How Peter Thiel Finds Billion Dollar Companies
What does Peter Thiel look for in investments and how does he predict which companies will become the next billion dollar company?
Peter Thiel, founder of PayPal and Palantir and early investor in companies like Facebook, Airbnb, Spotify, and SpaceX is without a doubt one of the best investors of all time. But what does he look for in investments and how does he predict which companies will become the next billion dollar company?
Competition Is For Losers
At Stanford, Thiel studied under the philosopher René Girard (who later became a close friend). Girard's "mimetic theory" strongly influenced Thiel as a person and investor.
Simply put, the theory assumes that desire is not a linear process in which people independently want a naturally desirable object. Rather, people see what others have/want and embrace this desire themselves. Desire leads to competition leads to rivalry.
However, this mindset makes you fall into the trap of superficial status games, the classic "buy things we don’t need, with money we don’t have, to impress people we don’t like". And once you’re in this trap it’s very hard to think outside the box and you will be distracted from what is truly important and meaningful.
This leads to one of Thiel's most famous quotes "competition is for losers". Many companies create value, but most are unable to capture the full extent of that value because the industry which they operate in is overcrowded. And trying to outcompete other companies leads to mediocrity.
Companies should avoid competition and aim for differentiation. The more unique a company is, the more it will thrive and according to Thiel, monopoly is the ideal end state for a company. Thiel’s example of this is to compare airlines and Google. Airlines have a much larger market than Google, however Google is valued higher than all American airlines put together and is also more profitable. This is because airlines can’t capture a lot of value due to the high competition in the sector.
Perfect Competition vs Monopoly
According to Thiel, one of the most important business lessons that most people do not understand is that companies operate on a binary scale "Perfect Competition" and "Monopoly", where companies end up in a monopoly state because they created and captured the most value. Shockingly few companies are in the middle of this spectrum.
Companies on both sides of the spectrum want to downplay their true position in the market and build their own narrative. Monopolies want to downplay their monopoly status due to the risk of being regulated. They often say that they operate in a larger market with more competition than they actually do.
Google prefers to say that they are a global tech company because then it seems like they have a relatively small piece of the pie. But if you focus down on what google actually does e.g. Search and Digital Ads, the truth is that they own a very large part of their respective markets.
On the other end of the spectrum, there is high competition and difficulty in long-term profitability. These companies commonly lie about how unique and niche they are in their respective market so that competition seems lower than it really is. Thiel’s typical example of this is someone who wants to start a British restaurant in Palo Alto. They can pitch themselves as the first and only British restaurant in the entire city! However, in reality few people sustain themselves on purely British foods, and even if they did it’s a short drive to other nearby cities.
One must be aware that there are strong incentives for companies on both sides of the spectrum to distort their place in the market. But there are characteristics that distinguish a company that is approaching monopoly status: High gross margins and an extreme accumulation of cash (See FANG companies).
Start Small, Grow Big
What is unintuitive about successful companies is that they often start in an extremely small market, take over that entire market and then expand to other markets. The market is often so small and niche that many believe that the company will never be able to generate any value.
Amazon started as an online bookstore, eBay started as a marketplace for PEZ dispensers, PayPal was started for power sellers on eBay. Facebook started as a small internal website for Harvard students, but thanks to this they were able to go from 0-60% market share in just 10 days.
The mistake many companies make is that they focus on far too large markets way too early. Many cleantech companies focus on disrupting the entire energy market worth trillions of dollars. But this means an extremely high competitive situation where it’s very difficult to differentiate.
The result is that these companies are never able to grab a large market share and reach extraordinary profitability. If market size was correlated with profitability, the restaurant industry would be an incredible market to start a business in. However, we all know that the restaurant business is incredibly difficult to succeed in.
Characteristics of a monopoly are:
Technology that is an order of magnitude better than other companies,
network effects,
economies of scale,
and branding.
These attributes provide a massive delta that allows companies to capture the value that they create.
Last Mover Advantage
A common trope within the business world is "first mover advantage", but the truth is that excellent companies want a "last mover advantage". Monopolies must survive over a long period of time and in order to succeed they almost always have to be the last of their kind. Today, few start-ups aim to build search engines due to Google's dominance resulting in Google being the last iteration of it’s kind (at least for now).
The reason why they need to survive a long period of time is because the value of most of these companies lies far in the future. When Thiel calculated the value of PayPal in 2001, he realized that 75% of the value was in cash flows generated from 2011 and onwards.
Value Creation
Great value creation for society does not necessarily mean that the value can be captured in terms of profitability.
An extreme example is Einstein: Has Einstein contributed more value to society than e.g. Netflix? Probably. However, it’s almost impossible to capture this value in terms of profitability.
In a similar fashion, many companies create incredible value for society - historically, there has been everything from the rail road companies to the disc drive companies - but they do not capture this value due to enormous competition.
In the last 200 years, mainly two types of companies have been able to capture enormous value:
Complex, vertically integrated monopolies with many different parts, which gives a large advantage when everything is interconnected.
Software companies with fast user adoption that allows them to quickly take over markets and minimize competition.
Identifying The Future
According to Thiel there are four ways to think about the future: Either you have a vision of the future or you think it’s a random walk (definite/indefinite) and you also either have an optimistic or a pessimistic view of the future. Thiel looks for entrepreneurs who are “definite optimistic”.
Thiel is looking for entrepreneurs with big visions and a plan for how they can realize this vision. Without a plan, you can’t achieve spectacular success, but this usually requires that you dare underperform in the short term in the belief that you can overperform in the long term.
To find interesting ideas that can become big visions, Thiel believes that one
Either need to look where no one is looking or
Be able to see things that are hidden in plain sight
But to identify this, it is necessary to be a heterodox thinker.
Airbnb had a vision that many thought was madness. Create a marketplace where strangers could stay with other strangers (which then morphed into renting out your entire home to strangers!). But it turned out that there was a huge market for this.
To identify these ideas requires not only heterodox thinking but also obsessive curiosity. Most people only do things that provide guaranteed returns and they only study what is guaranteed to be productive (and preferably in as short a time as possible).
The problem with this is that it leads to a risk avert way of thinking that leads them down conventional paths. Obsessive curiosity will drive you to read or do things that will not necessarily guarantee a return.
However, this is a requirement to be able to reach a deep intellectual exploration of various topics and ideas. Paradoxically, maximizing productivity in learning is limiting if you want to maximize long-term performance.
Obsessive curiosity is a trade-off where you will often go down paths that do not necessarily pay off but from time to time you will realize something transformative and see something others do not see. And that's when you can place big bets with great confidence.
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Original tweet from 29 April 2021: