Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: Tesla bets on Bitcoin, Reddit sees its valuation double, Chinese hedge funds beat foreign competitors, and the technology industry’s increasing returns to scale. To sign up for the Capital Note, follow this link.
Musk’s Bitcoin Bet
The technology industry markets itself as deterministic: Entrepreneurs imagine a different future and set out to create it. But as any venture capitalist knows, it’s difficult to predict which technologies will succeed and which will fail. Indeed, the VC portfolio model treats investments as lottery tickets, assuming that nine out of ten will fail and one out of ten will be wildly successful. That’s why W. Brian Arthur described the tech industry as a casino:
It is casino gambling, where part of the game is to choose which games to play, as well as playing them with skill. We can imagine the top figures in high tech — the Gateses and Gerstners and Groves of their industries — as milling in a large casino. Over at this table, a game is starting called multimedia. Over at that one, a game called Web services. In the corner is electronic banking. There are many such tables. You sit at one. How much to play? you ask. Three billion, the croupier replies. Who’ll be playing? We won’t know until they show up. What are the rules? Those’ll emerge as the game unfolds. What are my odds of winning? We can’t say. Do you still want to play?
In casino-like markets, competitive advantage is derived less from technological expertise or management acumen than from an ability to choose the right games. In Arthur’s words, “Bill Gates is not so much a wizard of technology as a wizard of precognition, of discerning the shape of the next game.” On this view, companies live and die not on their technology but on their adaptability. They must divine the future and be at its forefront before their competitors.
Which brings us to today’s news that Tesla has allocated $1.5 billion of its corporate treasury to Bitcoin. The company explained the decision as an effort to “diversify and maximize returns on our cash that is not required to maintain adequate operating liquidity.” But speculating on an experimental asset is an astonishing move for a growing business that only recently started generating positive cash flows. And yet there’s an underlying logic to the move.
With a market cap surpassing $800 billion, Tesla is one of the largest and best-funded companies in the world. It is valued on earnings that won’t materialize for decades, and its investors assume it will dominate the electric-vehicle industry for decades to come. Its success will thus be determined not only by its ability to produce and sell cars, but by its ability to stay ahead of the technological curve. In Arthur’s formulation, Tesla will need to play the slots — whether it wants to or not.
By leading the way as an early corporate adopter of cryptocurrency, Tesla is committing a relatively small amount of its cash to a nascent, growing business. It is “linking and leveraging,” using its large base of investors, customers, and fans to enter a new market. If Tesla follows through on plans to accept Bitcoin as payment for its vehicles, it could tack a host of crypto-adjacent markets onto its car-building operation. This kind of risk-adjusted bet on emerging technologies is exactly what a good CEO does.
Ironically, the casino approach is new for Elon Musk. Both Tesla and SpaceX entered competitive, logistically difficult manufacturing industries and won by bringing costs down and incrementally improving existing technologies. But Musk is now the richest man in the world, and (on a perhaps overly generous reading) he appears to be adapting to his role as CEO of a tech behemoth.
Reddit on Monday said it raised $250 million in a late-stage funding round led by venture-capital firm Vy Capital. Previously it was valued at $3 billion after its last funding round in February 2019, according to PitchBook, a provider of private-market data. Current investors in Reddit also include venture-capital firm Andreessen Horowitz and internet conglomerate Tencent Holdings Ltd.
“It’s a good market to fundraise,” Reddit Chief Executive Steve Huffman said in an interview. “Valuations are very high right now. It never hurts to raise money when there’s an opportunity to do so and Reddit had a strong year.” For example, advertising revenue for the company shot up 90% in the December-ended quarter from a year earlier, he said.
The nearly 15,000 funds offered by Chinese managers returned 30% on average last year, with the best-performers surging 10-fold, according to Shenzhen PaiPaiWang Investment & Management Co. That dwarfs the average 12% gain for hedge funds globally.
The out-performance is another impediment to global funds such as Bridgewater Associates and Two Sigma, which have struggled to make inroads into China’s 3.8 trillion yuan ($588 billion) hedge fund market since it was opened to foreign firms four years ago. Local funds added a record 1.3 trillion yuan in assets last year.
More from W. Brian Arthur’s essay (worth reading in full):
Two maxims are widely accepted in knowledge-based markets: it pays to hit the market first, and it pays to have superb technology. These maxims are true but do not guarantee success. Prodigy was first into the on-line services market but was passive in building its subscriber base to take advantage of increasing returns. As a result, it has fallen from its leading position and currently lags the other services. As for technology, Steve Jobs’s NeXT workstation was superb. But it was launched into a market already dominated by Sun Microsystems and Hewlett-Packard. It failed. A new product often has to be two or three times better in some dimension—price, speed, convenience—to dislodge a locked-in rival. So in knowledge-based markets, entering first with a fine product can yield advantage. But as strategy, this is still too passive. What is needed is active management of increasing returns.
One active strategy is to discount heavily initially to build up an installed base. Netscape handed out its Internet browser for free and won 70% of its market. Now it can profit from spin-off software and applications. Although such discounting is effective—and widely understood—it is not always implemented. Companies often err by pricing high initially to recoup expensive R&D costs. Yet even smart discounting to seed the market is ineffective unless the resulting installed base is exploited later. America Online built up a lead of more than 4.5 million subscribers by giving away free services. But because of the Internet’s dominance, it is not yet clear whether it can transform this huge base into later profits.
Let’s get a bit more sophisticated. Technological products do not stand alone. They depend on the existence of other products and other technologies. The Internet’s World Wide Web operates within a grouping of businesses that include browsers, online news, E-mail, network retailing, and financial services. Pharmaceuticals exist within a network of physicians, testing labs, hospitals, and HMOs. Laser printers are part of a grouping of products that include computers, publishing software, scanners, and photo-input devices. Unlike products of the processing world, such as soybeans or rolled steel, technological products exist within local groupings of products that support and enhance them. They exist in mini-ecologies.
This interdependence has deep implications for strategy. When, in the mid-1980s, Novell introduced its network-operating system, NetWare, as a way of connecting personal computers in local networks, Novell made sure that NetWare was technically superior to its rivals. It also heavily discounted NetWare to build an installed base. But these tactics were not enough. Novell recognized that NetWare’s success depended on attracting software applications to run on NetWare—which was a part of the ecology outside the company’s control. So it set up incentives for software developers to write for NetWare rather than for its rivals. The software writers did just that. And by building NetWare’s success, they ensured their own. Novell managed these cross-product positive feedbacks actively to lock in its market. It went on to profit hugely from upgrades, spin-offs, and applications of its own.
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