What Peter Thiel and Richard Branson have in common
While on holidays in Greece over the past week, I managed to finish reading Zero to One by Peter Thiel.
It’s an easy read – less than 200 pages in the paperback version.
I’ve already discussed how Thiel’s description of a monopoly will help to shape my investment process this year.
But there were plenty of other useful ideas in the book. Let’s focus on this one:
Huge market share is more important than a huge addressable market
According to this point of view, we need to put our sceptical hats on whenever a business aims for just a few percentage points of market share out of a large addressable market – even if (perhaps especially if) the addressable market is extremely large.
We should instead be aiming for companies that will achieve dominance in their markets – even if those markets are very small. These companies will probably generate super returns and an impenetrable, sustainable, competitive position.
On the other hand, those companies which operate in very large markets with small market share are always at risk of getting steamrollered into obsolescence, since they have no protection from competitors. Thiel gives undifferentiated solar energy companies as examples.
In the context of starting a new company:
“The perfect target market for a startup is a small group of particular people concentrated together and served by few or no competitors. Any big market is a bad choice, and a big market already served by competing companies is even worse.
This is why it’s always a red flag when entrepreneurs talk about getting 1% of a $100 billion market. In practise, a large market will either lack a good starting point or it will be open to competition, so it’s hard to ever reach that 1%. And even if you do succeed in gaining a small foothold, you’ll have to be satisfied with keeping the lights on: cut-throat competition means your profits will be zero.”
In economic terms, we should think about whether the return on capital that a company enjoys will reduce in line with how much capital enters its industry, or whether it will in practise be difficult for new companies to meaningfully reduce its returns, no matter how much capital they deploy.
For example, Richard Branson had plenty of resources with which to launch Virgin Cola in 1994, and he gave it his all.
Ultimately, however, he found that it was impossible to displace the classic brand.
“The problem was that, you know, we didn’t have something completely unique,” he says. “We had a great brand. But Coke had a great brand. The taste of the Cola was maybe marginally better. But it was neither here nor there.
“So since then what I learned from that was only to go into businesses where we were palpably better than all the competition.”
Thiel says something similar in Zero to One. For a technology company, its proprietary technology should be at least 10x better than its closest substitute. The creation of Thiel’s PayPal meant that payments were instructed instantly, at a time when the closest substitute was mailing a cheque.
For drinks brands like Coca-Cola (KO) or Pepsi (PEP), where technology is perhaps less important, new entrants must battle the incumbents in the fields of marketing and distribution – no easy task, especially when they are willing to use any tactic and resource to defend their positions.
It is possible to displace a drinks brand (see what Fevertree has done to Schweppes), but certainly not easy and is the exception rather than the norm. Fevertree identified an incumbent brand whose marketing looked tired, attacked it relentlessly, and is reaping the rewards.
The general business principle is that it’s not worth starting a business where there are many close substitutes and “me-too” competitors. Better to identify a specific market, even if it is small, and own it as completely as possible. Peter Thiel and Richard Branson would be in complete agreement on this point – and they know a thing or two about it!