Why do global stock markets appear so overvalued?

Are global stock markets spectacularly overvalued compared to their longer term trends?

One basic way to compare stock market valuations over time periods is to look at the market’s P/E ratio. This metric can be quite volatile due to short term variations in both price and earnings. A more stable metric is  the ratio of price to earnings that are averaged over a few years. This post on SeekingAlpha does a nice job of analyzing P/E ratios calculated using trailing 10 year average earnings. The chart below is quite interesting:

Credit: Doug Short / SeekingAlpha

The current market’s P/E ratio of 21.7 is significantly above the long term mean of about 15. So is the current market significantly overvalued?

Look carefully at the period after 1980 on the bottom chart. It appears that over the last 30 years, the market has systematically risen above its long term mean P/E ratios, and has stayed there – in spite of the two mega crashes of 2001 and 2008! Why should that be the case?

When looking at market valuations and P/E ratios over such a long term, a few other things come into the picture. Here are at least three reasons which could lead to secular changes in ‘normal’ P/E for the market:

1) Sustained period of strong growth expectation. This is the obvious one. However, it’s unlikely that the US market is factoring this in at the current point.

2) Risk free interest rate. The lower the interest rates are, the lower the denominator (discount rate) that the market factors into the valuation of each component, hence leading to higher overall P/E. Future interest rate expectation is disproportionately impacted by current interest rates, so the market would typically have a higher P/E when interest rates are very low – like now. Interest rates in the Western world have consistently fallen over the last 30 years. This coincides with the trend of higher P/E ratios over the same period.

3) The third confounding factor is the overall demand/supply for equities in the market. It would be interesting to see how the evolution of market P/Es correlate with wider equity/mutual fund ownership among the general population. Empirically, the advent of the ‘information age’ has made it much easier for small retail investors to own equities and mutual funds. Additionally, in the US, government-driven focus on 401K (retirement savings) plans has also increased equity market participation.  Both of these trends have significantly driven up overall demand for equities. Such a sustained increase in general demand would also lead to higher market P/E ratios over the long term.

I think the above factors could have led to a long-lasting shift in the market’s “normal” P/E ratio.  Wonder if there is a good way to assess market valuations in light of these additional factors?


Micropayments – huge opportunity ahead?

Micropayments are creating a brand new revenue stream for digital media, mobile and technology companies. An easy payment mechanism such as automatic billing significantly lowers the bar for making small purchases (up to a few dollars) on the web. For such small payments, it turns out, the bar is oftentimes not the users’ willing to pay. Rather, the showstoppers have been the overhead (pulling out credit card, filling up digits into the form, and the transaction processors’ minimum fee) and uncertainty associated with such transactions. Systems that remove these overheads and uncertainities by giving the user a seamless, trustworthy payment and billing mechanism are well positioned to unleash a huge new revenue stream on the web.

Apple’s iTunes and iPhone apps are the best examples of this. The seamless purchase mechanism and small amounts involved transform the user’s software purchase decision from a meditated one into an impulse purchase. The result is the ongoing “Gold Rush” where thousands of paid apps are being downloaded hundreds of thousands of times for a few dollars each. What does this signify for similar platforms on the web?

There is an immense potential to monetize online media and content through micropayments. Online micropayment systems have been around for almost as long as the Internet. However, several factors prevented first generation micropayment systems from taking off, including a) Lack of differentiated short-form content and applications that users would pay small amounts of money for b) Lower comfort with online credit card transactions c) Lack of trustworthy micropayment systems that presented a seamless experience to the user and were widely adopted.

However, with the wave of online apps (including those on social networking platforms) and the iTunes-iPhone mindset, all of the three factors above seem to be changing substantially. There is a large variety of apps, music, videos that is now legally available. And customers are more comfortable using their credit cards online, thanks to the increasingly high adoption rates of online ticketing and travel. 

