THE INTERNET AND VALUE INVESTING

Part I: Economic Fundamentals

December 15, 1999

The Internet is a paradox. It was originally conceived and built on a non-profit basis, and (thus far at least) few “Internet companies” have reported sustained profits. Yet scores and perhaps hundreds of billions of dollars are resting upon the conviction that the Net will generate enormous returns to those who unlock its commercial potential. The resolution of this paradox clearly has tremendous implications for investors. Is the Internet an unprecedented bonanza of opportunity? Has it been hyped into a bubble of speculative excess? Should investors change their principles in response of its development?

This six-part report addresses these questions. Part I defines e-infrastructure, e-business and e-commerce, and sets out some economic principles which appear to underlie them. Part II sketches some of the consequences of these fundamentals for the operations of Internet Service Providers (ISPs), and Part III does so for e-business and e-commerce ventures. Part IV sets out the criteria – and their consequent dangers – which market participants are using to evaluate Internet and technology stocks, and Part V reviews the impact of technology upon consumers, businesses and investors. Finally, drawing from the findings of Parts I-V, Part VI describes and justifies the approach that Leithner & Co. is taking with respect to the Internet and Net-related phenomena.

What’s the Big Deal?

More efficient production and greater choice for consumers are clearly important. But these developments can be attributed to a variety of causes and have been occurring steadily in Western countries for 200 years: by themselves, then, they cannot explain the enormous hype and expectations which currently surround the Internet. They do not explain why Jack Welch, the head of one of America’s largest corporations, has said “I don’t think there’s been anything more important or more widespread in all my years at General Electric. Where does the Internet rank in priority [for us]? It’s number one, two, three and four.”

Nor do these developments explain why the 1990s have been identified as the beginning of a third industrial revolution. Alan Kohler, one of Australia’s most prominent and respected business journalists, contends that “even the most cursory examination of history shows that the present period has most in common with the first industrial revolution, and in particular the period of incredible innovation that happened in England during the second half of the 18th century.” Kohler states that “there can be little doubt that the history of the third industrial revolution will place the [inventors and developers of the Internet] alongside the founders of the first industrial revolution – Watt, Hargreaves and Cartwight – as well as Thomas Edison and Alexander Graham Bell in the 1870s, who began the second industrial revolution with the telephone and electric light.”

Some Economic Fundamentals of E-infrastructure

The Internet is being hyped, ISPs are investing billions to build, modernise, expand and merge their networks, and companies are scrambling to get “on-line” because (theoretically at least) the Internet possesses “positive consumption and production externalities.” In plain English, the Internet seems to possess a highly unusual economic characteristic: the greater the number of people and businesses on-line, the greater the Internet’s value to both ISPs and their customers.

Positive production and consumption externalities do not normally co-exist in the markets for goods and services. Nor do they exist simultaneously in transport networks. When a company in a traditional industry introduces a successful good or service, it increases production until the cost of producing an additional unit exceeds the revenue obtained from selling it. This law of diminishing marginal returns is well known (at least in terms of its effects) by primary producers, manufacturers and service providers. Consumers might not recognise this law but have experienced its effects. Relative scarcity tends to increase items’ utility and underpin their value. Consumers are typically prepared to pay more for items whose supply is limited; conversely, the greater an item’s supply the less they will usually pay for it.

Contrast this with an interactive (i.e., telephone or other communications) network. If it has just one subscriber, then that subscriber cannot call anyone and the network is useless. The large sums of capital invested in it have produced a product which has no value, and investors’ returns will be correspondingly poor. But this situation changes dramatically when a second subscriber joins the network: suddenly calls in two directions can be made, and subscribers therefore attach some value (however modest) to this ability. Add a third subscriber and six types of calls can be made, and so on.As their number increases, the number of persons whom each subscriber can call increases exponentially; and as a result, the value of telephone communications to all subscribers also increases dramatically. This “network effect” (what economists call a “positive externality”) attracts still more subscribers, who generate more revenue for owners and thereby increase the network’s value to them. Under these conditions (and given the critical assumptions that the network can cope with the volume of traffic, technology does not render it obsolete and government regulations do not ruin its profitability) the network’s value to both its users and owners increases continually and exponentially. Communications networks can thus offer increasing marginal returns.

Some Economic Fundamentals of E-business and E-commerce

In considering the economic fundamentals which underlie e-business and e-commerce, it is worth keeping in mind that these businesses are, from the standpoint of ISPs, consumers of network services. They are not owners of a network and therefore do not supply network services.

Network Effects?

