Date: September 7th, 2012
Cate: Finance, Systems

Lottery stocks, horse races and the human love of the long shot.

In my book, “The Nature of Value” (Columbia University Press Summer 2014), I show how “hot” sectors work like lotteries enticing people in with big promises.  Hot sectors are often in exciting product lead innovation spaces.  Unfortunately great products don’t mean great businesses. Competitive dynamics determine the eventual business margins, not “great products”. You loved Facebook, but must learn the product is not the business model. This is the same as understanding that price is not value. Confusing great products with great businesses gets lots of people in heaps of trouble.

So lets pull a Charlie munger and think about the 2nd order effects of the entrants attracted to a hot product space. In a Lottery hot sector many firms are competing for the big fast growing market prize. Often times, each firm is priced to take it all. The result can be disaster as the hot sector matures and competition erodes the margins of even the fully grown survivors.

PV solar cells are an example of this effect. Each potential winning company originally competed with a $/watt product edge. They then discovered their edge usurped, margins crushed and threat of encroaching technologies still present even at large scales after years of growth.  PV solar firms were a classic case of one-trick innovations in a mostly commodity market. Customers needed the cheapest $/watt and as long as the technology was robust didn’t differentiate between businesses.  The best manufacturer with a 10 year history was only as good as the ideas coming out of some garage or university yesterday.

Innovation is deeper than product alone, it is a profound process. Quantified research from The Doblin group, shows that innovation covers 10 separate categories and that sustained margins are held by dominating as many capability categories uniquely as possible. Today’s great new mouse trap isn’t necessarily a business, its just a product innovation capability for some guy to riff on tomorrow. I know. I used to manage 70 science PhDs in Europe’s answer to the MIT media lab innovating in every field of science you can name.

The human desire to make it big fast often leads to disaster. I know this as well through painful personal experience as a software entrepreneur/ founder.  This innate human pattern of betting for the big payoff can be seen in studying pari-mutual horse racing odds and outcomes.  Where long shot bets are placed mostly for emotional kicks more than actual gains.  The insightful blog CSinvesting posted this article on the issue (see middle of post).

I have redacted a few graphics to give a visual summary of the paper by Eric Snowberg and Justin Wolfers.  The data shows the long-shot betting bias over 6.5million horse races. Betting the long shot is just a way to lose faster.

And for the international set, here is 50 years of data. Human nature isn’t changing any time soon.

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