The Nature of Value

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Chapter Goals
Focus : Contrast : Context
Introduction: Problem: Solution: Call for action
State question: formalize: propose solution: suggest actions

Chapter
4. Narrative
story with
historical
examples
3. Simple
Graphic
showing
behavior &
relationships
2. Easy to
remember
name tied to
behavior
1. System
links
(ecological &
value)
thinking
5.
Application
Sanity check for each Chapter

The Nature of Value is
The Economy of Life

$0
$25
$50
$75
$100
$125
$150
$175
Today 50% inflation
Excess customer value
Corporate profit
Cost of production
Moat cost
A.
B.
C.
Perceived value
Price
Cost (total)
A.
B.
C.
Inflation resistant moat working for 10 years

Inflation resistant moat
Today +10 yrs
Customer Perceived value $110.00 $165.00
Price $100.00 $150.00
Excess value to customer $10.00 $15.00
Cost of production $45.00 $67.50
Moat cost $45.00 $45.00
Total cost of production $90.00 $112.50
income $10.00 $37.50
Corporate value @ 10x profit $100.00 $375.00

http://www.ggdc.net/Maddison/ARTICLES/Causal_influences.pdf
Annual average compound growth rates
Source data: Angus Maddison

Ino for
distribution
strategy
Increased
inventory
turnover
Lower cost
shelf
prices
Genes & Inos are survival knowledge
enabling their own replication capabilities
Gene for
muscle protein
structure
Increased
leg muscle
mass
Faster
Antelope

Early cluster adopters value
shrinks as competitors adopt ino
Value($’s)
Adoption cycles
Early opportunistic
Entrepreneurial
Mature competitor
Endemic
Customers
Ino Vendor(s)
Cluster

Expressed Ino capabilities create &
discover economic possibility spaces
Successful value creation
Value destroying ino
Vector length/magnitude represents reproductive success

10 Types of innovation capability
Busines
s model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience
Unique capabilities help competitive outcomes

Innovation iceberg
Product offering
Business
model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience

Categories of life capabilities
Homeostasis
Organization
Metabolism
Growth
Adaptation
Response
to stimuli
Reproduction

Taxonomy of chairs

Aircraft taxonomy: adaptive radiation
of value capturing knowledge

Walmart’s unique innovation led
capability footprint 1970-80’s
Business
model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience
Unique Value creating capability

Life’s iterative organizing
cycles
Adaptive
Information
Expression
& form
Selection in
Competitive
Context

Moore’s law capability over time & technologies
semi-logarithmic plot
1010
108
106
104
102
1
10-2
10-4
10-6
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990
2000
Electrochemical Relay Vacuum Transistor Integrated Circuit
Tube
Calculationspersecondper$1,000
YearSource: Based on Ray Kurzweil’s Fifth paradigm chart

Value’s iterative growth cycles
Ino:
Adaptive
Information
Capabilities:
Expression &
Form
Selection in
Competitive
Context
Business plan
Employee list
Recipes
Supplier list
Lemonade $1.00
$
$$
$
$
$$
$
$
$$
$

Value flows through the economy’s network
growing & spreading evolution’s knowledge
1. Ino
2. Organization
3. Cluster
Value: growth
decay
Business
model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience
Business plan
Employee list
Recipes
Supplier lists
Designs
Tacit skills
Strategies
4. Economy

Growth in value flow vs.
Value capture
0 +
Growth(revenueflow)
+
0
_
1. Lottery ticket
4. Cigar butt
Value capture (ROIC)
3. Death spiral
2. Lollapalooza

Compounding virtuous positive
feedback cycles grow flows
Increasing
capability &
advantage
Increasing
value creation &
flow
Increasing
capability
& advantage
Increasing
metabolizing
biomass
Increasing species’ flow
capability
Increasing organization
value flow capacity
Ecology Economy

Virtuous cycle of
selective feedback
Antelope
Cheetah
Life’s capabilities improve
1. Input
(Knowledge &
expressed form)
2. Computation
(knowledge
transformation by
selection)
3. Output
(selected &
replicated
knowledge)
Macro-processing
generates knowledge
across domains

Inos expressed as an organization
Lemonade $1.00
Recipe
•1 gallon water
•1 cup sugar
•5 lemons
B-Plan
•Build stand
•Buy Ingredients
•Mix lemonade
•…..
Resources
•Bobby & Susie
•$5 start capital
•Cups & pitcher
•Wood & sign

Traders consume predictable low
entropy patterns arbitraging them
away leaving increased price entropy
Low Entropy = Predictable path straight line market
High entropy = Unpredictable random white noise market
4%
0%
-4%
Time

12%
10%
8%
4%
0%
Index
Nature
of
Value
Long-termreturns
Portfolio concentration
Missed hits
Too hot to hold
rebalanced away
Tax & transaction
costs
Know nothing
hold all the shares
Know something
hold a few shares
Typical
portfolio
Know nothing index returns beat
concentrated ignorance

20 years of compounding effects

A “hits” index returns 8% per year
when 1 out of 100 firms returns 800%
$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
$9.00

Year 1 Year 2 Year 3
+800%
+0%
Predicting the location of next years+800%
hit company is nearly impossible*
*The 3 Fama-French factors are an exception to the random distribution of returns

0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
Australia
Belgium
Canada
Denmark
Finland
France
Germany
Ireland
Italy
Japan
Netherlands
NewZealand
Norway
SouthAfrica
Spain
Sweden
Switzerland
UnitedKingdom
UnitedStates
1900-2011 Real Equity Index
Returns
Source: Credit Suisse Global Investment Returns Yearbook 2012, Elroy Dimson, Paul Marsh and Mike Staunton

