Free 7-day Trial
All Articles and Columns »

Entrepreneur Arbitrage Spreads and the Commonality of Locality

There is a great book that was written in 2000 by Amar Bhide called "The Origin and Evolution of New Businesses."

In "The Origin and Evolution of New Businesses," Bhide’s research showed that almost all businesses are started to take advantage of an arbitrage spread and in "Competition Demystified," Bruce Greenwald also explains the concept of locality of a business. (The importance of thinking local.)

The two abstract concepts “arbitrage spread and locality” had me thinking for the last few weeks about how an effective business uses these advantages to start and continue to use it as an advantage while they scale. There are two types or start-ups described by Bhide: the first, a promising start up like Microsoft, Google, Soda Stream, or Tesla, and the second a marginal start-up like a gas station, landscaping business, motel, hair salon or convenience store.

Marginal startups have low uncertainty, low investment requirements and low likely profit. Promising startups have high uncertainty, low investment requirements and low likely profit.

When it comes to locality of a business a mental model should be made. Think back to just the last few weeks as we watched the Olympic Games unfold in Russia or even the last time you heard about someone you knew from high school, post secondary school or a past job, complete or succeed at something astonishing, publicly.

A greater connection is made with someone (or something) when a prior association established. This association comes from perceiving a commonality.

In the case of the Olympics maybe you knew someone who grew up in your province or state, even a town close to your own, or quite possibly the same town itself. Did you find yourself cheering them on and telling friends about their triumphs?

Why do we feel a greater connection to the athletes that are “closest to home?”

Why do local businesses and products create an emotional response?

This is because of the commonality of locality, or having an association that is pleasant to the subconscious mind. Small businesses in small towns know this effect quite well as likely does Wal-Mart and other encroaching box stores on the opposite side of the spectrum.

Think Local”

We have likely all heard variations of this saying at one point or another in our lives but have we thought of the metaphorical keys it may hold? In the present business environment where the flow of information is quicker, transportation is cheaper, and today’s competitive advantages may be undone in relatively little time, it is important to have a concentrated strategy.

As Greenwald explains, competitive advantages that lead to market dominance are more likely to be found when the distribution and consumption takes place locally versus a large and scattered geographic region. This is ironic because competitive advantages tend to be specific, concentrated and local versus general, vague and diffuse. The more distance or time distribution must travel to meet consumption, the higher the costs of logistics. The less distance a message has to travel the quicker information can be absorbed. The stronger the connection or association to the service or product, the greater the emotional attachment and switching costs.

Thinking local in a globalized world seems to be very counter-intuitive and framed as a paradox. Upon closer examination we find that if emerging markets follow the path of the developed markets, the majority of their services and manufacturing will be consumed locally.

We consume the majority of what we produce and import goods to make up for the insufficient capacity and excess demand we have. To paraphrase Adam Smith, the wealth of a nation is determined by what surplus can be produced relative to the demands of the country of origin and traded to other countries that have sufficient demand, creating a positive trade balance.

“The key to investing is … determining the competitive advantage of any given company and the durability of that advantage.” – Warren Buffett (Trades, Portfolio)

Are entrepreneurs risk takers?

Gates' opportunity cost when he dropped out of Harvard to start Microsoft (MSFT) was exceptionally low. His labor was probably not worth very much in the market at the time. If Microsoft failed he could have simply returned to Harvard to finish his degree.

One could state Gates faced uncertainty and ambiguity, but not risk.

Think back to our example of the gas station attendant for a moment. This gas station attendant realizes that there are no gas stations for nearly a 30-mile radius and that people are forced to drive all the way to fill-up. He uses some of his savings to open up shop and he faces little risk of failure, as people will need to fill their cars with gas and an alternative is 30-miles away. If the venture does fail the man can go back to working as an attendant at another gas station or find another job. Things begin doing well for him but he is not likely to end up a billionaire as a result.

The arbitrage spread is the 30 miles between gas stations.

As business begins to boom and becomes more profitable competitors begin to encroach, opening gas stations 20 miles away, than 15 miles and finally 10 miles away, until the arbitrage spread is dissolved. He was collecting the spread until other entrants show up. The durable portion of the equation comes from being able to maintain or increase the arbitrage spread. The gas station has a wonderful competitive advantage when it starts, but that advantage is not durable. Hence it would make a poor investment.

Arbitrage spreads come from three “advantage pools”

1. Supply
2. Demand
3. Scalability

The good news is that the arbitrage spread can last for years. Given enough time, durable barriers to entry may be created such as a lasting brand or close supplier relationships and discounts. Jumping from niche to niche, taking advantage of new arbitrage spreads is the only way to scale, usually the result of demand and supply opportunities a business is able to exploit.

“Durable competitive advantage is usually the result of unpredictable and rare random events, like IBM’s call to Microsoft to sell them a PC operating system when Microsoft had never built an operating system before and did not have one to sell. These events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority. Once a startup has acquired a durable competitive advantage, and investors get an opportunity to buy in well below intrinsic value, backup the truck.” – Mohnish Pabrai (Trades, Portfolio)

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


Rating: 3.3/5 (3 votes)

Comments

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Hide