's become more tilted towards scaling over the last two decades. The first is the entry of public equity investors, mutual funds, Fidarity, TRO, Price into the private capital market where they some come in and supply capital with venture capital to startups, sovereign funds have joined in to make some pension funds have joined in. So we'll talk about what impact that has. The second is the end the fact that public equity markets in the last 20 years now public equity markets have always been pulled in two for by two forces. One is momentum where stocks that have gone up will continue to go up. Stocks that have gone down

will continue to go down. It's a strong force and reversal where at some point in time that changes and stocks that have gone up go down. You in a in a balanced market need both. I'm going to argue that in the last two to three decades the reversal process seems to have become weaker and we'll talk about the consequences but there are two big changes that have come. First, if you look at um entry of public funds into private capital, this is an old study. It came from a 2020 paper which used data from 2016. It already you can already see the jump in mutual funds that have started investing in private companies. And this was before the takeoff with Uber and Airbnb and of course AI companies. So basically the the gray market I call this a gray market for private capital where public equity is supplementing and often supplanting venture capitalists. You know the if you go back 40 years there were two markets. If you're if you're a

company that needed smaller amounts of capital you stayed private you go to venture capitalist. Then you got big enough that venture capitalists were no longer able to meet your needs. You went public. So 1980s that was the case. Now you got a gray market in the middle where you can be a private business, continue to grow as a private business, raise tens of billions of dollars while you're still private. That's a gray market. And you've seen it happen. You see the AI companies right now that hundreds of billions, maybe trillions, and they were able to stay private. So that's one development. It's already encouraging scaling up at private businesses because you now have capital you can draw on without having to go public. Now there's a second change in markets that's also kicking in. I talked about momentum versus reversal. I'm going to reframe it as momentum versus fundamentals.

And you know you can think of traders is driven by momentum. That's what traders do. They price assets. They try to take advantage of momentum. And some of them get very rich by playing the momentum game. So in the momentum mindset and this is not perfect. Scaling is good because that's how prices go up. you you know profitability matters but not as much as scaling. You stay with the winners and the crowd is viewed as generally right. That's the momentum. At the same time you have investors who focus on fundamentals. What do they do?

They want profitability. It's not that they don't want scaling but scaling is secondary to profitability. They look at losers as well because losers sometimes are priced too low and they start with the presumption the crowd can be wrong. In other words, a contrarian view. In a healthy market, both sides play out. And with some periods, the momentum side is winning. Some periods the fundamental side is winning. You've got momentum, you got reversal. But it's a market where you know investors win at regular intervals and traders win as well. You need both for a market to go. You know, if you look at the last uh you know, and these forces have always been around in markets, but there is an argument to be made that something has changed in markets. To make this argument, here's what I'm going to do. I went to Ken French's data sets, and Ken maintains some of the most amazing data. It's a basis for the former French papers that he keeps updated. And I track two things. One is returns from momentum.

The way you do this is, you know, on on Ken's data data site, he has 10 momentum deciles for stocks going back to 1927. I took the top and the bottom desile and look the difference. So if you have momentum, the high decile will continue to outperform the low decile and through time that has always that's been the case. And it stayed strong, right? So you can argue it's higher in some periods than others, but clearly it stayed strong. But Ken also maintains a second data set of reversals. Here's what he does. He breaks companies into six groups based on returns in the previous year.

And then he looks at the difference in the bottom two sectiles, the top two seexars. Yeah. So this is stocks that have done the worst in the last year versus stocks that have done the best. If you look through much of the 1900s, that reversal strategy delivered solid returns. sometimes much better than momentum. That's a flip side of the momentum strategy. Then starting in the 1990s, you can see that it's dissipated. It was almost close to zero in the 1990s, the dot boom, but even 2000 to 2009. Yet the market's kind of wallowing and not moving much. It's gone down. And in the last 5 years, it's become negative. This of course has played out in investors who bet on reversals not making money. I've you know I would said some harsh words for value investing at least oldfashioned value investing because much of it is built on mean reversion which is a fancy word of assuming reversal happens. You can

already see why value investing has struggled for the last two to three decades is that reversal process weakened. What does that mean? If um if momentum is about scaling up and reversals are about the fundamentals coming into play, it looks like scaling up is still getting rewarded but the fundamentals coming into play are not being emphasized as much. Now if you ask people why this has happened, you get a lot of self-serving reasons. You know, of course, they have a you have a whole group of people who view central banks as much more powerful than they really are, at least in my view, and who believe that the low interest rates we saw in the last decade were entirely because the Fed did it. They argue that low rates encourage scaling up at the expense of building business models. The rationale is, you know, that that be or momentum at the expense of reversal. The argument is when when you can earn close to zero interest rates on cash, you're going to be willing to take re there's

going to be a whole lot of reckless risk takingaking. The second and this is primarily from active investors. The argument is the growth of index funds and ETFs which has been inexorable. They now have more than 50% market share of all money invested that that has made investors lazy and investors are no longer looking at fundamentals and that's why momentum is winning. The third is that the types of investors in public markets has changed or the types of companies in public markets has changed that you go back you know starting in the 1990s you had the entry of these young companies without business models bypassing VCs and entering public markets and that's kind of ruined the mix and by ruining the mix made the reversal process weaker and the reason young companies it's more difficult for reversal to work is since there's nothing of of of substance on their financials. It's not like an earnings report is going to change your mind in the company. The catalysts are tougher to find. And there's a there's a

fourth and final component which comes into play which the way we get information about financial markets has changed. 40 years ago you might have read the Wall Street Journal. 20 years ago you might have watched financial news. Today you might be looking at Twitter for your news or social media for your news. Now you it's created what people in the social media might cause call a democratic effect which is you're no longer at the mercy of experts everybody has a view but there's a downside to that and the second is the information is coming at you constantly.

