Discuss why elephant ears - Heat production is effectively a function of weight - Which scales with volume or to the power of three - But your ability to dissipate heat scales to the power of two, or the surface area of your skin - that means that at a certain size, you will begin to produce too much heat for your surface area to naturally be able to expel. - You would pretty much cook from the inside out. - Elephants evolved their ears for this reason. They are big and flat and basically create an unnatural extension of surface area so that the elephant could grow bigger than what would have been possible otherwise. - Bring it over to investing and businesses - You can think of businesses the same way because in the same way biological organism are a network of cells working in tandem, a business is effectively a network of people working together to achieve some goal. - I’m thinking about the organizational time requirement scales with the number of people required to run all the operations of the business scales like volume. - But the surface area - the sales point to the customer - scales like surface area - For example, lets say you open a restaurant - Your waiters and waitresses are your surface area. They are the point of contact with the customer. - But you can’t run a restaurant with just waiters and waitresses. That would be a pretty awful restaurant. - You also need a kitchen with chefs and cooks, inventory management, scheduling and reservation management, accounting, cleaning, etc. - All that work is your volume. - Now, if you were to add a second restaurant, you would actually probably see efficiency gains. - Your surface area doubles. - Your chef and cook counts double. - Cleaning doubles - But you can probably keep the same number of people running the inventory management and accounting, with little extra work on their part. - You might even see disproportionate savings because you can bulk purchase inventory. - But, as you continue to add more restaurants into the network, your back office can no longer continue to absorb growth for free. - pretty soon your reach the point where you need to hire more back office staff - You need two or three inventory managers, you need multiple distribution managers, regional managers to make sure customer experience is consistent across all locations, etc. - This is okay, because you are still getting economies of scale. And a business can grow pretty large simply off this trend. But at some size the scale stops benefitting you and begins to cause real drag on your ability to deliver a great experience to customers and keep up with competition. - So how are some restaurant businesses able to scale to the national or international level, like McDonalds, or Dominoes, or Chipotle? - Well, they grew elephant ears. - Or, in english, they have a business model that allows for scale with much less coordination drag than would be possible otherwise. - For restaurants, its franchising. - This is a whole different kind of business model where restaurateurs essentially lease the rights to the name, menu, and operations playbook of the restaurant and then take on the management responsibility themselves. - It pushes the scaling problem down the network, closer to the edges and off the balance sheet of the central company. - The central company is thus able to scale far larger than they would have been if they had to actually manage and run each business in the network. - It’s an elephant ear. - And the reason its important is because as long term investors, we want two specific things. - A big market for the business to grow into, and for that business to have the ability to grow into it for as long as possible. - To do that, they need to be able to scale without being dragged down by the complexity and time-suck of central management. - We want to invest in business models that have characteristics that allow them to scale more efficiently than is natural. - We have to ask - “When this business doubles, how much more coordination is required?” The smaller the coordination lift, the bigger the elephant ear. - Examples of elephant ears in the wild - Franchising: coordination offloaded to independent operators - SaaS: the product itself is software, so serving more customers requires little added coordination, a “the product doesn’t need coordination to scale” ear - Decentralized serial acquirers: autonomous units, minimal central integration burden, structurally similar to franchising - Payment networks (Visa, Mastercard): the infrastructure itself scales near-independent of transaction volume, another “product doesn’t need coordination” ear
- How this differs from Buffet moat, or Hemler’s seven powers
- So i think there is quite a bit of overlap in this idea between Buffet’s moat and Hemler’s seven powers.
- But I also think there are some difference that make the elephant ear concept worth considering separately.
- The moat is really about a businesses durability.
- Pricing power, brand loyalty, switching costs, network effect, etc.
- It tries to understand the question “If given $10 billion dollars, and 10 year, could a competitor replicate this business?”
- A moat can exist even in a business that scales badly. To continue with the Buffet analogy, See’s Candies is like that.
- It has a real moat and brand loyalty
- But it scales pretty linearly. It needs labour and retail space to expand.
- A business with elephant ears has a quality, qualities, or a business model that allow it to grow bigger without being crushed by its own internal complexity.
- It’s about how structurally cheap or expensive is growth to the business.
- A business can have an elephant ear without a moat too.
- A narrow use software product for example might scale really well, but have no moat, especially with AI.
- This is why, I think, network businesses are the absolute best.
- The elephant ear is the network which makes them cheap to scale - Visa, Amazon, Booking.com.
- While the scaling of the network is also what increases its durability.
- The moat is really about surface of the business. Its product offering or service
- While the elephant ear is about the inside and how big it can get.
Reference
There Are Mathematical Limits To Growth
Entropy And The Second Law Of Thermodynamics
Truth is less important than trust
Loss Of Institutional Trust Led To A Greater Sense Of Responsibility