Innovation, Change and Investment-Tea Party Record-Investment Thoughts Essay

We held an internal sharing and discussion session before the new year, focusing on exploring innovation, change, and their relationship with our investment decisions. Many areas for improvement and enhancement were identified during the session.

Zsquare summarized "The Innovator's Dilemma" and shared relevant case studies.

Another approach to avoid getting into a dilemma

The success of Berkshire Hathaway does not come from conquering change but from avoiding it. For example, it is difficult to think of an industry more traditional than the railway industry, but no one would attempt to build another mainline railway. Meanwhile, Burlington Northern was adept at applying technology to railways, such as converting all trains to double-decker designs and increasing tunnel heights.

Case Study: ARM's dilemma

All hardware instructions recognized by a processor are referred to as an Instruction Set, and the operation of these instructions is called Instruction Set Architecture. Processors can be broadly categorized into Complex Instruction Set Processors (CISC) and Reduced Instruction Set Processors (RISC) based on different instruction and computational characteristics. Licensing integrated circuit designs to others is known as Silicon Intellectual Property (SIP), and the profit model usually involves charging customers license fees, including one-time fees (non-recurring expenses) and royalties based on the proportion of chips sold.

ARM, the world's largest design IP licensing company, excelled in the field of SIP. As ARM belongs to the RISC category, which is power-efficient and cost-effective compared to Intel's CISC processors, all application processors in current smartphones, including those from Apple, Qualcomm, Samsung, and Huawei, use ARM's designs. The so-called application processor is the heart of a smartphone, responsible for executing the operating system and apps, and it dominates the processor market beyond personal computers.

However, despite its apparent dominance, ARM's financial situation is not as favorable. One-time fees typically amount to several million dollars, but the number of customers that can be acquired is limited, and royalties are usually a percentage of the sales value per processor. Currently, high-end application processors (Cortex-A) are priced at a few tens of dollars, while low-end microcontrollers (Cortex-M) may cost less than one dollar. Although the quantity is significant, the revenue generated is relatively low. According to SoftBank's financial reports in the past two years, ARM's net sales in the 2019 fiscal year were approximately $1.928 billion, with a modest annual growth rate of 2%, and an operating loss of around $400 million. In fact, in recent years, ARM's revenue and growth rate have remained at this level or even lower. ARM's growth rate in the 2018 fiscal year was only 0.2%. Such revenue and growth rate figures are in stark contrast to other major chip manufacturers.

ARM currently finds itself in a predicament with no clear path forward and relentless competition from the emerging RISC-V architecture, which has captured a significant share of the low-end microcontroller market. Meanwhile, Intel and AMD hold firm in the PC and server markets, making it challenging for ARM to make inroads. ARM's current predicament may also be a significant factor behind SoftBank's desire to sell ARM at a high price in the context of a globally expansive environment.

Cong：

Thank you for Zsquare's sharing. This book has had several impacts on our investment approach. Firstly, the philosophy underlying our method is to invest in opportunities from stages 1 to 10, where companies have established competitive advantages. The premise is that these competitive advantages can be maintained. However, disruptive innovation often breaks existing patterns, challenges, and disrupts traditional competitive advantage owners, posing a challenge for us.

Secondly, disruptive innovation represents an opportunity for new entrants to establish a new order and competitive advantage from stages 1 to 10. If we can identify disruptive innovators and grasp the opportunities from stages 1 to 10, it can lead to more substantial returns.

Z：

I fully agree with Cong's points about the impact of disruptive innovation on our investment approach. One is to be particularly attentive to the challenges that disruptive innovation poses to our scenarios of buying sustainable competitive advantages. Disruptive innovations are often not easy to detect in their early stages and can be easily overlooked, so we need to be extra careful and maintain an open mindset. The other point is that if we can identify investment opportunities in disruptive innovation, the potential returns can be significant, which greatly contributes to our investments.