Players to watch out

Besides Apple, there are a number of players who are positioned to take advantage of this trend. Here is an attempt to capture some of the categories:

  • Startups such as Spare Change and Tinker which are enabling monetization of social network apps and blogs. Space Changeis apparently already processing $30M of micropayments annually. Expect to see social networks such as Facebook and MySpace start their own competing micro payment systems, or buy some of these small players.
  • Mobile phone companies, which already have billing relationships with customers are really well positioned to build micropayment systems of their own. Indeed, Apple is eating what could have been AT&T and Verizon’s lunch, had they given up their walled-garden approach as the times evolved.
  • Similarly, ISPs and Cable companies such as Comcast/CIM have an opportunity to create or integrate micropayments into their broadband customer sites, use micropayments to monetize some of the premium content on their new media sites, and charge customers directly through their monthly bills. 
  • Other usual suspects who have customer relationships and/or customers’ credit card numbers include Internet giants Google, Yahoo, Microsoft, Amazon and Ebay/Paypal, and eCommerce providers.

Product Innovation in India

I was recently asked to comment product innovation in India – i.e. the often-raised questions around why we haven’t seen extensive product-based innovation from Indian companies, what the challenges have been, and how that can change etc. I have given thought to this issue a few times in the past, and I’ve copy pasted some of my thoughts below.

Product innovation is a step in the life-cycle of an industry’s evolution that comes after significant maturity. Product innovation requires a complex interlinked talent pool (engineers, researchers, designers, managers, executives, lawyers etc), sufficient amount of risk capital, and proximity to the customer. None of these had achieved critical mass in India till a few years back, but this should happen soon (possibly with the exception of the ‘researchers’ category).

Moreover, the need for path-breaking innovation wasn’t very apparent in the past. Most consumer needs were best satisfied by taking concepts already invented elsewhere, and customizing those to the Indian landscape. This still continues to be the case – after all, what is the point of reinventing the wheel? The best returns to customers, investors and entrepreneurs still continue to be from these so-called incremental products. However, the zeal within a lot of Indian entrepreneurs, engineers and even investors for helping build some truly innovative products is tremendous.

However, there clearly are several encouraging success stories now in the product domain in India (especially wireless equipment and mobile apps), but I think there is still some ways to go for Indian products in the areas of:

  • User interface: The UI of a large chunk Indian products and websites has a lot of catching up to do. There are obviously some notable exceptions though, and the situation will change as UI design talent availability in India improves. The core of the IT ecosystem in India has been composed of teams working on outsourced or off-shored work, and in the past, the UI design work was typically not done in India, which propagated the dearth of UI design talent in India.
  • Product management and customer focus: Most products and services built in India in the past were targeted at a Western/foreign customer. Innovation is an exercises that is intricately intertwined with customer input and feedback, and becomes an order of magnitude harder if the innovator is removed from the customer. 
  • Focus on quality
  • Research-based Innovation

We are now seeing some decent products coming out of Indian startups. Also, large tech companies such as Google, Cisco, Microsoft, Adobe etc are now developing a few of their products almost entirely in India. This will create a viruous cycle that iteratively reduces the intensity of the aforementioned challenges. 

I think that the first wave of products is/will be around areas where there are direct customer touch points in India, so this would include areas such as:

  • Information and advertising services tailored to more restricted interfaces such as SMS, VoiceSMS etc
  • Payment and micro transaction mechanisms
  • Products around new media formats such as interactive TV, digital signage and animation
  • Gaming (both mobile and otherwise)
  • Wireless equipment
  • Productization of services such as security testing, banking software, specialized accounting etc

I believe (and hope) that we would start to see extraordinary companies of the magnitude of Apple, Google, Microsoft and Facebook being created in India within the next 5-7 years.

Evolution of Online Video offerings

The Digital Media space in general, and Online Video space in particular, is a sector that has perhaps seen the maximum amount of startup activity over the past couple of years. It is an industry undergoing massive disruption, as traditional content moves online, new business models are experimented with, and viewer habits evolve. Given the numerous venture-funded players that entered the online video market over the last year, there could be a shakeout in the near term. However, the long-term fundamentals of the space are strong. I believe that new players that are able to innovate ahead or along with the consumer preference curve will be able to build sustainable businesses. The rapid changes that the space is undergoing still provides for a window of opportunity for new entrants that offer clear value to their consumers.

