Internet Economics

The internet has disrupted business and investing more than any technological change in our lifetimes. Yet, we still cling to the fundamental analysis and metrics that were developed for the 20th century.

“Internet Economics” has replaced Econ 101 and the changes brought about by Internet Economics are responsible for most of the major winners and surprising losers of the last 20 years on Wall Street.

The Internet Changes Everything

Traditional economics centers around the idea that there are choices or tradeoffs that customers and businesses need to make. Factories have capacity limitations, commodity prices rise and fall, distribution is a choke point, and scale is a differentiator.

I looked back at the curriculum for Econ 101 and across the board “supply and demand” and “scarcity and choice” are key topics for the class. This makes sense in a world where most companies made or sold physical goods.

Go down the cost structure of a traditional company and you have expenses like building a factory, raw materials inputs, sales and marketing, distribution, and then the retailer. I show an example of this supply chain in the graphic below.

In last week’s article “The Value Trap”, I highlighted that the power of companies like Procter & Gamble, Anheuser-Busch, Kraft, and dozens of others really centered around power at the point of distribution (#4 below), which was leveraged by a cost advantage from scale (#1-3 below).

How did the internet disrupt this power dynamic? Geographic barriers go away (#5). Startup costs drop dramatically (#1). Production and marketing costs not only fall, they don’t require scale the way they used to (#2, #3). And distribution costs go to zero (#5).

Zeros don’t work well in Econ 101.

In Internet Economics, zeros are the key to success because they’re the point of leverage.

Every business is different, but the zero distribution cost is one concept in Internet Economics that we need to hammer into our investing brains.

When Google was ascending it gained power with each new user it attracted. The increased cost to serve an incremental search result or ad was effectively zero so the incentive was to increase usage as fast as possible. Profits would follow, and they did. Newspapers with physical and geographic limitations didn’t stand a chance in a zero marginal cost world.

This changes how businesses think about the price of products and how important growth is to their fundamentals. The tenant of scarcity is gone.

Zero-cost distribution is the biggest shift the internet brought, but marketing has also been turned on its head as well. Scale used to be the price of entry, but that’s now gone. Is a $5 million Super Bowl ad that convinces 1 million people to buy a $5 bar of soap a better deal than a $3 targetted Facebook ad that convinces 1 person to buy the same soap? Absolutely not.

Internet Economics has given businesses and individuals who embrace them an unfair advantage over existing competition. This is why most newspapers failed. It’s why YouTubers can take on media giants. It’s why Wall Street sees a newsletter like this as a threat. Old business models can’t compete in a world where the constraints of Econ 101 are gone.

Points Of Leverage

Analyzing how the internet changes economics will be different depending on the business, but this will be a theme here on Asymmetric Investing.

Think about the zeros in the examples above as points of leverage. If distribution costs are zero then maximizing reach increases revenue and profits. A $1 price point for a product with 1 million customers now generates 10x the revenue of a $100 price point with 1,000 customers.

This is why falling ad rates on Facebook, Google, and YouTube can be good for businesses. They make it up in volume. This is why I’m more worried about Spotify’s user growth and hours listened than I am about their current margins. It’s why Peloton increasing content quantity while simultaneously lowering prices for app access could be a brilliant strategy. Both companies are examples of leaning into Internet Economics.

Counterintuitively, the incentive for internet businesses is to have low variable costs and increase the fixed costs they can leverage.

When Everything Goes to Zero

We aren’t done seeing pieces of the supply chain go to zero. Distribution of digital content is zero and production is moving in that direction with the help of AI.

Econ 101 wasn’t built for the internet and neither are traditional financial metrics like price-to-earnings multiples and return on equity. As investors, we need to understand this new internet economy and leverage it as much as possible. If we don’t do it, someone else will.

(more on this topic next week)

Disclaimer: Asymmetric Investing provides analysis and research but DOES NOT provide individual financial advice. Travis Hoium may have a position in some of the stocks mentioned. All content is for informational purposes only. Asymmetric Investing is not a registered investment, legal, or tax advisor or a broker/dealer. Trading any asset involves risk and could result in significant capital losses. Please, do your own research before acquiring stocks.