Now, I would like to elaborate on how to identify and discover disruptive innovation. The book provides vivid examples, and there are several key points to summarize:

1. The experiences and selling points that disruptive products/services bring to consumers are very different from those of the disrupted ones. If we view disruptive products from the perspective of traditional products, we may perceive them as inferior, like hitting a stone with an egg. For example, the classic case of smartphones disrupting feature phones: when the iPhone was introduced, it was often compared to Nokia, highlighting concerns such as fragile screens and poor battery life.

2. Initially, the market for disruptors may be niche, with a small market size and non-mainstream customers. At first glance, this market may seem insignificant and dispensable, especially for traditional industry leaders, where the cost-benefit ratio may be low. However, disruptors will gradually erode the mainstream mass market and threaten existing participants.

3. Even if large companies recognize the imminent disruption early on, it is challenging for them to transform. Transformation obstacles stem from various factors, including rigid relationships within the industry chain, internal resource allocation favoring traditional advantageous departments, and performance incentive mechanisms that do not support long-term continuous investment with relatively low returns.

Lastly, I also agree that our focus should be on seizing growth companies with competitive protection. Although investing in undervalued competitive advantage owners in stable industries is a viable approach, it presents challenges for us. On one hand, such stable companies often have mediocre growth prospects, with investment returns mainly coming from dividends and value appreciation. Often, dividend yields are insufficient to meet our compounding return requirements, and the timing of value appreciation is unpredictable. If there is no significant revaluation for 1, 2, or even 3 years, we become passive. Buffett can indeed make such investments, but it is challenging for us to actively participate in these opportunities. On the other hand, with the advent of digitization and the internet, the pace of change has accelerated in various industries, including seemingly stable industries like carbonated beverages. The digitization of various aspects of infrastructure, from product development to reaching users, has significantly shortened the process and time, giving rise to companies like Yuanqi Forest. Even in industries that currently appear to be changing very little, it is difficult to say whether this state can be maintained in the long term.

Cong：

In fact, we have encountered many examples of disruptive innovation, and Tesla is a recent example in which we have actively invested. Seizing such opportunities can lead to significant returns.

However, on the other hand, "The Innovator's Dilemma" discusses success stories of disruptive innovators. In reality, the process of disruptive innovation is filled with uncertainty and challenges, which is related to the next book we will discuss, "Crossing the Chasm." In fact, over 90% of innovation or disruptive actions end in failure. This is why the world still maintains a certain level of continuity instead of undergoing drastic changes every day.

Catering to a niche market is a necessary step for innovators, but crossing the chasm is not easy. Staying in the niche market often offers limited value, while moving from the niche to the mass market can create a tremendous change in the perceived growth potential and market value.

Classic examples of this include Apple turning smartphones from a niche market into a mainstream market, and Tesla gradually entering the mainstream market with electric cars.

Zsquare：

So why didn't we invest in Bilibili (B站)?

Cong：

The reason we did not invest in Bilibili is quite simple. Firstly, we did not have enough awareness and conviction regarding its ability to successfully transition to a broader audience. While we admire and respect its achievement of 200 million Monthly Active Users (MAU) and 50 million Daily Active Users (DAU), relying solely on these numbers may not generate sufficient monetization and sustainable cash flow even at relatively low stock price levels. Therefore, investing in Bilibili would require a strong understanding of its future user scale and stickiness. In other investors' words, it needs to become China's YouTube, but we lack conviction in that aspect. On the one hand, Bilibili's operational model differs significantly from YouTube's, and on the other hand, it faces fierce competition from other video giants such as Douyin, Kuaishou, Shipin Hao, and Xigua, in terms of user engagement, product form, and user base. It is difficult for us to have enough awareness and conviction about its future prospects.

Secondly, compared to a relatively simple market cap/user ratio investment approach, we lean towards a value creation chain that is clear and visible. Since we started observing Bilibili, we haven't seen sufficient clarity regarding its monetization potential and pathways in gaming, advertising, e-commerce, and live streaming, making it difficult for us to evaluate its true value potential.

Overall, our understanding of innovators is that while we can try to fully understand how a trend challenges or even replaces the previous trend, the ultimate value evaluation still requires a deep assessment of whether competitive barriers can be established, how value creation occurs, and how we can assess the compounding level.

