August 11, 1998
TMF Interview With Tom Kippola, Part 1
Fool: Brian Arthur's concepts of path dependence, lock-in, network effects, and the law of increasing returns obviously have influenced the work of you and your co-authors. And Microsoft is clearly a key example for you and Arthur, with its mega-gorilla status following from its ability to leverage its monopoly in operating systems into new areas.
What I find interesting is that while you and your co-authors essentially celebrate Microsoft, Arthur has said he believes the software giant has crossed the line into unfair competition. In fact, Joel Klein at the Justice Department is said to have been influenced by Arthur's work. What are your thoughts about the Microsoft case, and assuming the government could actually win some ground, what impact could it have on gorilla game investing?
Kippola: There are a number of questions there. As far as celebrating Microsoft, I'm not sure if the word celebrating accurately depicts what we're trying to do in Gorilla Game. What we have done is laid out how high-tech companies are able to gain control of market places and how that manifests itself into the valuation of a particular company, and Microsoft is the best example of that. There are lots of things that Microsoft has done that are not illegal and have allowed Microsoft to gain significant power in the marketplace. There are some things that Microsoft has done that are under question as to whether they are legal or illegal. And you know, we'll wait and see what the courts say about that.
There are a lot of allegations that Microsoft has asked companies to accept the browser along with the operating system or risk not getting any of it or not getting favorable terms from Microsoft. Clearly, things like that will probably be ruled illegal going forward.
I think there's one other point to make here. We're now dealing with the computer industry and some other industries where we've not seen the law of increasing returns work before. We haven't see it work in traditional industrial industries, and I think what's happening is that in some cases, the marketplace and politicians are looking at these companies and automatically assuming that they did something illegal because of the kinds of profits that they're throwing off when, in fact, that may not necessarily be the case. It may just be the case that the rules of the game and the ways the markets play out in high tech are just different and give some high-tech companies competitive advantages that we haven't seen in other industries. So I'm not sure that we're celebrating Microsoft so much as we're explaining what happens in high tech, and Microsoft is probably the best example of this new kind of competitive advantage. You asked a couple of other questions.
Fool: I guess the real question here is, at least in the book, you don't address the possibility that some of Microsoft's competitive advantage -- say regarding the browser wars -- might be derived from illegal activity. One could make the argument, for example, that in the battle with Netscape (Nasdaq: NSCP), Microsoft illegally leveraged its monopoly in the market for operating systems to completely change the competitive landscape. The question is, if the government can prove its case, would that have any significant effect on gorilla game investing?
Kippola: I think first of all, the answer to the question is yes. But the impact remains to be seen because it depends on the ruling from the Justice Department. If the Justice Department comes back and says, "Microsoft, you have to split into 50 different entities," then that's going to be very different than if the Justice Department comes back and just slaps them on the wrist like they've done previously.
Quite frankly, if they take something in between where they say, "Okay, we're going to break you up into an operating system company, a languages company, an applications company, a content company" so that there's going to be four or five companies, I think the game still works beautifully. In fact, I want to invest in the NT and SQL server company because that company is where a lot of Microsoft's profits are going to be generated in the next four or five years.
Fool: Interesting. To shift gears, I think maybe the main topic not addressed in the book, or at least an issue that's downplayed, is the valuation issue. It seems to me that you're saying that a company's stock price is tied to the economic value added (EVA), which is tied to competitive advantage. But as a practical matter, you're kind of ignoring nitty gritty valuation questions. It seems like you're really just focused on locating possible gorilla markets or gorilla candidates. So I'm wondering, is there a kind of gnostic gorilla game teaching for serious investors where you do tie EVA and return on invested capital (ROIC) into the equation?
Kippola: I personally look at valuation. But number one, I'm going to split the world into the kind of companies we talk about in Gorilla Game versus a lot of what we can just call "Internet companies." And into that group I'm throwing a lot of content companies, search engines, Amazon.com, etc. Those companies are not gorilla game companies. They don't follow the rules of the game at all. They're not about proprietary architecture and high-switching costs; they're about brand. So I want to separate those from classic hardware, software, and networking companies. And if you look at hardware, software, and networking company spaces over the last 20 years, the valuations will have some large correlation to where they are on the [Technology Adoption] Life Cycle. So, for example, if you're buying in at the bowling alley, the companies are going to have a much lower valuation than they do inside the tornado.
So what we're trying to do is provide a framework for investors who don't know anything about valuation and aren't going to be able to figure out how to use valuation to make their investment decisions to buy into [a basket of] stocks that are likely going to go up regardless of what price they bought them at. That's because the history of looking at these kinds of spaces suggests that when you buy into two or three gorilla candidates and you buy in at the right time -- that is, before the tornado -- and you ride them through the tornado, the gorilla is going to enjoy such huge appreciation in its valuation that it's going to be able to overcome any depreciation of the candidates that end up as chimps.
Fool: But it seems like you're just assuming that the gorilla will always be undervalued. Yet the market is always correcting inefficiencies, and one could argue that by writing the book, you've essentially pointed out an inefficiency that might now be corrected out of existence. How do you determine when a Microsoft or an SAP (NYSE: SAP) or a Vantive really is just too expensive, even for a gorilla or potential gorilla?
Kippola: Well, I think that's the million dollar question that really everybody is trying to figure out. I don't know if anybody has that answer. I've always maintained that things like price-to-earnings ratios are nonsensical for investing in early high-tech stocks. To start getting into all those metrics and ratios is useless. I think a lot of people get tied up in not buying stocks because the P/E ratio is too high. People who do that would never have bought Microsoft or Cisco or SAP or a lot of the other companies that we talk about.
I use valuation when I compare a space like the CIS [Customer Interaction Software] space (Vantive, Siebel, Clarify, etc.) to another cousin space that's gone through the life cycle before, like the ERP [Enterprise Resource Planning] vendors. I start looking at the valuation of the ERP vendors, PeopleSoft at $10 billion, SAP at $25 billion. And you ask yourself, the CIS space, where is it in the Life Cycle? How much opportunity is there in the CIS space, and are these companies going to have advantages that are going to allow them to overcome the ERP vendors incursions into the space. And if they're trading at valuations of $300 million for Vantive and $1.7 billion for Siebel, is that going to allow these companies enough running room to get up into multi-billion dollar valuations. So that's how I personally use valuation, but again, it just translates back into the Technology Adoption Life Cycle. Even if I wasn't looking at valuation at all and I said the CIS is in the bowling alley and the ERP space is in the tornado, the model still holds.
Fool: So do you look at things like return on invested capital?
Kippola: No. Never.