I’ll apply my consumer themes framework to the Online Video space to look at where the key opportunities for innovation and investment lie moving forward. I will focus on user-generated and semi user-generated content arenas (as opposed to professional content). Also, monetization of online videos is a space in and of itself, and I’ll look at the monetization aspect in another post. I’ll focus on the online video product offerings in this post. Using our list of consumer themes, here are some current consumer new product opportunities and areas that are seeing a lot of action:

  • Hyperdiffentiation and Long Tail: Online video started as (and still is to a large extent) a phenomenon that appealed to a narrow segment. Quantcast shows that audiences of most online user-generated video sites are still dominated by male youth, while sites that offer TV content are frequented more by slightly older females. However, this is quickly changing, and in the near future, online video sites will succeed more by catering to a an increasingly wider variety of tastes. The rise of MetaCafe, (which does a better job of categorizing its videos using wisdom of the masses), even on entering the scene long after YouTube, is a case in point. In the future, we’ll see more and more successful sites that offer tailored content that resonates with more and more narrowly-defined communities and tastes. Example successes include CollegeHumor, which provides a platform of UGC for college students, and BarelyPolitical, which creates videos combining politics and humor. Sites will come up that cater to narrow behavioral preferences, regional choices (e.g. South Asian video sites e.g. Saavn), fine arts, independent films etc.
  • Personalization: Video content is perhaps the ultimate arena for personalization. People’s tastes are inherently and increasingly different, and consumers today are constrained by content discovery in the types of content they consume. Offering personalized front pages and page trees will become increasingly important. Pages and listings can be customized based on viewing habits, past history, the user’s friends, and even time of day and mood. One example is the recently launched Fancast.com, which personalizes what’s on TV. Another related area is improved recommender systems for online video. This would be like an advanced form of StumbleUpon applied to online videos. Currently, according to Forrester research, web search is the most common way of finding online videos, ahead of specialized video sites such as YouTube. This can change if users can go to a site which will let them discover content that they are more likely to like.
  • Convergence: In line with the trend of increasing convergence between access types, we’ll see more consumers taking to consuming video on other devices besides the PC – including mobile phones, Television, specialized devices, and advertising signage. Apple TV was one of the early attempts to bring online videos to TV. However, there is a long ways to go in making the viewing experience seamless. An upcoming stealth-mode startup is Zillion.tv, which will offer a software/hardware combination that makes viewing online videos more seamless. The instant success of Hulu.com, which represents the other side of this trend (i.e. bringing TV content online) is another case study. Cellware is a startup which offers users the chance to participate in a social network, and gives mobile users the opportunity to download videos, ringtones, wallpapers and more.We should also see more specialized devices being used to consume videos – e.g. future versions of portable DVD players could download customized online content for viewing in offline mode on airplanes, hotel lobbies etc.There is also potential for new desktop applications that can automatically download video content for offline viewing, or enable the consumption of higher quality videos that cannot be streamed effectively.
  • New Communication Mechanisms: The most popular current video content types in UGC are short-form humor and news content (source: Forrester). Other forms being experimented with includevideo Twitter’. There is certainly scope for a variety of other innovative forms of expressions that startups may bring to market.

  • Consumers want to be Producers: This goes beyond the current form of User-generated content. New services could give users increasingly interesting ways to interact, produce and collaborate in ways beyond the current YouTube model. One example is BigThink.com, which lets users post video responses to interviews with major celebrities and politicians. Future applications could enable better interactivity and collaboration between multiple contributors.

  • Community: Surprisingly enough, social networks are not yet fully integrated with videos. Facebook’s video sharing and video mail feature is popular, but YouTube and other UGC sites still don’t have dominant social networking features. Imagine a site that recommends videos for you to watch, “based on videos that your friends have watched/liked”. One interesting new offering is Election2008TV, which gives users a place to put their political videos supporting candidates, to see candidates in the news, to see the videos put up by others about candidates, and more.  There is a host of upcoming general UGC sites that offers some good community features, e.g. ClipShack. But this may only be the beginning. We’ll likely see a lot of action in the video-meets-social-network arena.
  • Information Organization: This is another area that will keep seeing a lot more innovation and new products. Advances will include increasingly better ways of searching (including vertical video search, semantic search), more intuitive categorization, social discovery and recommender engines. There are currently loads of players in the video search space, and all are experimenting with a variety of new features. Blinkx has an interesting approach that combines video search and aggregation (though I believe they don’t host any of the videos).

