Amara’s Law: Applying an old adage to new technology

6 minute read

When thinking about investment opportunities in technology, it is easy to become consumed by the fortunes of the FAANGS (Facebook, Apple, Amazon, Netflix, Google) or their Chinese peers such as Baidu, Alibaba and Tencent. However, the opportunities are far broader, both within the tech sector and beyond as consumer preferences and aspirations change.

In the UK, Zoopla operates in real estate; MoneySuperMarket delivers price-comparison services; and On the Beach is a leisure company. The link that binds them is technology and network effects.

Amara’s Law – various forms of which have been around since the early twentieth century – is relevant for investors wanting to capture the benefits of technological change: “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run”.¹

As company valuations are largely driven by investors’ expectations, Amara’s Law means technological innovation in listed companies typically drives the share price too high, too fast, before making it tumble when markets hit the “trough of disillusionment”, as defined in the Gartner hype cycle.² Some companies do not survive, while others go on to prosper over the longer term after weathering the storm.

Amara’s Law in action

As major investors in UK companies, we have seen the effects of Amara’s Law first-hand, and its logic feeds into our analysis of tech-related firms.

In July 2008, real-estate listing firm Zoopla (ZPG Ltd.) was being shunned by the market. Our analysis of the company revealed investors were underestimating ZPG’s brand equity and the strength of its network effects – and therefore its long-term potential. In simple terms, the firm still only has one credible competitor in Rightmove, and few would try and sell a property today without listing it on one or both sites. We were ZPG’s third-largest investor a year ago, when private-equity firm Silver Lake also recognised the potential and took it over.

MoneySuperMarket offers another stark example of Amara’s Law. Its share price precisely followed the Gartner hype cycle: overvalued at time of the firm’s IPO in 2007, the price then fell by 76 per cent, as the company was too concentrated on its Money business line, which was badly impacted by the financial crisis. This highlighted the need for diversification into other areas, which MoneySuperMarket has since done successfully. With consumers becoming ever more comfortable using comparison sites, demand for this service has grown dramatically and looks like it is here to stay.³ The number of competitors has remained static since it floated, and the company has captured a larger share of the growing pie, becoming the UK’s number one provider. Our research, and good fortune, led us to invest near the bottom, and the company’s value has since gone up by 648 per cent.

Figure 1: MoneySuperMarket share price (GBp/pence)

On the other hand, we were caught on the wrong side of the Gartner hype cycle with an investment in Sepura in 2016. The company operated in the promising field of TETRA radio handsets, and owned world-leading technology. Shareholders were misled, not by their own enthusiasm, but by the company management’s inflated expectations. In quick succession, the firm announced plans for a major relocation to bigger premises and acquired Teltronic, a large Spanish peer. Then, seemingly out of nowhere, the company announced a dire warning on revenues and cash. This led to an emergency fundraising, bank covenants were breached, and the share price collapsed. We didn’t see the signs in time to sell our shares before they hit the trough of disillusionment.

Sobering investment experiences provide important lessons. In this instance, we were painfully reminded that overconfident management can be more dangerous than overhyped shareholder expectations. It also taught us to take even greater care when investing early in the life of a new technology, and to recognise where a company is in the hype cycle, so we can make and stake our investment decisions accordingly.

In a similar case, but driven by investor expectations rather than management’s, Vodafone has never fully recovered from the trough of disillusionment. In the late 1990s, investors thought mobile phone companies were invincible and demand would expand forever. They loved seeing Vodafone pursue a global acquisition strategy to become the largest player in the market. The share price shot up over five years but crashed in the early 2000s. Today, Vodafone trades at similar multiples to utility companies and struggles to demonstrate it is more than just a commodity player. A market-leading position in 5G could determine its fate. However, the jury is still out.

Figure 2: Vodafone share price (GBp/pence)

Predicting how successful 5G will be, in both the short and long run, is fraught with danger. One way to hedge for this without shunning telecoms altogether is to find companies that will benefit irrespective of which operators prove to be the winners. For example, Spirent Communications is a global testing firm serving all the major telecoms companies and should be a beneficiary of long-term investments in 5G, which are very early-stage. Being out of the spotlight, less subject to the hype cycle, can be an advantage.

In terms of the second half of Amara’s Law, innovations like artificial intelligence and autonomous cars raise the question of whether we are underestimating their long-run effects. Firms like Blue Prism in the UK and Tesla in the US have seen their share price struggle this year. After a lot of initial hype, investors are now concerned about costs, practical applications and timeframes.⁴ While there will be material winners in the medium to long term, they are difficult to identify.