Inos expressed in an organization
Knowledge
Capabilities
Lemonade stand business
Product performance
(refreshing drink)
ice-cooled
Fresh
squeezed
Marketing
(perceived as
local
business)
Hand made
signs
Business
model
(retail)
Store front
cash business
Channel(direct
distribution)
Sold from the
front lawn

Iron law of economic survival
Cost Price
Value
Raw
materials &
production
Goods sold Perception of
consumer

Complex Adaptive System Elements
10102020203
Oiu-riewer-
ljksfd
32290-afoufd-
oiuqoiurqeou

Unique competitive capabilities define
organizational morphology (shape & behavior)
Busines
s model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience

2003-2012 Apple’s unique
capability footprint
Business
model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience

GM 2012 unique
capability footprint
Business
model Networking
Enabling
process
Core
Process
Product
Performance
Product
System
Service
Channel
Brand
Customer
Experience

Basic Avalanche model

Innovation constantly trickles in

High Tension (instability)

Vulnerable component

Innovation diffusion cascades
through economic network links
Ino adopting
Organization
Supply Chain or
cluster

Innovation cascades

Power law: innovation
cascade
System & component
behavior1,000
100
10
1
1 10 100 1,000
Cycles between events
Magnitudeofchange

Input Process Output
System
Inputs
• Capital
• Management
• Team &
resources
Process
• Moat
• Competitive
cluster
Output
• Return on
capital

Increasing knowledge bifurcates into
new forms increasing value flow
Over time material & energy flows grow
Product&service
Variation/Adaptation
Replicating system
Dead system

Adaptation rates
TimeTime
Steady Linear increase in variety Log normal shifts in variety
Gradualism
Punctuated
Equilibrium
Process Efficiency & System complexity increase over time

Ontology of CA probabilities &
selective forces
• Bit information probability
• Gene phenotipic probability
• Ino value probability

Trial/Error
Variation/Selection
Bifurcation/Convergence
Radiation/Consolidation
Innovation/Consumption
Complex Adaptation & System Feedback
Variety
Time

Ino: a unit of economic probability
−∞ +∞
Net Economic Impact
(efficiency/throughput)
#ofInos(Logscale)

All Some None
Competitors using &
expressing an ino
#ofInos(Logscale)
Ino trait survivorship among
economic participants

Experience curve: unit cost
declines at each production
doubling
$0
$25
$50
$75
$100
1 2x 4x 8x 16x
UnitPrice
Total cluster/organization unit/cycles production

Evolution explores possibility spaces
inside network clusters & edges
Humans
Human
Guts
New Bacterium
possibility space
Cars
Headlights
New type of light
possibility space

Clusters adapt & emerge externally or
internally from existing clusters
Cell-phone
Cell
phone
games
House
Mortgage
insurance
Mortgage
External cluster birth Internal cluster birth
Cellphone
Operating
System

Purchase cycles/key Capability (value) cycles
P/C=Adaptive factor
Key Innovation cycles/T
Purchasecycles/T
Difficult
Difficult
Deadly
<0.5
Desired
>5.0

Cluster traits stable v. unstable
Trait Stable Unstable
Key innovation cycle Long/ minimal change Short/large change
Customer cycle Recurring/long Volatile/short
Strategies displayed Stable Volatile
Market share Stable Volatile
Cluster competitors Known familiar Volatile new entrants
Operating margins Stable Volatile
Cash flow Stable Volatile
Value creating
process
Stable Volatile
Capital or Value at
Risk
Normal Extremely high

The Cluster impacts of inos
None Some
All
Competitors expressing an ino
EconomicImpact
(efficiency/throughput)
+∞
−∞
Growth Red
Queen
Cluster
collapse
Competitor
consolidation
Ino occurrence: Rare Common

1. Cluster Shock
• First Innovator receives margin
or share benefits
2. Cluster adoption wave
• Follow on firms adopt
innovation
3. Innovation normalized
• Margins revert & stabilize
Innovation flows through clusters
Value passing to
cluster customers
Excess margins to
cluster participants

Read more:
http://www.businessinsider.com/the-collapse-
of-best-buy-in-two-simple-charts-2011-
12?utm_source=feedburner&utm_medium=fe
ed&utm_campaign=Feed%3A+clusterstock+%2
8ClusterStock%29#ixzz1giGD7LWB

Clusters: defined by customer
choice set
Customer
Viable
Product
offering
Product
offering Product
offering
Product
offering
Viable
Product
offering
Product
offering
Viable
Product
offering

Schelling beach & flavor solution spaces
Vendor/offering
Customers/cost or preference
Fred-Sue
Sweeter
More Sour
Physical location preference space
Taste preference space
Fred-Sue

Long-term combined inter and intra
cluster growth is more powerful
+7.5% SSS
growth (intra -
cluster)
+7.5% # of stores
growth (inter cluster)

$0.00
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
$9.00
1 3 5 7 9 11 13 15
15.0% v. 7.5% growth
compounded for 15
years
15.0%
7.50%

Competitive Cluster
(Economic Niche)
• Carrying capacity:
measured in $s
• Stability: measures
competitor flux
• Maturity: carrying
capacity fullness

Customer’s & competitor’s pressure
squeeze cluster profit margins
cost
unique capability (value add)
excess value capture (profit)
price to consumer (revenue)
high margins
low margins

Cluster growth & maturation
empty early growth mature

Early stage cluster:
close & distant strategies
open field fast followers
Wal-mart in 1970’s Search engines 1999
(pre-Google)

Selection forces dominant
design & capability convergence
Evolution discovers a radical new dominant design
Surviving organizations converge on the dominant design
Most organizations fail to adapt & express the dominant design
Productandservice
Phenotypicvariance
Time (ino & product cycles)

Organizations are defined by valued
goods and services they deliver
Busines
s model Networking
Enablin
g
process
Core
Process
Product
Performanc
e
Product
System
Service
Channe
l
Brand
Customer
Experience
Value delivery enabling
capability categories
The structure of unique value
creation capabilities determines
firm survival

Elements, capabilities & impacts found
in value delivering organizations
Cost of goods
Revenue from sales
Unique value delivery capability

Unique value adding
capabilities improve margins
and ROIC
No unique value
adding capabilities
leads to lower
margins
Many unique value
adding capabilities
create higher
margins
Cost of goods
Revenue from sales
Unique value adding capability

Moats shrink margin pressure from
cost, competitors & customers
Unique value creation
capability expands margins
Competitor moats
reduce customer choice
sets
Efficiency moats
shrink cost of goods
Boundary of addressable revenues
Pricing power expands grey margins space
Cost of goods
1. 2.
3.