You could argue that as information has become more accessible and spread out across more sources that the reversal effect in a strange way has weakened because it's it's diluted the effect of the information. The catalysts again are tougher to find. Whatever the reason though, I think I don't think there's any denying that momentum is stronger, reversal is weaker and that kind of makes scaling more again a a a choice that more companies make than used to be the case. The consequences of these changes, the gray market and public equities becoming more momentum, less reversal driven is the types of companies going public has changed over time. This graph I look at the characteristics of IPOs. I look at the revenues that a typical company going public brings to the table and I look at what percentage of them are profitable. If you look across time and I've broken it down by periods, you can

see that first IPOs are waiting longer to go public. That's a gray market effect. They're getting capital. Why why be in a hurry to jump the gun? Second, they're bigger than they used to be in terms of revenues. These are constant dollar revenues. Some adjusting for inflation. They're bigger, so they wait longer. They're bigger in terms of revenue. But here's the contradictory component. They're not building business models. far fewer companies are profitable now than before. So you're make getting bigger businesses with nonworking or still in process business models going public. And here's the flip side. They're also getting much higher market caps than companies 10 years ago, 20 years ago, 30 years ago did. You look at the median market cap, it's risen over time and far less of the shares outstanding are being offered in the public, which tells you that these companies are less dependent on on the capital they're raising from public markets again because the existence of the gray market

and the and venture capital is becoming larger is you're less dependent on those proceeds. larger less form companies with higher market caps and I think in in many ways it makes sense with the lead. So what are the implications of these these businesses getting bigger without a business model? First is we're develop you know we're building potential corporate governance nightmares. [clears throat] Why? Because since these companies can get much bigger while staying private, there's nobody putting checks and balance. If your response is, oh VCs will be doing it. I mean the age of founder worship that we have and where VCs are using these founders to sell these companies.

You might not get the questions you need to be asking these question uh these these the CEOs and founder CEOs of these companies, you know. So as you look at anthropic and open AI go public and SpaceX and this corporate governance issue is going to rise to the top and in a in in a strange way we're actually disarming ahead of this problem coming to the surface because more and more of these companies create v two class of shares one with voting rights and one without and kind of entrench the existing founder CEO in so corporate governance issues are going to come to the surface. Second, because these companies have delayed business model building because they're so busy scaling up. Some of them might have built scaled up so much that it's too late to fix the business model. You're saying, "What do you mean?" It's easier to fix business models early in the process when you have 10 million in revenues than when you have 10 billion in revenues. So, if you scale up first, you know, again, you

might say, "Won't venture capitalists kind of step in and help on that?" Not really because they're interested in you scaling up and exiting before this problem comes to the surface. The third is the nature of these companies. They've scaled up. They don't have a business model is you're going to get storytelling and I have no problems with storytelling with young companies. You expect it but the stories are incomplete. They're almost all about scale and none of them is about business models. This was my core issue with AI is everybody was selling me AI is telling me how big the market is and how big these companies can get in terms of revenues but none of them seems to be talking about unit economics and economies of scale and how these businesses become money-making machines.

And there's a final issue that I've kind of wrestled with over the last two decades of disruption where you've got these young companies come out of nowhere, raise capital, build themselves into big scaling businesses, disrupt an existing way of doing business, but they're doing it while their business models are still incomplete. And you're saying, "So what?" Well, let's assume that these companies disrupt the existing way of doing business. They drive out the status quo.

And you can say those the status quo deserved it. What if the disruptors end up with business models that are not sustainable? It used I mean the nightmare scenario and I'll make it very specific is ride sharing has always struggled with building a business model that that can deliver sustainable profits. Let's say they never succeed that Uber andyft never find a way to be able to sustainably wake up. I think those those big problems they've put behind them but five years ago this was still an issue.

What if both Uber and Lyft go bankrupt? What are you going to do? You're saying go back to taxi caps. Well, remember most of them have gone out of business because right sharing disrupted them. Building disruptors up by supplying them endless amounts of capital and focusing just on scaling. You're playing with fire and sooner or later it's going to blow up on you. So what's the bottom line? I started with a tweet about scaling versus profitability and as I said this is not about the tweet the general emphasis around us now is on scaling up but scaling up is not for every company and it comes with challenges so but am but it's true ambitious founders will feel the urge to scale up and we've created a system where the incentive to scale up have increased even if it makes little business sense to scale up we're going to get bigger failures than we used to because of the scaling up incentives. And changes in both private and public markets have tilted the scale even further in favor

of scaling. And that's going to mean that we're going to see more companies go public with hundreds of billions, even trillions of dollars of market cap, but the business model is not even in sight. I think those are all developments you'd expect. Some of them are going to create trouble for us in future years. I hope not, but I'll keep my eyes open. Thank you very much for listening, and I hope you've enjoyed this session.