When Amara’s Law meets The Butterfly Effect

The Butterfly Effect is one reason it is hard to accurately assess the long-term impact of innovation and identify winners and losers early on. In complex systems, a tiny change can have a non-linear impact (i.e. not proportional to its size – it can have none or it can be huge).⁵

The smartphone is a good example. As smartphone adoption grew, it encouraged companies to develop better websites, then mobile-friendly sites, and then apps. All these steps made it increasingly easy for consumers to do everything on their smartphone, creating a snowball effect. Consumption in a variety of sectors – from banking to transport; from media to music – has been transformed beyond recognition.

This, in turn, has multiplied the impact of consumer perception on brands and sales, and nimble companies have adapted. While investing in technology to enhance consumer experience increases short-term costs, in the age of networks this is critical to a company’s long-term competitiveness.

MoneySuperMarket was criticised for how much it spent on its mobile phone app but is now considered among the best-in-class, which should make it more competitive in the long run.⁶ Similarly, EasyJet kept its services, website and app relevant, eventually forcing Ryanair to invest in a comprehensive upgrade of its offering, service levels and digital presence as it played catch up.⁷

Dynamic behaviour and preferences mean that businesses have to second guess which way consumers will turn: they can either stand still and hope their product has duration, or continuously make incremental improvements to keep up or get ahead.

The pace is getting faster

In technology, The Butterfly Effect compounds as the speed of innovation increases.  As a recent Farnam Street blog post stated: “A crowded market actually means more opportunities to create something new than a barren one. Technology is a feedback loop. The creation of something new begets the creation of something even newer and so on.”⁸

Just Eat, for example, was alone in its market from its creation in 2001 to 2013, but with Deliveroo and then Uber Eats coming in, food delivery suddenly became very competitive.

This acceleration presents opportunities and risks for investors. New offerings and competitors constantly crop up and, while it is ultimately healthy for markets and consumers, it can make it harder to identify the long-term winners. Unlisted market players further confuse matters, and investors should not underestimate their importance. For instance, specialist travel retailer On the Beach has a clear privately-listed peer in Love Holidays, of which many investors may not be aware.

Accelerating innovation also means some technologies have limited lifespans. GPS navigation systems are a good example. UK retailer Halfords dedicated large areas of its shops to TomTom devices and other GPS system; yet, once smartphones incorporated the technology, they made dedicated products seem redundant. Halfords has had to adapt, and today offers a range of dashboard cameras and smartphone accessories that completely outnumber satnav products,⁹ but TomTom’s share price, which is now down by 80 per cent from its November 2007 highs, reminds investors they must always be prepared to react to change.

Knowledge is power… to an extent

Traditionally, equity investment decisions are made on expectations of future earnings, but this is more difficult with emerging technologies. Conducting a discounted cashflow analysis on Severn Water is certainly more straightforward than forecasting the price of Bitcoin in the medium term. The digital currency peaked at £14,700 in December 2017, fell to £2,600 a year later and is now trading at £8,332.¹⁰ Could it be the future currency of default on the internet, now on the “slope of enlightenment” in the hype cycle? If so, the market is still vastly underestimating its value, but it might also never amount to anything – making it impossible to model.

On the other hand, a company like Oxford Metrics,¹¹ and particularly its Vicon division which specialises in motion measurement analysis, could be an example of the stock market underestimating the longer-term opportunity. While its turnover is tiny, at around £24m, Vicon technology has multiple potential applications and is used by organisations ranging from universities to hospitals, NASA and blue-chip companies such as Dyson and General Motors.¹² As things stand, there looks to be less uncertainty in its evolution than for cryptocurrencies.

Even though investing in technology can be done early in the life of a new concept, it remains a high risk/high reward endeavour. Investors must be clear on their expectations and understand where a company is in its life cycle, identify barriers to entry and assess what the market expects in terms of future growth. Assessing companies through the lens of Amara’s Law, as well as a combination of skill and luck on the timing of an investment, can lead to tremendous long-term opportunities.

References

1. Amara’s Law, Matt Ridley Online Blog, 12 November 2017
2. Gartner Hype Cycle, Gartner website, as of September 2019
3. Moneysupermarket Group annual report 2018: 12.9m active users in 2018
4. ‘Investor concerns for Tesla’s stock could start weighing on its business, analyst warns,’ MarketWatch, 9 April 2019
5. ‘The Butterfly Effect: Everything You Need to Know About This Powerful Mental Model,’ Farnam Street, August 2017
6. ‘Moneysupermarket so low on growth,’ The Times, 23 February 2018
7. ‘Ryanair wants its customers to be happy!,’ Flight-Delayed.co.uk, 14 March 2019
8. ‘Gates’ Law: How Progress Compounds and Why It Matters,’ Farnam Street, May 2019
9. Halfords website, as of September 2019
10. Coinbase, Inc. data as of 12 September 2019
11. Oxford Metrics
12. Vicon website, as of September 2019