The Increasing Returns Framework

In the past few years, we've seen an incredible amount of Schumpeterian creative destruction. We've seen the rise of Google, Apple, Facebook, Amazon, and the fall of almost everyone competing with them, including Dell, Hewlett-Packard, Microsoft, RIM, Motorola, Nokia, etc. We've seen Amazon destroy brick-and-mortar retailers (Barnes & Noble, Borders, Gamestop, Best Buy). Those operating under the false ideology of mean reversion in the technology sector will continue to be destroyed. Horace's quote, "Many shall be restored that are now fallen; and many shall fall that are now in honour,"  only applies under economic framework that does not apply to the new economy and its constituents.

The "Increasing Returns" framework is based on a paper written in 1996 by W. Brian Arthur in the Harvard Business Review called "Increasing Returns and the New World of Business." Arthur divided the business world into two distinct buckets: 1) The Marshallian theory of diminishing returns and perfect competition and 2) The theory of increasing returns. The former can be characterized by mean reversion, negative feedback, equilibrium. The latter is dominated by positive feedback and instability. Using Soros' Theory of Reflexivity as a guide, we could also similarly divide these two categories into non-reflexive, near-equilibrium conditions and reflexive, far-from-equilibrium conditions. 

The world of diminishing returns includes commodity-type business and manufacturing. The increasing returns world is the current world of technology and information-processing, i.e. the knowledge economy. In this world, if a system/product gets ahead, it will get further and further ahead, and if it loses, it will continue to lose. Arthur outlines the properties of increasing returns: market instability, multiple potential outcomes, unpredictability, the ability to lock in a market, the possible predominance of an inferior product, and fat profits for the winner. It is a winner-take-all (most) market, which is why we've seen the rise of the "Big 4" (AAPL, GOOG, AMZN, FB) to the detriment of anyone competing with them. 

Keeping in mind the principle of ever-changing cycles, going long increasing returns businesses and short everyone else has worked and most of the losers of this game are terminal shorts. The problem is that, by now, most of the losers have been snuffed out or have high short interest. But this framework will continue to apply and there will be more opportunities.

Here's a copy of the paper.