For example, we may understand the replacement of horse-drawn carriages by automobiles or feature phones by smartphones. However, it does not mean that we should stick to purchasing undervalued horse-drawn carriage or feature phone companies. Similarly, it does not mean that we can blindly invest in automobile manufacturers or any random smartphone manufacturer to achieve long-term returns. The core depends on whether it can generate long-term growth opportunities under significant barriers and create satisfactory compounding opportunities in terms of pricing.

Z：

Yes, we watch a lot of YouTube, so we can understand the entire value chain of content creation and monetization mentioned above. It's easy to compare Bilibili with YouTube, and although Bilibili may not reach the level of YouTube due to the characteristics of the Chinese market, it still has advantages in the domestic market. However, when judging the potential returns, we need to assess how well it compares to its counterparts. It's not a simple question.

I've always been puzzled as to why original content from Bilibili's content creators is often premiered on Bilibili, but in terms of overall video views and monetization, Bilibili's share is relatively poor. So why do content creators still have the motivation to maintain this state?

Zsquare：

I have pondered this question and interviewed some Bilibili content creators. For them, Bilibili is a community where content creators and fans can form deep connections. Content creators and fans grow together in this community. This relationship and experience are unique to Bilibili and cannot be found on other platforms.

Z：

Now that WeChat Video Account is launched, which is based on social connections and has the potential for mass appeal and monetization, could it pose a challenge to Bilibili?

Zsquare：

Now that WeChat Video Account is launched, which is based on social connections and has the potential for mass appeal and monetization, could it pose a challenge to Bilibili?

Z：

I think I understand better now. For many content creators, if they start on a broader platform right away, they may not have enough exposure opportunities. Bilibili allows them to gradually build followers and grow their presence. The current issue is that if Bilibili's traffic pattern becomes relatively stable, it becomes extremely challenging for a new content creator to gain attention from existing users. It seems that Bilibili has reached a stage where it needs to seriously consider its monetization potential. However, answering this question is quite challenging.

Zsquare：

Profiting from video websites is indeed difficult, or perhaps pricing is not the most important factor. For example, Netflix has not been profitable to this day, and its cash flow is also poor.

Cong：

Zsquare has a significant misconception about Netflix. From a business model perspective, Netflix has the most extensive and efficient content distribution model globally. It is not just a content creation company. In this sense, Netflix is very unique and virtually has no competitors.

Although Disney has made significant progress and is trying to catch up, it still lags far behind Netflix. Furthermore, there are significant differences in content attributes, making it unlikely for users to unsubscribe from Netflix and solely subscribe to Disney. Netflix still offers evident advantages in terms of efficiency and cost-effectiveness compared to offline and local operating networks. Netflix and Disney still benefit from user migration.

Especially after the COVID-19 pandemic in 2020, Netflix's cash flow and profits have significantly improved. The most important cost item, content investment, has even shown a decrease on a sequential basis. This has led to significant economies of scale and operational leverage. Although its valuation is not cheap, its profitability is clear. Looking into the future, it is not in a state of bubble-like expansion.

We currently do not hold positions in Netflix simply because we do not have sufficient confidence in the compounding returns it can provide. However, its business model has clear competitive advantages, and its future value creation is also relatively well-defined.

Z：

I want to go back to discussing Tesla as a classic example of "The Innovator's Dilemma." Previously, we talked about how to identify disruptive innovation, which involved three points: 1) Differentiating characteristics of the product from traditional offerings; 2) Initially targeting a niche market with limited scale; and 3) The challenge for incumbent players to transition even when they recognize the disruptive technology.

Applying these points to Tesla's case:

1. Tesla's products, when viewed from a traditional perspective, had significant flaws such as poor quality control, basic interiors, and initial issues like leaks due to missing waterproof seals in the trunk. If evaluated solely based on traditional standards, it would be easy to dismiss Tesla as a disruptive innovator. However, if we shift our perspective and consider the aspects of electrification, software-based user interactions similar to smartphones, and the simplification of driving, these characteristics make traditional cars seem inadequate. Furthermore, the decreasing costs of electrification are expected to reach price parity with combustion engine vehicles at some point in the future, or even become cheaper. Software can be continuously upgraded to offer more advanced human-vehicle interaction features. Additionally, the continuous improvement of autonomous/assisted driving capabilities can eventually lead to fully autonomous driving. At a certain stage of development, the perceived shortcomings of traditional cars become insignificant, and these weaknesses can be easily overcome.