A critical question thus presents itself: do the “network effects” which can under certain conditions apply to ISPs also apply to e-business and e-commerce? Given the very special conditions outlined below (i.e., conditions even more favourable than those required by ISPs), the answer appears to be “maybe.”

Take as an example a hypothetical e-commerce Web site called Acme.com. Assume that consumers want to make purchases via the Internet; that they are overwhelmed and bewildered by the huge number of products and vendors on the Net; and that in order to cut their search and transaction costs these overwhelmed consumers gravitate to a few well-known sites, including Acme.com. (They might gravitate to Acme.com for any number of reasons: perhaps it sells those goods and services which consumers want; perhaps its customer service is outstanding; and perhaps its prices undercut its competitors).

If, in response to the growth in “hits sites such as Acme.com further extend their product range, improve their standards of customer service, lower their prices, etc., then it is likely that they will attract more customers, whose purchases provide the revenue which improves the site further, which attracts more customers, and so on. If these assumptions are valid, then this e-commerce “network effect” produces a zero-sum (winner-take-all) outcome: a handful of e-commerce sites which conduct most of the e-commerce, and the rest with next to nothing.

Exclusion and Rivalry

Two principles which underlie the consumption of most goods and services further illuminate the economic fundamentals of e-business and e-commerce – and help us to judge whether the assumptions which Acme.com requires for success are reasonable. The first is the “exclusion principle.” It states that if you cannot pay for a good or service, then its producer, supplier or owner can exclude you from the enjoyment of its benefits. You might, for example, like to eat a Big Mac; but if you cannot pay for one, then McDonald’s can prevent you from enjoying one. The second principle is that most goods and services, by their very nature, either cannot (or can only to a limited extent) be consumed jointly. Economists call this “rivalry of consumption”: only one of us can consume a particular Big Mac, and only a few of us can ride in the same Holden Vectra at the same time.

The principles of exclusion and rivalry not only underlie the consumption of most goods and services: they also provide incentives for their production by private-sector firms. Exclusion is a reflection of most goods’ and services’ inherent scarcity; and scarcity is the basis for consumers’ assessments of the value of what they are consuming. Businesses have an incentive to enter a market and can remain in business because, thanks to the exclusion principle, they are able to demand and receive payment in exchange for their products. Moreover, although the enjoyment derived by consumers from their consumption of goods and services is subjective, the fact that most consumption is either partly or completely rival makes the establishment of market values for businesses – as well as market prices for both their inputs (capital, supplies and labour) and outputs (goods and services) – an inexact but nonetheless non-arbitrary exercise.

Explicit Information and Tacit Knowledge

To grasp the fundamentals of e-business and e-commerce, it is important to appreciate the distinction between explicit information and tacit knowledge. Explicit information can be verbalised and therefore expressed in either words or numbers. It is derived from rules (whether formal or informal) of logic, observation and evidence. Accordingly, it tends to be universal, (i.e., its scope is not limited to a particular person, time or place); can be standardised and codified and assembled into manuals, textbooks, tables of statistical data and similar formats; and can be disseminated relatively easily from one person to another.

Implicit knowledge, on the other hand, cannot be easily verbalised, and therefore cannot be expressed in words or numbers. It is derived from long experience and intuition rather than strict logic and evidence. Because it is usually pertains to a particular person, time or place, it cannot be standardised, codified or assembled into manuals, textbooks and tables of data. And for these reasons it cannot be disseminated easily.

The Consumption of Explicit Information

The consumption of explicit information and ideas – on which much e-business and e-commerce depend – violates the principles of exclusion and rivalry. As noted by U.S. Secretary of State (and later President) Thomas Jefferson in 1795, the exclusion principle cannot be easily applied to explicit information and ideas:

“If nature has made any one thing less susceptible than all others of exclusive property, it is the action of the thinking power called an idea, which an individual may exclusively possess as long as he keeps it to himself; but the moment it is divulged, it forces itself into the possession of everyone, and the receiver cannot dispossess himself of it.”

It is not easy, in other words, to exclude non-paying users from the consumption and enjoyment of explicit, technical or “standardised” information and ideas. If exclusion is desired, the usual way to attempt it is through legal contrivances (such as patents) and technical devices (such as scramblers and passwords). Not surprisingly, the phenomenal rise of the Internet has been accompanied by the greatly increased prominence of intellectual property. Hence lawyers, once disdained by entrepreneurs and hired only to keep them out of court, are now key players who are frequently engaged in order to bring Internet companies into court: litigation is one of the few means to enforce the exclusion principle on which their existence often depends.

