#45 - Base Rates, Brad Pitt, and the Outside View
Why Big Tech Isn’t Invincible
Big tech feels unassailable right now. With the physical world partially shuttered, more activities are shifting online. Zoom hosts birthday parties, board meetings, and weddings. Apple, Amazon, and Microsoft all sport market caps over $1 trillion. Yet despite tech’s aura of invincibility, history suggests that it too is mortal.
15 Minutes of Fame
Alphabet, Amazon, Apple, Facebook, and Microsoft are some of the world’s most valuable companies today. A decade ago, only Microsoft cracked the top ten. Over the past twenty years, the world’s largest companies by market cap have been a changing mix of energy, financial, and technology, according to analysis from Visual Capitalist:
Source: The Visual Capitalist, A Visual History of the Largest Companies by Market Cap (1999-Today), June 21, 2019.
Zoom out and the story is the same. Jason Zweig, author of The Intelligent Investor column at the Wall Street Journal, highlights that the most valuable company crown is always in flux. Zweig found that over the past ninety-five years, eleven companies have been the most valuable and none stayed on top forever. Once dominant firms like AT&T, GE, and IBM don’t even crack the top fifty today. General Motors isn’t in the top 1,600:
Source: Wall Street Journal, Apple Still Wears the Market Crown. It Can Easily Slip., September 4, 2020.
Larger surveys have come to the same conclusion. For example, Leslie Hannah, dean of the City University Business School, London, analyzed the performance of the world’s top 100 firms in 1912. By 1995, only 19% remained in the top 100. Just over half of the companies survived. The remainder disappeared by bankruptcy (29 of the top 100), nationalization, or merger:
Source: Leslie Hannah, Marshall's "Trees" and the Global "Forest": Were "Giant Redwoods" Different?, January 1999.
Hannah provides a base rate for thinking about the fates of top companies over time. Base rates are the unconditional probability of some event occurring, based on historical data. If the base rate of someone being a Chipotle enthusiast is 88%, then there’s an 88% chance that any random stranger you meet is a Chipotle enthusiast. Not sure what’s going on with the other 12%. In Hannah’s analysis, the base rate of surviving in the top 100 for eighty years is 19% and the base rate of bankruptcy is 29%. Over decades, major companies are more likely to go bust than to remain on top.
Base Rates & Growing Pains
Part of the reason why technology companies are so valuable right now is because they have a long runway for growth. Despite a pandemic-driven uptick in e-commerce penetration, nearly 80% of US retail sales still happen offline. TV, radio, and print still account for large pools of advertising budgets. The migration to cloud computing is still early. As more activities shift from physical to digital, lots of dollars are up for grabs.
Revenue is a significant driver of corporate value. Unless you’re Uber, more revenue typically translates into larger profits, more free cash flow, and higher valuations. The prospect of growth is intoxicating, particularly given winner-take-all dynamics common in tech. That’s why unprofitable but quickly growing companies like Snowflake and Unity are valued at $10 billion or more.
For high-growth companies, most of the value resides in the out years. What investors are paying for is not just performance this year or next year, but a vision of the future that anticipates many years of high growth. Through the magic of compounding, small differences in growth rates over a long enough period of time lead to big differences in value. For example, a company growing revenue at a compound annual growth rate (CAGR) of 12% will be about 30% larger than a company growing at a 10% CAGR after 15 years. This differential widens every year:
The flip side of this is that being slightly too optimistic about future growth prospects today can mean drastically overpaying for an asset. If you’re expecting a 12% CAGR and you get a 10% CAGR, watch out below. What’s more, the further you look into the future, the more uncertain things become. It’s unlikely that anyone incorporated a 2020 global pandemic into their financial estimates a few years back, yet here we are.
Base rates can be an antidote against wishful thinking. The Base Rate Book from Michael Mauboussin, Head of Research at Counterpoint Global and former Head of Global Financial Strategies at Credit Suisse, highlights just how hard it is to sustain high growth rates. Mauboussin and his team at Credit Suisse analyzed the revenue growth of the top 1,000 companies by market cap in the world between 1950 and 2015. Out of a sample of roughly 50,000 businesses, only 1%, or 502, were able to maintain a five year CAGR of 30-35%. Move this out to ten years and the number drops to 0.6%, or 235 companies. Sustaining high growth rates is possible, but it’s not likely:
Source: Michael Mauboussin, The Base Rate Book, September 26, 2016.
Mauboussin’s research also uncovered two biases common in forecasts: optimism and overconfidence. For example, while half of all businesses fail within five years, surveys of entrepreneurs show that they rate their odds of survival at much higher than 50%. This is excessive optimism. As Mauboussin puts it:
People frequently believe that their preferred outcomes are more likely than is merited.
Overconfidence manifests itself in forecasts as a range of outcomes that’s too narrow. Here’s what that looks like:
The Outside View
When small changes in growth rates can result in large changes in value, overconfidence and overoptimism can cause problems. This is where leveraging the outside view can help. The outside view asks: “What happened to other similar companies in this situation?” It considers a specific forecast in the context of a larger reference class, like the world’s 100 largest companies or Chipotle enthusiasts. Base rates are a form of the outside view.
This is not a common way of thinking. Mauboussin finds that executives and investors tend to rely on their own judgement, the inside view, without taking the outside view into account. The inside view asks: “What’s unique about the situation?” Customers love the product, retention is off the charts, unit economics are spectacular, yadda yadda yadda. These characteristics are important, but so is the broader context. That’s why the best forecasts tend to combine both views:
Source: The Base Rate Book, Michael Mauboussin, September 26, 2016. GQ, Brad Pitt is Still Searching, and Average Joe Success Blog, About Me.
While tech is ascendent today, history suggests that companies don’t dominate indefinitely. Few firms can sustain high growth rates for long periods of time. With markets giddy and a large number of tech companies preparing to go public, revenue growth base rates provide reason for skepticism. A few companies will get very big. Many more will disappoint. There are few phrases more dangerous in finance than “this time is different.”
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