2. The market for electric vehicles (EVs) was initially small, and even now, the penetration rate of EVs remains relatively low. Tesla operated at a loss for over a decade since its founding, with accumulated R&D investments exceeding billions of dollars. This does not account for the substantial capital expenditures in building factories, establishing sales networks, and charging infrastructure. Despite investing significant resources, for the majority of the past decade, Tesla operated at a loss, with sales volume only recently surpassing one million cumulative units. From the perspective of traditional combustion engine vehicles, the cost-effectiveness of these investments may initially seem poor, and it may seem justifiable to abandon them.

3. Incumbent players find it difficult to transition. The automotive industry has evolved over a hundred years, and various aspects have become highly efficient. For example, automotive brands focus on vehicle design, OEM manufacturing, brand promotion, and automotive financial services. R&D in the automotive industry primarily involves minor improvements rather than major innovations, and large-scale capacity expansions are not necessary. R&D and production of components, as well as sales networks, are outsourced. Automotive brands are relatively lean, and the cooperation efficiency throughout the supply chain is high. However, the downside is that the tightly interwoven automotive OEMs and the entire industry chain form a complex network that is difficult to change. Changing the network requires comprehensive transformations and substantial investments. For example, R&D and production need to be adjusted to meet the requirements of new products, and the development mode of components needs to shift from providing black boxes and slow updates to open interfaces and rapid iterations. Sales networks also need adjustments. Traditional automotive dealerships rely on post-sales services to generate profits, even if selling cars alone may not be profitable. However, with electrification and digitalization, the value of post-sales services significantly declines, eroding the interests of traditional dealerships. In addition to the rigid external network, there are also internal organizational barriers. Traditional combustion engine vehicle sales contribute to the entire company's revenue, while electric vehicles act as a long-term investment with continuous losses, making it difficult to obtain resources within the organization. Moreover, the current incentive structure for professional managers does not support long-term investments without short- to medium-term returns, unlike the first-generation entrepreneurs.

Of course, one crucial factor is that when we invested in Tesla, it faced significant skepticism and had a market valuation of around $30-40 billion. At that time, our research and analysis indicated that the upside potential it offered and the risks we had to bear were very attractive.

There's another interesting case, Pinduoduo, which is not a typical story of disruptive innovation.

Zsquare：

I think Pinduoduo is great, and I can understand it. It aligns well with one point mentioned in "The Innovator's Dilemma," which is that incumbent players tend to offer increasingly high-end and expensive products for their own growth, even when customers don't necessarily need them. In the cases of Pinduoduo and Alibaba, many of the products offered by Alibaba have the suspicion of overconsumption, where customers don't actually need such expensive products. Pinduoduo, on the other hand, aims to provide users with what they truly need at the best possible prices.

Z：

I agree. However, for a long time, I didn't fully understand it and saw Pinduoduo as Alibaba giving up a portion of the market, which Pinduoduo then captured using the traditional Taobao model. But as you mentioned, Alibaba and Pinduoduo have different positions in e-commerce. Alibaba transitioned from Taobao (online "street stalls") to Tmall (online department stores and shopping centers), continuously pursuing brand-building. In this aspect, Alibaba has to strike a balance between users and brand merchants. For example, similar products may prioritize flagship stores, even if their prices are higher. Pinduoduo, on the other hand, staunchly stands on the side of users. They prioritize showcasing products with the highest cost-performance ratio and de-emphasize the presence of stores, focusing on the products themselves.

Additionally, I feel that Pinduoduo doesn't fit the classic scenario of disruptive innovation because it's not clear if it will overthrow Alibaba. Instead, we need to assess how the e-commerce market will be divided among the participants and determine how much of consumer demand can be better fulfilled by Pinduoduo compared to Alibaba. This assessment is more complex than in typical cases of disruptive innovation where the disruptor displaces the incumbent leader. It's not a simple question to answer.