Moats reduce cost, competitor & customer
pressures allowing margins to expand
Consumer choice pressure defines maximum price and viable market size
Competitor pressure determines marginal value delivered to the customer

Efficiency moats deliver value cheaply
Consumer pressure limits maximum unit price & total viable market size
Competitor boundary pressure forces value delivery to the customer
Cost factor
• Network effects
• Scale effects
• Experience curves

Consumer pressure limits maximum unit price & viable market size
Cost factor
• Physical &
geographic factors
• Patents, licenses &
regulations
Moats reduce customer choice &
competitive margin pressure

Consumer behavior moats
Consumer pressure limits maximum unit price & viable market size
Cost factor
• Brands, behaviors &
social perceptions
• Sunk switching cost
• Mental switching costs

Moat forces alter
consumers & competitors
1. 2.
3. 4.
Consumeralteringforce
BeliefCost
Behavior/capability Cost
Competitor altering force

MV=P environmental stability
fosters economic growth
-30% 0%
30%
Money (flow/growth)
Value(flow/growth)
Optimal GDP
Growth Zone
Depression
Failing monetary
stimulus
Price stability
High
Low
Price (CPI)
+15
%
0%
-30%
Price
Hyper inflation
spiral
Boom

Moat to own based on MV=P
location relative to attractor basin
-30% 0%
30%
Money (flow/growth)
Value(flow/growth)
Optimal GDP
Growth Zone
4. Equities based
1. Real assets
Price stability
high
low
Price (CPI)
+15
%
0%
-30%
Price
3. Debt based
2. Cash based

Berkshire Hathaway’s
business categories & the
moat to own
-30% 0% 30%
Money (flow/growth)
Value(flow/growth)
Optimal GDP
Growth Zone
4. Equities based:
Manufacturing, servic
es & retailing
1. Real assets:
Utilities & regulated
capital intensive
businesses
+15
%
0%
-30%
Price
3. Debt based:
Banking & finance
2. Cash based:
Insurance/cash
Price stability
high
low
Price (CPI)

Inflation strains profits as costs
exceed consumer value demand
Input cost
Inflation
Demand for
delivered
Value
Profit
Loss
$0

Extreme environment pendulum shifts
lead to tension or system failure
Long-term resilient
operating capacity
Brittleness
leading to
susceptibility of
minor shock
failure
Competitive
softness
leading to
failure
Valuedeliveryefficiency
0%
25%
50%
75%
100
%
Operating network flow efficiency: energy, material, money
Minimal Low Normal High
Extreme
Functional vitality
Dead
High
Sloth risk
Greed risk

Average organizational lifecycle
on the S&P 500 is accelerating
70
60
50
40
30
20
10
0
1960 1970 1980 1990 2000
2010
7 year rolling average of the average lifespan
Data: Innosight/Richard N. Foster/Standard & Poor’s

Viable value creating firm
Selection & adaptation process in economic &
ecological network domains
Failed maladapted economic firm
Viable biological form
Failed life form
Economic dominant design &
required capability set
Evolutionary bifurcation into
multiple clusters/niches
Economic forms using inos adapt faster than life forms using genes

Herman Daly insert into chapter 8 from ecological economics Herman E. Daly
& Joshua Farley, 2004
Cycling from ends to means (value) creates, relics, information and
embedded information and entropy.
Ultimate end
(final cause, God, ??)
Intermediate ends
(health, safety, comfort)
Intermediate
Means
(artifacts)
Ultimate means
(material cause, low-
entropy, matter-energy)
Religion, Philosoph
y
Ethics
Economics, politics
Technics
Physics

for chapter 8 Erwin Schrodinger
• Life is a system in steady-state thermodynamic
disequilibrium that maintains its constant
distance from equilibrium (death) by feeding on
low-entropy inputs. E. Shrodinger, What is Life?
Cambridge, England: Cambridge University Press
1944.
Economics is system in steady-state value
disequilibrium that maintains its constant distance
from equilibrium (death/stasis) by feeding on low-
entropy inputs and innovations.

Chapter 7 on Hyperinflation
• Hyperinflation occurs when money fails in 2 of
its 3 functions. (store of value, and medium of
exchange) It is often measured as 50%/month
inflation.

Evolution’s energy dissipation structures evolve into increasing Φ(m) capacity
structures ascending across the panarchy.
Wasp wing F-16
wing
Algorithmic fluid
mechanical model
Airflow related dissipative structures as
expressed across network domains
Volcanic
smoke
Geology Ecology Economy Symbology

Firms in U.S. television industry
1950 55 60 65 70 75 80
85
Numberoffirms
100
75
50
25
Stylized from source data: James M. Utterback, “Innovation and Industrial Evolution in Manufacturing
Industries,” in Bruce Guile and Harvey Brooks, eds., reprinted with permission from Technology and
global Industry (Washington, D.C.:National Academy Press, Copyright 1987), based on data from R.
Fabris, “Product Innovation in the Automobile Industry,” Ph.D. Diss., University of Michigan, 1966.

