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Market Inefficiencies Are an Investor’s Best Friend

Market Inefficiencies Are an Investor’s Best Friend

There are many different ways to think about which startups to invest in. Some prefer investing in highly disruptive technologies or businesses — like Uber, Tesla or Impossible Foods. Others prefer startups with large or rapidly growing markets. Others like to focus on strong traction or a high level of defensibility. Early Investing co-founder Andy Gordon would argue a good startup investment needs all of these attributes.

A vastly underrated element in investing is identifying market inefficiencies. Market inefficiencies occur when an item or asset isn’t being valued fairly on the open market. It happens more often than you think. 

For 21 years, Apple was a mediocre company. It went public in 1980. And it struggled to stay relevant as a computer company despite having what many considered a better operating system than Windows.

Then in 2001, Apple launched the iPod. And the universe changed. 

The true genius behind the iPod wasn’t the device. iPods were nice. But digital music players, even back then, weren’t revolutionary.

The real secret behind the iPod’s success was Apple’s ability to spot and exploit a market inefficiency.

Prior to Apple’s launch, music consumers were extremely unhappy. Most CDs/albums had only one or two songs that people wanted to listen to. Yet people had to pay for an entire album just to get a couple of hits.

When record companies had to produce albums, cassette tapes or CDs to distribute music, people were willing to pay more for the one or two hit songs they wanted. There wasn’t a good way to distribute individual songs cheaply. So there was value in getting several songs at once. 

But once individual songs could be easily transmitted using the internet, sentiment changed. People wanted a cheap and easy way to buy and store individual songs digitally. But the music industry didn’t want to give it to them. Music executives were afraid of destroying the business model that made them billions.

So music industry executives let Apple destroy their business instead. In 2003, Apple started selling music via iTunes. People could buy songs for just $0.99. And music fans finally had the ability to buy just the songs they wanted — and easily store and access them. 

Apple built a digital empire by exploiting a market inefficiency created by stubborn music executives. The iTunes store built hooks into the wallets of consumers everywhere. People became used to buying digital goods through Apple. So when the iPhone came around, they had no problem buying apps (or buying through apps) using Apple. 

Just as importantly, iTunes helped lock people into the Apple ecosystem. The millions of people who used iTunes to store their music wanted to continue accessing and listening to it on their iPhones. Apple’s iMessage and FaceTime features completed the trap. For many iPhone users, the combination of music, iMessage and FaceTime has them locked into the Apple ecosystem for life.

Netflix took advantage of a market inefficiency to build its brand as well. In the pre-streaming days, people used to rent movies from stores. There were two big problems with that system.

  1. The movies customers wanted to watch were frequently out of stock or not available.
  2. With most rentals — especially popular movies – customers had to return the movie to the store by a certain time (usually within three days). That way, other customers could come in and rent the same movie.

Both issues were massive pain points. But people were willing to live with not getting the movie they wanted to watch. They usually just rented something else. But the late fees were truly frustrating.

Home movie watching doesn’t happen on a set schedule. It often doesn’t happen all at once. It can take a few days to watch a movie. Plus, it was often hard for people to build in the time to fight traffic or drive out of their way to return a movie. So late fees piled up and added so much stress to the process that it became an unpleasant experience.

Netflix changed all of this by mailing DVDs to customers. Customers could reserve DVDs in advance through a watch list. And they could keep DVDs as long as they wanted with no late fees attached.

By the time the streaming revolution was ready to take off, Netflix was a dominant brand in the movie rental business because it had exploited a market inefficiency.

Market inefficiencies exist in the venture capital (VC) space as well. That’s why during a time in which venture funding has hit its lowest levels since 2020 and most VC firms are holding back on investing, two new VC endeavors have launched.

Booz Allen Hamilton has created a $100 million venture arm that will target startups that focus on four key areas — defense, cybersecurity, machine learning and deep technology.

Booz Allen is doing this because it understands that startups with new technology that are fighting for government or defense contracts struggle to get venture funding. It’s a serious market inefficiency. The advanced technology of many of these early stage companies is largely unproven — especially in live environments. The sales cycles for defense and government contracts are uncertain, long and unwieldy. And there are absolutely no guarantees in navigating the government/defense contract process. So despite the incredible potential upside many of these startups have, traditional VCs stay away — at least until later stages. That’s why Booz Hamilton is jumping in early. It knows how to identify winners. And it can mine its own client list for potential investments.  

Christie’s, the London-based auction house, is also jumping into the venture business. It’s funding seed stage companies that will help people buy and sell more art — including NFTs.

The art world is another blind spot for early stage VCs. It has its own set of market forces and values that fall outside the expertise of most VCs. So Christie’s has an opportunity here. Using its deep knowledge in the space, it can identify massive upside potential early on while also de-risking the investment. So instead of just making money off of auctions (and it makes a lot of money), Christie’s can share in the upside of whatever future disruptions or changes might occur. And hopefully it will also prevent an outside force from coming in and taking over the market — like Apple did in the music industry.

As an investor, you need to start thinking like Booz Allen and Christie’s — or Warren Buffett. 

“I’d be a bum on the street with a tin cup if the markets were always efficient,” is one of Buffett’s more famous sayings.

So if you’re seeking big returns, start looking for market inefficiencies. The markets have blind spots. And that’s where you want to invest to make money.

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