  • Ease of Use/Better User experience: Online videos today are predominantly low quality. Applications such as Joost and other online TV content sites that aim to provide higher quality content are still not entirely reliable. Any application that enables content creators and owners to deliver higher quality video more reliably to consumers (either by using new compression technologies, or by smart caching or by using desktop applications etc) will certainly make space for itself.  On another note, the average duration of online videos being watched today is about 2.8 minutes. The type of content that is watched by users is highly correlated with this short length. It will be interesting to see where the average video length evolves towards.

Needless to say, there will continue to be a lot of opportunities around the entire online video ecosystem. There are a large number of plays in the video infrastructure/hosting/storage space – players that enable all the video sharing sites to exist. The 800 pound gorilla, however, is the monetization of online videos – an area where we are seeing a lot of action and experimentation, but where no one seems to have good answers as yet.

Hyperdifferentiation and Personalization

We live in an era where consumers are asking for products that are increasingly differentiated and yet personalized to their tastes. This is evident in a very wide variety of domains, ranging from new forms of personalized expression (Video Twitter anyone?), to personalized T-shorts and mugs (see KPCB funded zazzle.com), to hyperdifferentiated offerings and tastes in foods (e.g. increasing popularity of a much wider array of cuisines and restaurants) and beverages (e.g. explosion in the types of juices, flavored teas, coffees, beers that are available). 

This theme is related closely to the concept of Long Tail. Due to the rapidly decreasing costs of offering a wide variety of products, it has become much more feasible today to cater to the long tail tastes of consumers. There is then also a positive feedback loop, where the wide variety of available products is fueling consumer demand for an even wider variety of products.

What does this mean in terms of startup opportunities in the Internet/Media/Mobile sectors? The good news is that this theme applies to almost all forms of content and access mechanisms, ranging from online videos to music and publishing. There now exists a market for a much wider variety of content than was historically available through traditional media.

The even better news is than since there is a niche audience for long tail content, advertisers are willing to pay a lot more for reaching out to that audience. The CPM that can be obtained through sponsorships for a niche content website (e.g. a site that targets college students, or a site that targets soccer moms) can easily be 5-10X the CPM that advertisers will shell out for untargetted eyeballs. Overall, this economics makes it feasible for a much larger number of startups to profitably enter the ecosystem of producing, hosting, organizing  and delivering content to consumers.

Review of current consumer themes in Internet, media and mobile

New ideas and startups don’t necesarily succeed by trying to drastically change consumer behavior. Instead, they succeed more often by identifying shifts that are happening in consumer behavior and needs, and then leveraging then capitalizing upon them with slick execution.

A framework that can help identify, assess and classify potential opportunities is to look for dominant consumer themes that are taking shape across a broad spectrum of products and industries. These themes represent major shifts in consumer behavior, and can  help identify new products and services that consumers are ready to adopt now, or will be in a few years.

Here’s a shot at listing some major current themes in consumer behavior evolution, which are applicable to the Internet, media and mobile sector:

  • Hyperdifferentiation and Personalization: We are in an era where consumers are asking for products that are more and more differentiated, and at the same time more personalized to their tastes.
  • Convergence: As the complexity of types of media and access mechanisms increases, the human need for simplicity keeps creating opportunities for various types of convergence – convergence of access device (e.g. TV content on mobile phone), convergence of media types (e.g. blurring boundary between TV content and online videos), convergence of desktop software and web services (e.g. SaaS).
  • Acceptability of new communication mechanisms: In the beginning, there were phone calls, email and personal web pages. Then came SMS, social network pages, blogs, personal videos, twitter, video twitter… whats next?
  • Consumers also want to be Producers: User-generated content (blogs, videos, music etc) represents a major shift in consumer behavior from the early Internet model, where most consumers were happy being just consumers. Even though the percentage of consumers who contribute content may still be low (less than 20% of YouTube users ever contribute a video), the key theme is that consumers are now ready and eager to consume content created by other non-professional users.
  • Community: The advent and popularity of the Internet took away a little bit from real-world social interactions, as an entire generation grew up spending enormous amounts of their leisure time in front of screens. However, humans are social animals, and the human need for social interactions and affiliation has given rise to an entirely generation of online tools that relicate real-world social behavior – ranging from social network platforms to people search tools to match-making sites.
Then there are some evergreen themes, that have always been around, but which keep acquiring a different flavor with each generation of new technology. These themes include:
  • Information Organization: As the amount of information that is available continues to grow exponentially, opportunities for new mechanisms to organize that information keep on arising. Version 0 was Yahoo-type directories. Version 1 was google-type horizontal search. The current frontiers seeing a lot of action are vertical search (e.g. Indeed for jobs, Kayak for travel), social discovery tools (e.g. StumbleUpon, Digg etc), recommender systems (like the ones used by Amazon for instance). One area where we could see more action in this domain the near future is more comprehensive Personal Information Management.
  • Ease of Use or Lower Cost: Anything that helps me simplify what I already do, or lowers the costs of what I do in some way is always attractive.

These, of course, are all very broad themes. But they can provide us a good framework to look for opportunities. We can cross-index these themes with the major macro trends and structural changes that I laid out in a previous post, to have a matrix that we can classify currently evolving opportunities into.

In a few posts, I’ll start delving into each theme, with the end goal of identifying upcoming players that are well positioned for harnessing those themes.

Vacuum Spaces

Given the knowledge of today’s key structural trends, how do you determine what the right market timing for implementing your cool idea is? If you know the answer to this question, I’d like to meet you.

Google, Apple, Facebook, MySpace, Skype, Youtube… These are of course some fabled companies that are known, especially in the popular media, to be the most innovative entities of our times. But what was it early on in the life of today’s category dominators that put that put them on their incredible growth trajectories? Was it that they invented a new path breaking product that didn’t exist before? Or was it that they identified and created a brand new market?

The answer to both questions is No! In fact each of these companies’ success was (and still is) about finding the perfect timing, and then following it up with flawless execution. Here’s a quick look:

  • Altavista, a leading claimant to the title of The First Search Engine, has been around 1994 (“The Search” makes for an interesting read). Google burst on the scene in 1997 with a technically and visually superior product. Moreover, the concept behind Google’s now legendary AdWords and AdSense systems (originating around 2000) finds their roots in Goto.com (later Overture, now a part of Yahoo), which was operated an ad marketplace with a similar concept way back in 1997.
  • Mp3 players and portable music players have been around for years and years. Apple surfaced with the iPod in 2001, and by 2003, it owned the entire category.
  • Friendster, in 2002, was the first on the online social networking block (in its current form), but how many of us have Friendster accounts now? facebook and MySpace of course own that category today.
  • I started using Yahoo Messenger’s Voicechat functionality sometime around 1999. Skype came to the scene with similar functionality in 2003 and owned the entire category within a year.

Each of these snippets is about a product that came to a space that had existed for a few years, but was stagnating or linearly growing. The new product then bowled over the consumer with a technically superior product. But perhaps most importantly, all of these products entered the scene at a time when consumer attitudes in these spaces were at their inflection points. I call these spaces Vacuum Spaces – spaces waiting for a fresh new wind of change and innovation to come rushing in, and fill them up.

The good news, then, is that in order to build a behemoth category dominator from scratch, you don’t need to identify and create an entirely new market. You have a shot at identifying spaces that are ripe for disruption, and then enter them with full force and slick execution. One of the hard parts, of course, is identifying what these spaces are at any given point (the other one is carrying out the slick execution). Knowing that some of the spectacular successes of tomorrow will be in spaces that already have a few players in them today, how do you identify and bet upon them?

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