Birth & death of competing
U.S. auto manufacturers
1900 1920 1940 1960
Numberoffirms
75
65
55
45
35
25
15
5
Stylized from source data: James M. Utterback, “Innovation and Industrial Evolution in Manufacturing
Industries,” in Bruce Guile and Harvey Brooks, eds., reprinted with permission from Technology and
global Industry (Washington, D.C.:National Academy Press, Copyright 1987), based on data from R.
Fabris, “Product Innovation in the Automobile Industry,” Ph.D. Diss., University of Michigan, 1966.

Cluster stability v. lifecycle
stage
StableUn-stable
Growing Maturing
1. Lollapalooza
3. Lottery
2. Cash Cow
4. Red Queen
no / low barriers to competitive entry
high barriers to competitive entry
Strategy&capabilitystability
Cluster life cycle stage

Number of competitors during
dominant design convergence
Product/capability cycles over time
Competitors
1. 2.
3.
100
75
50
25
0
1 2 3
4 5
Innovation radiation explosion of variety in offerings
Dominant design emergence
Expressed economic capability and design convergence
1.
2.
3.

Cluster supply chain outcomes:
Competition v. corruption’s impact
$ cost/unit of value=7.6x
$100
Corruption extracts value as each clusters throughput
Competition delivers value as each clusters throughput
$125 $156 $195 $244
25% corruption impact/cluster
$100 $75 $56 $42 $32
25% competition impact/cluster

Ino
Organization
Cluster
Economy
Complexity
EffectiveStability

Ino the unit of Innovation
• Innovation is a physical unit of uncertainty
• Works similar to an avalanche model
• Power law impacts
• Can be positive or negative for individual firm
• Sustained innovation delivers benefit to
consumer

Socio-
cultural
Political/lega
l
InnovationCompetitive
cluster
Environment
(physical)
SPICE environmental factors determine
limits to economic value flows
Economy (network of competing clusters & value flows)
The Nature of Value website is licensed under a Creative Commons Attribution-ShareAlike 4.0
International License. Based on a work at http://thenatureofvalue.com.

Cluster Value at Risk
Ease of competitor entry
RateofInnovation
10X
Risk

Data sources: Bureau of Economic Analysis & Bureau of Labor Statistics

A century of railroad
convergence
http://nicolasrapp.com/wp-content/uploads/2011/09/RAIL_MAP.gif

Cluster Categories
Growth: Convergence: Maturity
StableUn-stable
Snowball Cash Cow
Lottery Red Queen
Risk: low
high

Firms with many unique capabilities in slow
cycle clusters may live to create value
longer
Offering & capability cycles
Coke / IBM
Blockbuster
1 5 20 50 ?
Growthrate
60%
50%
40%
30%
20%
10%
0%

Stable v Unstable Cluster Market Share with
multiple competitors over time
ClusterShare
Years (Product cycles)
A
B
C
Mature stable cluster
ClusterShare
A
B
C
Unstable cluster
D
Years (Product cycles)
0%
100%
0%
100%

Evolution’s maturation path
Organism,Ecosystem,and
EvolutionaryCharacteristics
Stage
Early successional Late successional (climax)
Unbounded expansive bounded - constrained
"stressed” "unstressed"
Juvenile Adult
Selection
Rapid Growth, R selection Slow Growth, K selection
Growth Development
High fecundity Low fecundity
Short Life span Long Life span
Broad niche Narrow niche
Cycles Simple Complex
Rapid Slow
Open cycles (leaky cycles) Closed cycles (recycling)
Few cycles Many cycles
Network with loose network
articulation
Networks with highly articulated
networks
Thermodynamics&
energetics
Closer to Thermodynamic Equilibrium
Farther from Thermodynamic
Equilibrium
Lower free energy and exergy Higher free energy and exergy
Shorter energy residence time Longer energy residence time
Small size Large size
Skewed negative size distribution Unimodal size distribution
Simple structures w/ few hierarchical
levels
Complex structures w/ many hierarchical
levels (more parts)
Less complex, less diversity More complex, higher diversity
Lower average mutual information Higher average mutual information
Lower systems efficiency Higher System Efficiency

60%
40%
20%
0%
60%
40%
20%
0%
Fad business v. stable moat
Depth
ROC&RevenueGrowth
Duration (Years)
1 5 10 20 30 40
Technology / fad business
Duration (Years)
1 5 10 20 30 40
Moated business (cash cow)
Moat effectiveness ROC over time
Revenue growth
Depth
ROC&RevenueGrowth

Lollapaloozas combine unit
growth & high margin moat
Moat effectiveness ROIC over time
Revenue growth
Duration (Years)
1 5 10 15 20
30%
20%
10%
0%
ROIC&RevenueGrowth

Shrinking unit selling price over adaptive
capability cycles shrinks competitor
numbers
$0
$25
$50
$75
$100
16 8 4 2 1
Unitprice(survivalfactor)
Cluster firm carrying capacity over time/cycles*
*assumes a simple fixed unit cluster demand

Depth(%margin)
Duration (estimated years)
AddressableROC
Participants & Strategy mix
Measuring cluster & moat quality
Stability
60%
40%
20%
0%
45%
30%
15%
0%
0 10 20 30 40 50

Unique inos & capabilities create
excess margin for a finite time
Time in years or product cycles
Extra%ROC
Extra margin capture trajectory
Extra value captured over time

Price reflects future margin &
earning’s expectations
Time in years or product cycles
Extra%ROC
Price reflecting predicted excess margin capture (yield)
1.
2.
3.
1. Overly optimistic early stage lottery ticket pricing
2. Accurate pricing for future yield
3. Underpriced asset

