This article was written by Nicholas Mitsakos : Chairman and CEO at Arcadia Capital Group.
“Assume no knowledge” (Socrates)
No successful company can create or sustain its competitive strength without constantly examining its First Principles. It means defining a problem effectively, understanding the actions needed, and then implementing those plans. This requires a unique combination of perspective, talent, drive, and organizational flexibility. It is rare, but when discovered, it is where the most valuable investments are found.
Defining a problem in its most basic form is essential for the most effective solutions. Most thinking stays at a superficial level because not enough thought is given to the problem one is trying to solve. There are many examples of this but mostly it comes from an attitude that says “it can’t be done that way” until, of course, someone does it.
This is the true source of any disruption. It is not simply doing things differently but looking at how the same thing can be done in a more basic and fundamental way. Assumptions about how things work (“assuming knowledge”) impedes innovation. “We’ve always done it that way” is usually the death knell of creative thinking. Many examples exist but some fundamental and obvious examples range from several well-known developments and innovations that were generated more from asking simple, basic questions instead of coming from some ill-defined inspiration.
Obvious answers only come from asking the right questions.
How do we manufacture? Manufacturing was a piecemeal operation until Henry Ford realized that work could be specialized and made extremely efficient via an assembly line. This process existed for many years in the meatpacking plants in Chicago where it seemed obvious that no one person could do all the tasks associated with preparing the final products for consumption. It only became obvious that this applied to many manufacturing processes, especially complex ones such as producing an automobile. This specialization in the assembly line led to a fundamental disruption in the automobile industry but permeated all manufacturing processes from then on.
How do consumers want to consume? What is retail shopping? Amazon looked at “retail” shopping and realized that if one does not make any assumptions about how people consume, the model can be inverted so that instead of having people come to you, you can deliver your products to the people. Many factors converged to provide this opportunity, but a fundamental understanding came initially from asking the question that assumed a certain behavior was not necessarily preventative to this new business model. When Amazon was launched, there was a lot of pushback that said people simply will not consume this way because that is not the way they have ever consumed. Obviously, this assumption about how people behave did not understand the components that enabled a new business model.
How do we write in space? NASA wanted to develop a zero-gravity pen. This is much more complex than it may sound because in zero gravity Inc. does not flow. In 1960s dollars, the pen cost over $1 million to make. The basic question that needed to be asked was not “how do we make a pan?” But how do we make an effective writing implement for zero gravity? The answer seems intuitive and obvious – it’s a pencil! – But obvious answers only come from asking the right questions. This obvious answer would have saved over $1 million.
How much does that battery cost? Tesla, in designing its electric vehicles, was exploring various battery technology. When first presented with cost estimates, the lithium-ion battery packs were going to cost between four dollars and five dollars per pack. This was a meaningful cost because Tesla estimated it would need over 1000 battery packs but in asking some basic questions about the components to these battery packs – the lithium-ion, the anode and cathode componentry in the electrolytes – turns out that all these components could be assembled for less than one dollar per battery pack. This is indicative of the same question that Henry Ford asked: “how do we manufacture?” Tesla decided that it would, in contrast to other car manufacturers, the vertical manufacturer. That is, it would source products keep the design and production of those components internal to the company. This led to specialization and enhanced innovation from a fundamental understanding of each basic process. This contrasts dramatically with the assumed model in the industry which is horizontal manufacturing. That is, there are many suppliers of key components and automobile manufacturers tend to be assemblers more than innovators and designers. Tessa believes this gives it a competitive advantage because it enables them to go to First Principles regarding every component, system, and integrated design for their automobiles. It is the source of their sustainable competitive advantage in the electric vehicle market.
Why do rockets cost so much? Space X looked at the cost of rocketry and realized that over 90% of the cost is the discarded fuselage once a spaceship is launched. The fuel, while combustible, is not that expensive. But the assumed knowledge was that the rocket could not be reused and was therefore discarded. Why? First Principles tell us to ask these kinds of questions – make no assumptions in question every aspect of a cost structure. In this case, Space X realized that if they could reuse each rocket, it would drive the cost of space exploration down by 90%. Once again, a fundamental disruption came from asking some basic questions and pursuing those solutions. Now, space-based communication, scientific research, and many other commercial dimensions that were not otherwise feasible are now potentially cost-effective.