Cong：

It's evident that we underestimated PDD's potential, and the same applies to our understanding of Meituan, which has also gained significant popularity.

This reflects the differences in our pricing models, understanding of value creation, and market perspectives. It may be proven in hindsight (so far, it hasn't) that the market is correct, but at least in advance, it is not as easy to comprehend.

Compared to companies like Amazon, Alibaba, Tencent, and Apple, we find it relatively easier to evaluate their value. The main reason is that these companies have more direct and clear profit models, and their pricing power is more apparent. For example, Amazon earns up to 40% in commissions from merchants (from listings, advertising, payments, warehousing, and logistics services), and the unit prices of their products are higher, providing clear economies of scale.

BABA's current profits primarily come from the value created through services provided by branded merchants. Whether following foreign or offline models, the proportion of this value can be quite high. As for PDD, although the logic of group purchases resulting in cheaper prices has driven rapid growth in GMV, it's difficult to determine the net take rate due to the characteristics of standardized products and fierce competition in China. Furthermore, at the earlier stages, it was challenging to have a clear answer regarding the GMV potential of PDD's business model. Would it be 20 trillion or several tens of trillions or even more? In the case of Meituan, if they can achieve the management's vision of processing 100 million orders per day with a profit of 1 yuan per order, it still poses challenges in terms of the time required to achieve this goal and the achievable profitability per order. Of course, in a trend-driven market, high-growth companies are often linearly extrapolated, imagining the potential of their second curve after achieving current growth. This is certainly understandable, but if expectations run too far ahead, we may overestimate our predictive abilities. In the current stage of abundant capital and various investment logics rushing ahead, it indeed presents a significant challenge for investors like us who tend to have a slower reaction speed.

Cong：

Regarding the viewpoint on ARM, I haven't conducted in-depth research on ARM as a company, but I believe Zsquare's analysis is too static. I think ARM's development trajectory can be analyzed by comparing it to Qualcomm (QCOM). Qualcomm also started as an IP and patent company and eventually developed into a chip giant. However, due to its business model of simultaneously charging for patents and chips, it faced resistance from the industry and encountered many antitrust investigations. Despite this, a company with a $170 billion market value and generating $6 billion in annual free cash flow cannot be considered unsuccessful. Even Apple, as strong as it is, still has to maintain its cooperation with Qualcomm. ARM has always maintained its position as an IP provider, which limits its monetization and scalability. The situation described by Zsquare is a result of maintaining good relationships with partners and other reasons related to ARM's capabilities. However, we believe that if NVIDIA, with its rich experience in processor design and long-standing partnership with TSMC, successfully acquires ARM, it will undoubtedly have greater leverage in ARM-based processors. This value proposition is likely the reason why NVIDIA is willing to spend $40 billion to acquire ARM. However, this acquisition has not been finalized and is still subject to antitrust investigations to determine its success.

In summary: The study of innovation and change is the core of our investment framework and methodology:

1. The philosophical foundation of our approach is to invest in companies that have already established a competitive advantage and have opportunities for growth from 1 to 10. We invest in the continuity of competitive advantage owners, but this is predicated on the ability to maintain that competitive advantage. However, innovation and change are often driven by disruptors entering the market and breaking the existing pattern, challenging and disrupting traditional competitive advantage owners. This poses a challenge to us.

2. Disruptive innovation is the process by which new entrants establish a new order and competitive advantage from 1 to 10. It also represents opportunities for us to invest. If we can identify disruptive innovators and seize the opportunities from 1 to 10, it often brings more substantial returns.

3. Whether investing in existing winners or what we believe will be future winners, our investment methodology needs to be based on growth opportunities with established barriers (the difference lies in whether the barriers have been formed in the past or are newly established and deemed sustainable). Our investment decisions still need to be based on the opportunity for compounding at a rate exceeding 15%. This means that even in the era when cars are replacing horse carriages, we might not invest in horse carriage companies or car companies unless there are some unique companies within the automotive industry or related supply chains that offer sustainable barriers and reasonable valuations.