Automobile dominant design selected &
adapted more functionality & complexity
Steam engine
Combustion engine
Doors & Fenders
Glass window enclosure
Seat belts and airbags
Superfluous luxury capability zone
Substandard product capability zone
Structural&functionalcomplexity
Evolution’s adaptive selective cycles over time

Lemonade stand
$150
Assets
$50
Liabilities
$100
Equity
(Book value)
Produces $40
FCF
Balance Sheet

$100
Book
value
$150
Assets
$50
Liabilities
$100
Equity
(Book value)
$200
Intrinsic
value
$100
Moat value
$100
Moat
value
$40 ongoing
Free Cash Flow

$0 $100
Price
Price is created by opinions of value
Value
BearBull

Most people confuse me
with price because I am
invisible and uncertain.
$0 $∞
Moat factors*
Cluster dynamics*
Forces pushing the invisible intrinsic
value Goose
Management
capital allocation*
*explained in the The Nature of Value: How to invest in the adaptive economy
Intrinsic
Value

$0 $100
Traders and
opinions
News & noise
Quarterly earnings
Price
Forces pushing price & value
Cluster
Competition
Customer demand
& moat
The Nature of Value by Nick Gogerty

$0 $100
Old
Price
Your brother in-law’s “money maker”
Current
Price
“Is it really a winner?”
Intrinsic
Value

$0 $10,000
Bubbles
Price
Intrinsic
Value

$0 $100
3.
Price
now
Be greedy when others are
fearful.
1. Old
Price
2. Negative price shock
Intrinsic
Value

$200 20%
Price and free cash flow Yield for
an asset with $40 in free cash
flow

$0 $100
Price
InvestmentHorizonTime horizons & decision factors for
various types of investor
Value
Seconds
Days
Quarters
Years
Price based traders
Fundamentals based fund
managers
Evolving competitive process
Nature of Value investor

0%
20%
40%
60%
80%
100%
120%
1%
5%
10%
12%
15%
18%
21%
26%
31%
38%
46%
Valueneededforbreakevenrecovery
Value lost
Siegel's slippery slope

$0 $100
Price
Short term price balloon movements
approximate heat diffusion.
Black-Scholes can’t see the goose.

Risk house elements:
1. Moat as
shield against
innovation
2. Asset based
“margin of safety”
foundation as book value
Ino’s Constant erosive forces
FirmValue$’s

Organism: management resource
allocation layer
moats
resourcesOperations
Attributes:
•Metabolism /
cash flow cycle
•Birth / growth /
death
•Adaptation
(potentials)

Innovation’s shifting focus
Ino-cycles / maturity
Competitors
Revenue growth
focus
Market share &
operating margin focus

$0 $100
Price
As the price balloon wiggles backward &
forward faster, modern portfolio risk models
get nervous*
*the fast wiggling balloon model of volatility won a Nobel prize in economics and
underpins many financial risk models.
Whether my balloon is
ahead or behind me doesn’t
matter in modern financial
theory. If price wiggles
faster, modern portfolio
theory says I am riskier and
thus worth less.
Quants say I look
positively
Gaussian, but
complain I have
fat tails. I blame
the goose for the
fat tail thing
Value

$0 $100
Volatility
News/noise
Quarterly earnings
Long term earnings
Moat factors
Cluster dynamics
Price
Intrinsic
Value
Forces pushing price & value

Source: National Renewable Energy Labs

http://www.macsolarindex.com/index_breakdown.php Index is spread around 3 global regions
$-
$50
$100
$150
$200
$250
$300
2004
2005
2006
2007
2008
Global Solar Energy Index ETF (TAN)

Source: National Renewable Energy Labs
0
5
10
15
20
25
30
35
2007
2008
2009
2010
2011
2012
Installed global solar PV
market (GigaWatts)

Individual lottery psychology
leading to lost value
Final
cluster
capacity
Individual
market share
expectations
Innovative
individual
competitors

Cat herding chasing the “next bowl of
milk” price/earnings jump
Include examples of no milk bowl and “percieved smart cats” beta herding.

Perceiving Panarachy’s
Perspective cycles & flows
Buddhist temples which reflects multiple levels and cycles of
heaven and hell are abstractly represented as 2-D
mandalas

SVE-0406-3DC-5N
Ino
Organization
Cluster
Economy
Gene
Organism
Niche
Ecology

Organization
Cluster
Economy
Ino
Energy cascades through a value maximizing
economic panarchy producing dissipated heat &
increased complexity in the form of information
embedded structures

Organism
Niche
Ecology
Gene
Energy cascades through a life maximizing
ecological panarchy producing dissipated heat
& complexity

Value
Life & value adapt by macro-processing selected flow
through Ecological & Economic panarchy networks
Ino
Organization
Cluster
Economy
Eachlayermacro-processestoselect
survivors
LifeGene
Organism
Niche
Ecology

Economy
Cluster
Organization
Ino
Panarchy of Ecology vs Economy
Ecology
Niche
Organism
Gene
Change occurs in an upward direction and is accepted & amplified or rejected
with feedback at the boundary layer above it.
Each boundary between layers selects creating feedback which is likely stable
with punctuated radical shifts, similar to Gould’s punctuated equilibrium model.
Nature of Value focus areas
Slow variables
Faster
cycles

Increased personal energy harnessing capability:
Hours of labor required to capture a unit of power
1860
1880
1900
1920
1940
1960
1980
2000
10 KW Otto cycle gas engine
100 KW
reciprocating
steam
10 KW reciprocating
steam
100 HP
diesel
10 HP Otto cycle
Diesel
1,000 HP
Diesel
1,000 HP
gas
turbine
Envelope mobile
prime movers
10,000 HP
aero gas
turbine
Diesel
Aero derivative
gas turbine
(stationary)
Envelop; stationary
prime movers
(electric power)
1,000 KW
steam turbine
10 MW
steam turbine
Data: The Economic Growth Engine, Robert Ayres
0.0
0.1
1.0
10.0

Adaptive systems filter survivors creating
life/value feedback at each system level
Example: The ecosystem ends up with optimal genes/inos by selective
pressure at each layer. Organization pursues the best innovation by selective
feedback.
1,000,000,000
10,000,000
10,000
1
Components
Median cycle
(days)
1
10^3
10^4
10^5
Gene
Organism
Niche
Ecology
Ino
Organization
Cluster
Economy
Adaptation
Filter/feedback

Evolution’s economic panarchy of
network links and elements
Mediansurvivaltime(logscale)
$/element value (log scale)
Centuries
Decades
Years
Weeks
Thousand
s
Millions
Billions
Trillions

Ecology’s panarchy
networkTime(logscale)
Space meters / resource
Millennia
Centuries
Years
Days
Thousands
Millions
Billions
Trillions

Flowing energy adapts more complex
dissipative structures across domains
Timeyears(logscale)
Now
5,000
2 billion
14 Billion
Φ(m) Energy dissipation rate Ergs/gram/second
1-4
1,000
10,000
?

Gradient pressures drive evolution
to higher Φ(m) dissipative structures
People’s perception/ (Maslow
hierarchy drives the process)
Economy competitively
amplifies selected inos
Inos form organizational value
creating capabilities
Concept/idea
Increasingly structured information as formally
embodied and amplified

Evolution’s knowledge creating cycle across:
Ecological, Cultural & Economic domains
Knowledge/info storage
• DNA
• Meme
• Ino
Form for expressing capability
• Organism
• Idea/Culture
• Organization
Selection /competition
• Ecological Niche
• Attention/History
• Cluster/Consumer sale
Reproduction/dissemination*
• Sex
• Tradition culture
• Manufacture
*Information successfully
selected to replicate as
knowledge increases its
propensity to spread.
Selection & reproduction
distinguish knowledge from
inert statistical information.
Instantiation/
Expression
Feedback/
Information by
macro-processing
Amplification
Propensity
Expression

Evolution’s adaptive knowledge domains:
Ecological, Economic & Symbolic
Knowledge stored in:
• DNA
• Meme/Ino
• Symbolic
Capabilities embodied in:
• Organism
• Idea/Culture/Organization
•Logical Instantiation (deep structure)
Fitness measured in a:
• Ecological Niche
• Competitive Cluster
• Algorithmic Computer
Reproduced /amplified by:*
• Sex
• Manufacture/production
• Duplication
Instantiation/
Expression
Selective Feedback/
Macro-processing
Amplification:
Expression
Propensity
Existing in a
networked
panarchy
*Information
selected to
replicate is
knowledge
with a
propensity
to flow &
cycle.

WWI
WWII
Great
Depression
Base year 1900
Total Exergy 15.6 eJ
GDP 1900 G-K$ $312.5 billion

Maslow’s hierarchy of needs &
value
Self Actualization:
morality, creativity, spontaneity, problem
solving, lack of prejudice, acceptance of
facts
Esteem Needs:
confidence, achievement, respect of
others, respect by others
Love/Belongingness needs:
affiliation, acceptance, affection, sexual
intimacy
Safety needs/security of:
body, employment, resource, morality, the
family, health property, psychological safety
Physiological needs:
breathing, food, water, sex, sleep, homeosta
sis, excretion

Allocator’s Instrument Panarchy MapTime(logscale)
$/resource (log scale)
Ino / Venture Capital
Organization /
shares
Cluster /
sector ETF
Economy /
Indexes
Centuries
Decades
Years
Weeks
Thousands
Millions
Billions
TrillionsThe Nature of Value website is licensed under a Creative Commons Attribution-ShareAlike

Timing cycle mismatch 10% v. 60%
Buy Wait Buy Wait
Returns
+35% +0% +65%
-30%
100%
75%
50%
25%

Additive inclusive v. extractive
value chain raw input conversion
Inclusive chain delivers $244 equivalent to 760% more economic
value than $32 from the extractive value chain
+25% value per Additive inclusive cluster
-25% value per Extractive cluster
$100 $125 $156 $195 $244
$100 $75 $56 $42 $32
Value processed
Low High

Returns 500%
0%
-100%
Ranked organizations
0 25 50 75 100
Median return
Average return
Value creation among orgs

ROIC 500%
0%
-100%
Years
0 2 10
+20
Median return
Average return
Moat duration and depth

Economies grow as organizations expand
value flows in existing clusters &
successfully explore new possibility spaces
New clusters grow value rapidly
with profit margins typically
following the cluster maturity
curve lifecycle and innovation
diffusion rate. TFP productivity
growth quantitatively and
qualitatively grows the economy.

New possibility spaces create rapid profit expansions
before innovations diffuse among competitors as value is
transferred to consumers leading to higher GDP.
Innovation radiation explosion in new possibility space
Diffusion process as innovation matures
Full diffusion as margins return to normal but GDP increases
1.
2.
3.
Product/capability cycles over time
1. 2. 3.100
75
50
25
0
1 2 3 4
Margin captured
cluster competitors
Change in value
flow (GDP)

Inflation / deflation
money &
available
credit
Prices of
value
available for
purchase
Inflation
Deflation

Money & Values creative/destructive
flows tip the price balance
Inflation
Price
Deflation
Money (Near & Far) Value (near & far[wealth])
Issued currency
Available credit
Debt
Equity
Goods & services
Investible projects
income streams
Assets

Money
market
instr./weeks
Money risk & inflation premiums
FaithinMoneyfunction*
Highest
High
Medium
Low
Lowest
Typical required yield/expectation
Currency=B
ills, Coins/N
A
Checks &
demand
deposits/days
Short-term
debt/months
Long-term
govt.
debt/years
Equity/
years
Long-term
corporate
debt/years
Money form/
Duration until
decay into
currency
*Faith in money’s social information utility as a unit of
account, store of value, means of exchange.
Central bank’s definition of
money (M0,M1,M2&M3)
Near money
Far money

$0.00
$1.00
$2.00
$3.00
$4.00
Money paid back over time reflects demand for
capital, inflation expecations and payback risk
Non-credit related
risk yield reflect loss
of belief in monies
three functions

(In/De)flationeffect
100x
10x
1x
0
1/10
1/100
Diffused magnitude of value impact
Organization Cluster
Economy
(In/De)flation distortion magnitude
vs. Scale of initial impact
Opec 1970’s
oil shock
Weimar
Germany
Great
depression
Central bank
inflation targeting
Money
shocks
A single
commodity
shortage

(In/De)flationeffect
100x
10x
1x
0
1/10
1/100
Fully diffused scale of value impact
Organization Cluster
Economy
(In/De)flation MV=P shocks vs.
scale of initial impact
Early
Internet
Opec 1970’s
oil shock
Weimar
Germany
Great
depression
Average
ino
Central bank
inflation targeting
Money
shocks
Value
shocks

Investor confidence & knowledge
drive portfolio outcomesAssetConcentration/
AllocatorConfidence
Nature of value knowledge
3. Below index
returns
1. Significant
losses likely
4. Index plus
returns
2. Berkshire
type returns
Few managers
Most managers

Protecting the moat and balance
sheet prior to price changes
Anticipatedpriceinflation
Moat Balance Sheet
3. Below index
returns
1. Increase
turnover by
accelerating
payment
terms
4. Pay down
debt and slow
capex
spending
2. Accelerate
capex spend
with current
cheap debt
DecreasingIncreasing
3. Grow
relationships
and sales
cycles

Mode, median & mean
-10% 0% 10% 20% 30%
40% 50%
20%
15%
10%
5%
0%
Mode
Medi
an
Mean
Shares annual rates of return
Frequencyofoccurrence

Lottery tickets
Source data: Longboard asset management

An economy is a flow of energy and
structures perceived as having value
Upstream: Downstream:
•Innovation’s impacts travel at each cluster’s innovation adoption cycle and diffusion rate
•Each moat is potentially eroded at the rate of the innovation cycle speed
•Value Chain throughput cycle speed is determined by slowest cluster’s capacity
•Each cluster passes innovation as information embedded in structure towards consumers
Raw materials Finished goods & services

As value & information flows through
network links, Economies macro-process
Cluster Top View
Raw upstream
supply chain
Finished goods &
services
Value chain flow = GPP (gross produced product)
Low value
raw inputs
Cluster Side View
Higher value
goods & services

Inclusive vs. Extractive economies
Raw material
inputs
Finished goods &
services outputs
Inclusive economy: all may compete to add value
Extractive economy: a few use power/violence to extract value at
each stage in the value chain

Inflation shocks compress margins
as they pass through linked value
chains
Upstream: Downstream:
Inputcostshock
45%
30%
15%
0%
Average historical COG (cost of goods) margin
Low value
raw inputs
Higher value
goods & services
Time

$Cost/Unit
System Capacity Utilization
Profit price
System throughput
efficiency curve (profit smile)
$100
$75
$50
$25
$0
Low Normal Extreme

$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
$16,000
0
25,000
50,000
75,000
100,000 1…
1…
1…
1…
2…
2…
2…
US Business bankruptcies
GDP ($billions USD)
Unpredictable corporate death &
GDP resilience

Energy
gradient
driven
process
Evolution: Energy flows through an
adapted structure selected to grow or die
death
Growth & amplification
Selection filter “competitive process”
Organized structure holding knowledge (DNA/INOs/Bits etc.)

High
quality
energy
Evolution’s cycle: Energy flows through
organized forms selected to replicate or die
Knowledge death
Knowledge growth
Selection process
Organized structure

GDP/capita
Government control of economic actors
v. long term GDP flows per capita
Rigid governance &
control of a state
extractive
economy, limited
adaptive learning
capacity
Extreme libertarian no
governance chaotic
random power based
mafia extractive
economy
Well regulated, free agent
additive inclusive learning
economy yields knowledge
growth
Economic controls & governance

Energy/resource flow rate (temperature)
Φ(m)capability
Environmental conditions required to
support knowledge & growth
Frozen knowledge
= no macro-
processing
Boiling random
structures unable to
store knowledge
Viable range for
knowledge to adapt higher
Φ(m) capable structures
over cycles
Low
High

Burundi
USA
y = 0.1275ln(x) - 0.4634
R² = 0.88171
0.20
0.40
0.60
0.80
1.00
$0
$10,000
$20,000
$30,000
$40,000
$50,000
$60,000
$70,000
$80,000
HDI(HumanDevelopmentIndex)
UNDESA
GDPPPPper capita 2005 constant dollars(World Bank)
GDP(PPP) v. HDI 2011

Burundi
USA
y = 5486.1x - 9804.3
R² = 0.64899
$100
$1,000
$10,000
$100,000
0 2 4 6 8 10
GDPpercapita(Semi-log)
Transparency International Corruption index
higher = lesscorrupt
GDP(PPP) per capita vs. Corruption index
Source: World Bank & Transparency International 2011

y = 903.48x - 42348
R² = 0.41233
$ 100
$ 1,000
$ 10,000
$ 100,000
30 40 50 60 70 80 90 100
GDP(PPP)percapitaWorldBank
constant2005$'s
Economic Freedom Index (HeritageFoundation 2012)
Economic Freedom v. GDP(PPP)