What’s really going on? As much as anything, this is the fundamental question. Specifically, this perspective focuses on the actual factors driving costs and revenues. What assumptions are we making about the way people consume, and how should we modify our business model (think Blockbuster versus Netflix)? Consumers are modifying the way they consume traditional products. Consumption on a more personal experience. People do not want to drive to a store and have a limited choice. They want their choices delivered to them. We are seeing this in all aspects of entertainment, especially film and music (remember CDs? – Not with iTunes and Spotify as options).
While the Netflix and iTunes business models are properly categorized as disruptive, recognize the source of that disruption. It did not come from asking “how can I change the way people behave and consumers purchase?” It came from understanding, at its most basic level, a fundamental knowledge about behavior and the way people want to consume and how products can be manufactured and delivered versus how things are currently structured.
The core factor of every disruption is questioning First Principles.
These changes can be gradual or sudden, but every industry, whether it is recognized or not, is under disruption. Every successful new competitor, whether it was Ford in automobiles, Walmart in mass retailing, Amazon in online retailing, Google in search, Apple with mobile phones, etc. created and is sustaining its position by first assuming no knowledge and then addressing more effectively first principles at work.
First Principles are dynamic, as well. This has been dubbed Creative Destruction for good reason. To sustain a competitive position, companies must be willing to fundamentally change their business model. We have seen the failures, from Blockbuster to Nokia to IBM to others whose names are lost to competitive history, because they could not understand how to modify the business model. Modification means risk and the potential loss of revenue. But, understanding the combination of effective disruption to create competitive strength in a growing market is ultimately how true equity value is created for any company.
Disruption from exploring first Principles is happening to every major industry.
In healthcare, we are seeing dramatic changes through telemedicine, drug prescription services, insurance, and even fundamentally the way doctors practice. A combination of technology that allows for more effective monitoring and personalized medicine is disrupting all the assumptions behind healthcare practice.
Entertainment is seeing on-demand services, fragmentation among different streaming options available, more devices accessing content, and increasing demand for personalized services. Location-based entertainment has become a variety of locations, ranging from the home, and entertainment center, as well as any individual’s pocket. The industry must respond with more fundamental questions about what consumers want and how to deliver that product as effectively as possible versus an existing infrastructure of production and distribution, assumed to be the sustainable model which is now questionable.
Energy is going through a fundamental metamorphosis, forced by a combination of increasing awareness of climate change, the economics of renewable energy, different forms of distribution of that energy – whether it’s localized through home-based solar panels or, as the case in Japan, neighborhood-based from hydrogen. Automobile consumption is now morphing into electric vehicles with charging stations, not gas-powered internal combustion engines with filling stations. There is potentially an anachronistic infrastructure and revenue stream that disrupts every major economy.
The financial industry has been disrupted via technology enabling the disintermediation between consumers and providers of services. Finance and banking have morphed from a local branch to the device in your pocket. Smartphones have now enabled all banking, consumer finance, payment, and consumption transactions to be accomplished with one single device in your hand. This is created a fragmentation of services and then condensation of capital within the major players providing this efficient financial service. Alibaba now has the world’s largest investment fund simply from holding the cash from the users of their AliPay app. Aunt Financial, initially the finance arm to Ali Baba, has very quickly become one of the largest financial institutions in the world. This represents disintermediation between a bank a consumer and a provider of services. The bank is now an infrastructure that provides direct interaction and is no longer an intermediary in providing cash, payment options, and capital.
Artificial Intelligence is, at its best, a tool that enables more effective questioning. Machine learning helps to accumulate incomprehensible data at inconceivable speed and efficiency allows for potentially insightful understandings of industries, consumers, and how they interact. Used effectively, more than anything, it is a tool of First Principles. The possibilities are enormous for potential applications. We are already seeing dramatic impact ranging from the way entertainment products are offered up to consumers via Netflix or Spotify, to complex manufacturing processes simplified and streamlined, to innovative designs and more efficient products using new technologies, ranging from a Boeing jetliner to a Tesla electric vehicle. The true impact of Artificial Intelligence is only beginning to be felt. But it is important to recognize what it is and what it is not. It is not a product in and of itself, as I will later discuss. It is a tool that, when used properly, seeks basic knowledge and understanding and enables the more effective provision of services and product design.