The consumption of standardised information and ideas – and therefore the consumption of its most important current manifestation, computer software – also violates the principle of rivalry. Through a network, for example, many people can jointly use a copy of Windows, Word or Outlook Express. Moreover, my use of these software packages does not decrease others’ use and enjoyment: indeed, because it enables me to send material to them and receive it from them, jointness of consumption produces positive externalities. Jefferson also recognised this point:

“The peculiar character [of ideas], too, is that no one possesses the less, because others also possess the whole of it. He who receives an idea from me, receives instruction himself without lessening mine. That ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man. seems to have been peculiarly and benevolently designed by nature, when she made them, like fire, expansible over all space, without lessening their density at any point. [Ideas and knowledge], then, cannot in nature be a subject of property.”

If the consumption of explicit information and ideas is non-rival and not inherently exclusive, then the establishment of clear property rights over them will not be straightforward, and entrepreneurs will lack unambiguous motives to produce them. And if they do, they will not find it easy to capture the revenues from their production. In plain English: the barriers to entry into e-business and e-commerce will be very low and in some instances virtually non-existent; and it will be very easy for a firm to steal a march on its competitors, only to lose it soon thereafter to another firm.

Perhaps most ominous for e-business and e-commerce, computer and Internet technology makes it possible to copy and transmit explicit information and software at virtually zero cost and almost anywhere in the world. To economists, the duplication of goods at almost no cost is a contradiction in terms. Unless something (i.e., patents, passwords and litigation) prevents it, articles which can be copied and distributed almost effortlessly will quickly become low-value commodities.Robert Kuttner, writing in Business Week, argues that few e-business and e-commerce firms will prosper – let alone make big profits – because the Internet is a nearly perfect market. Kuttner, citing economist Joseph Schumpeter, contends that all firms must rely on some imperfection in the marketplace n order to make money. “Every grocer, every filling station, every manufacturer of gloves or handsaws relies to an extent on imperfect consumer information, limited time for comparison shopping and a lot of brand loyalty.” The Internet, however, acts as a powerful solvent on all these market imperfections.

The Forbidding Economics of E-business and E-commerce

The foregoing analysis implies some less-than-encouraging implications for the providers of e-business and e-commerce goods and services (as opposed to their consumers). If we assume, like a standard microeconomic theory textbook, that there are few or no barriers to entry into a particular market and that no business can dominate this market sufficiently to influence prices, we describe a situation very similar to that faced today by e-business and e-commerce firms. E-business and e-commerce requires little more than an idea to get started, and these ideas are so easily imitated and duplicated that any successful idea will quickly attract a raft of competition.Standard micro theory also tells that, as long as revenues cover variable costs and make some contribution towards fixed costs, in the short run businesses can operate at a loss. The Internet provides a host of examples: as long as the revenues from the sale of (say) a CD cover the cost of obtaining the CD from a wholesaler – even if these revenues do not cover all of the monthly lease payment on the computers, the warehouse and office space or the salaries of staff – an e-commerce company can remain in business.

The short run can last either until the company’s capital is exhausted or it finds ways to increase its revenues such that all fixed costs are covered and a profit is earned. In the Internet economy, with its low fixed costs, this short run can last a long time. But this is a mixed blessing: if e-business and on-line shopping grow and revenues derived from them rise, new entrants will quickly enter the market and profits will remain as elusive as ever. Hence Amazon.com, the flagship e-commerce firm, accepts short-term losses whilst seeking to expand its revenues. To date it has found other things to sell; but these efforts have simply produced more losses. Which firms, then, will make a profit in an economy in which the Internet plays an increasingly prominent part? Microeconomics – and common sense – provide no ready answers.

Conclusion

This is the great paradox of e-commerce and e-business, “knowledge industries” and the “Information Economy.” In such an economy, the marginal utility (and hence the value) of explicit information, technical knowledge and software is purportedly greater than that of oil, steel and Snickers Bars. But because explicit information, data and software can be copied and disseminated so easily and cheaply, their price is threatened with collapse. If a motor car could be “copied” and shipped anywhere in the world as easily as a software package, e-mail message or data file, the price of cars – and hence the car industry – would collapse immediately. Hence the predicament of Information Technology, e-commerce and e-business firms: they are, at their core, collections of explicit but nonetheless intangible capital over which property rights are neither easily established nor maintained.

Given certain critical caveats, then, positive production and consumption externalities can make the ownership of communications networks – and therefore telecoms companies and Internet Service Providers – an extremely attractive proposition. In contrast, non-exclusive and non-rival consumption of standardised information and technical knowledge, together with the unprecedented ease of copying and disseminating it, makes the economics of e-commerce and e-business firms more problematic.

Part II sketches some key implications of these economic fundamentals for the operations of ISPs; and Part III does so for e-business and e-commerce firms.

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