Inflation increases working capital costs
shrinking real value flow capacity
•Inflation increases working capital costs across the chain
•Inflation shrinks capacity and viable chain lengths & flow paths
Working capital cycles & requirements
Upstream Downstream
Low value
raw inputs
High value added
goods & services

Ino value flows through the cluster
Cluster Top View
Required ino
capability
Customer
value derived
from ino
Cluster Side View
ClusterROC
margins
Cluster margins revert to mean
1.
2.
3.
4.
1. Normal returns on capital
2. Innovator reaps higher returns
due to cost saving ino
3. Others adopt cost saving ino
4. Normal returns on capital

ClusterROCmargins
Ino margin shock & mean
reverting cluster margins
1. original normal returns on capital
2. hype spike: initial adopter has high margins due to exclusive
capability
3. diffusion phase: competitors adapt by adopting the ino
4. normal returns on capital as competitive pressures erodes
margins
1.
2.
3.
4.
Innovation diffusion over time forces value
flow to consumers
20%
10%
0%

Pig 05049’s value spread across
the network to 185 clusters
by knowledge & capabilities
Pig 05049
Value
Flow
Bullets
Medicine
Chewing gum
Bone china
Automobile paint
Train brakes
Aluminum mold
coating
Cigarette filters
Cosmetics
Yoghurt
Rubber bands

Meta-panarchy of nested networked
dissipative domains evolving over timeOrigin/Singularity(logscale)
Energy dissipation rate Phi(m) Ergs/gram/second
Particle based
(cosmo & geo
logical)
Gene based
(ecology/life)
Ino based
(economy/human)
Algorithm based
Symbology
Now
5000 yrs
2 billion yr
Billions
1-4
1,000
10,000
?

The Sun’s energy dissipating capacity
Φ(m) adapts for flow over time
Φ(m)(erg/gm/s)
Billions of Years Ago
10^2
10^1
1
5 0
-
5
Newborn
star
Current
sun
Subgiant
star
Red
giant
Source data: Eric J. Chaisson, Cosmic Evolution

Evolution’s increasing Φ(m) structures create
singularities as network domains emerge
Adapted from Eric J. Chaisson’s, A Singular Universe of Many Singularities: Cultural Evolution in a
cosmic context, The Singularity Hypothesis: A scientific assessment, The Frontiers
Collection, Springer, Berlin 2012. Symbology is the author’s addition.
EnergydissipationΦ(m)
Billions of years ago
10^6
10^4
10^2
1
10^-2
15 12 9 6
3 0
Sun
Animals
Plants
Earth
Milky Way
Economy
Symbology?
Physical
Biological
Economic
Symbology

Plant dissipating capabilities
Φ(m) adapted quickly
Φ(m)(erg/gm/s)
Millions of Years Ago
10^4
10^3
10^2
500 250
0
protists
gymnosperms
angiosperms
C4
plants

Evolution adapted Animal’s Φ(m)
capabilities to be 10X greater than plants
Φ(m)(erg/gm/s)
Millions of Years Ago
10^5
10^4
10^3
500 250
0
fish amphibians
reptiles
mammals
birds

Evolution adapted Φ(m) 10X greater
than animals using memes & symbols
Φ(m)(erg/gm/s)
Hundreds of thousands of years ago
10^6
10^5
10^4
300 150
0
hunter-gatherers
agriculturalists
industrialists
technologists
First recorded symbols: bone tally stick 44,000 years ago, Border Cave, South Africa

Evolution used information stored in
ino form to create structure’s with
rapidly increasing Φ(m) capacitiesΦ(m)(erg/gm/s)
Years ago
10^7
10^6
10^5
100
0
Early
machines
Automobiles
Airplanes
Jet Aircraft

Energy flows adapt, creating greater phi(m)
capacity panarchy relics
Domain
Primary
Energy
source Age
informational
unit
Gradient
resolved to
increase
Local
network
scale
Unit of
relic Phi(m)
Cosmology &
Astrophysics
Nuclear,
fundamental
particles
gravitational
13.7
billion yrs
spatio & physical
mass flow
efficiency
Cosmology
astronomy
Emerging
Astronomical
features
0-100
Geology
Physical,
Gravitational,
chemical
Billions
of yrs
physical constructal
substrate, lattice
mass flow
efficiency
Geography
Geologic
features
100-1,000
Ecology
light / bio-
chemical
2 billion
yrs
Gene
reproductive
efficiency
Ecology / life Fossil 1,000-10,000
Economy
bio-chemical
fossil fuels
nuclear/electri
cal
300k yrs meme/ino
value creating
efficiency
Human
symbolic/Cultur
e/ economy
History/
Archaelogy
10,000-
1,000,000
Symbology
Electrical /
quantum?
35k yrs alg
Algorithmic
Parsimony?
Technium/symb
olic singularity?
Archive? 1,000,000-??

beta
• Given enough time all beta’s go to zero.

Exponential results from reinforcing moats
and cash-flow feedback cycles
X
ZY
!
XxYxZ=Snowball!The Nature of Value website is licensed under a Creative Commons Attribution-ShareAlike

Lalapaloozas are intrinsic value
exponential growth spirals
Each square area is a cash
flow cycle with volume
representing moat capacity.
Distance travelled reflects
earnings or value captured.
Free cash flow
Expands
innovation
capabilities &
moat depth
Growing moats create free
cash flow which flows back
into creating better moats

?’s
• What is the nature of the Cluster? Stable?
Mature?
• Where is the offering in terms of design cycle?
• How efficient is the firm operationally? ROE?
• How is the company capital allocation
function?
• How is the price?
• Could I purchase this for 3-7 yrs with no exit?

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