VenChar

Fragflation and radio text ads

The NYT reports on a new form of radio marketing.

Big radio companies like Clear Channel Communications and Infinity Broadcasting are equipping some stations with technology that broadcasts not just commercials but text messages that appear on car radio displays. And advertisers like First Charter Bank in Charlotte, N.C., which will use the approach in a campaign beginning in late January, are signing on to see whether extra text can give their spots extra heft.

The technology - called R.D.S., for radio data system - has long been common in Europe and available in the United States, where it is gaining as cars increasingly come ready for the technology and radio stations compete more fiercely for ad revenue against satellite radio and other media.

Really terrible idea - reflective of a bankruptcy of the marketing imagination. The article quotes someone attributing this desparate measure to fragflation: "'the fragmentation of audiences combined with media inflation". Google turns up no hits, so it must be a true neologism.

Distributed computing project

Via Slashdot, this interesting distributed approach to finding MD5 collisions. It leverages the computing cycles on browsers that visit any website whose html contains the Javascript code.

What is interesting about this approach - when we reach final release stage - is that any website that adds this small snippet of code their their pages, will have their visitors working on the problem for the duration of their visit to the site. The applet stores its state every 5 seconds in a cookie which is used to re-initialize the applet at next load. Should a few high-traffic, "sticky" websites carry this innocuous HTML code, a massive amount of work can be done.

Neat application of Javascript, requires no client software installation.

VCs and extra-financial value

It is part of the received wisdom that who you get money from is often more important than the terms of the financing. Top-tier VCs arguably provide the following items of "extra-financial" value:
* certification: especially for first-time entrepreneurs, affiliation with a big-name backer can confer a degree of credibility that is useful in dealing with customers and suppliers, recruiting employees and attracting follow-on investors.
* VC network: access to high-quality managerial talent, strategic alliances and partnerships, etc. (The "value-added" component often touted by VCs)
* Mentoring

Given these sources of extra-financial value that present ways for VCs to differentiate their "value-adds", it is reasonable to suspect that VCs who enjoy a higher reputation and are more plugged-in would be able to price deals at a discount with respect to their competition. Via Infectious Greed comes a link to this study which asks (and attempts to empirically address) the following two questions: "Is there a market for affiliation with reputable partners? If so, what are the prices for such affiliation?" In other words, given the sources of extra-financial value identified above, how much of a discount does a reputable VC command (in terms of price paid per share) compared to less-reputable investors? The analysis looks at 149 Series A deals of which 51 received multiple financing offers. Interestingly,

only 43% of the start-ups among those receiving multiple offers accepted their best financial offer. Moreover, the start-ups not accepting their most generous financial offer left a considerable amount of value “on the table,” amounting to $173.9M in aggregate pre-money valuation. This was calculated as the sum of the differences between their best financial offer and the accepted offer. For the group of multiple offer firms declining their best financial offer, the foregone pre-money value as a fraction of the accepted offer ranged from a low of 3.6% to a high of 217%, with an average of 33.2% for the sample.

The punchline of the analysis seems to be that "A financing offer from a high reputation VC is approximately three times more likely to be accepted by an entrepreneur. [Moreover], highly reputable VCs acquire start-up equity at a 10 to 14% discount."

Of course, there are a number of possible objections to the results obtained, many anticipated by the author: (1) sample size and selection biases, (2) measures of VC reputation, (3) use of the pre-money valuation as the sole measure of deal pricing (excluding other dimensions of the termsheet such as liquidation preferences, ratchets, warrants, etc.), etc. However, given the lack of transparency around deal terms and the offers received by startups, this work represents an interesting start.

eBay auction data and the economy

Via Infectious Greed comes this very interesting USA Today piece. I had written earlier about eBay's stated move towards licensing its auction data and what that might mean. Well, this article takes a look at the year 2003 through the lens of eBay auction data. Some excerpts:

There are many ways to analyze 2003. You can sift through major news events. You can chart best-selling books and top-rated TV shows. You can dissect the stock market. But if you want the gestalt of America — the unified essence of this nation at this time — there might be no better place to turn than the massive databases that run eBay.

There sits a repository of culture and commerce unlike any before it. No executive decides what eBay sells. Instead, millions of individuals post items on the Web site in response to shifting nuances in the marketplace. Because it is so fluid, the site captures the collective mood and unique extremes of the 86 million people who use it.

Though government numbers show the economy is rebounding after more than two years of doldrums, the eBay economy suggests something different. In fact, it seems to show a lag effect. People and companies downshifted as 2003 wore on.

For instance, eBay tracks searched words, which in turn are indicative of what buyers are looking for. Word searches for all of 2002 reflect a society still spending freely. Among the top 10 searches for the year were BMW, Louis Vuitton, Prada and Coach. Similar terms dominated the top 10 into early 2003, until August, when there was a sudden shift. The Iraq war was dragging on. Companies were still cutting jobs and keeping raises flat. The blackout hit. California was in political chaos with its recall vote. And just then the luxury names dropped off eBay's top 10, replaced by more mundane words such as Ford, Chevy and diesel.

In September, "salvage" made it to the top 10.

"I don't see any huge economic recovery," says Neal Sherman, whose company, The Advantage Group, uses eBay to liquidate goods for companies and public entities. It recently listed the entire contents of a supermarket, minus the food, and sold a yacht for the state of Maryland for $275,100.

"Take coffee equipment and mixers — a good operator in flusher economic times would buy those new," Sherman says. "When times are tough, they save money and buy it in the aftermarket." From everything Sherman sees, the aftermarket for used business stuff is turbocharged.

Some other tidbits about 2003 from the eBay files:

* The Aug. 14 blackout in the Northeast shook confidence in the power grid. In the week after the blackout, sales of portable generators jumped 67% vs. the previous week. But it wasn't just a knee-jerk spike. Generator sales on eBay are running at an annualized rate of $12 million, up 191% over 2002. It seems we're sure another outage is coming, and we want to be ready.

* The war proved a boon to eBay's category for pieces of gold. Sales are up more than 70% over a year ago. People generally buy gold when they believe bad times will drive down the value of the dollar.

* In October, when the Cubs seemed on the way to their first World Series championship in more than 80 years, everyone wanted a piece of that, too. EBay's sales of Cubs paraphernalia shot up more than six times over the year before.

* During Arnold Schwarzenegger's campaign for California governor, everyone wanted a piece of him. EBay's sales of Schwarzenegger-related items — from a 1969 Iron Man magazine with him on the cover to Terminator 2 talking dolls — climbed 1,500%.

* eBay's industrial products market took off in 2003. As an example, doctors and dentists, squeezed by insurance companies, turned to eBay in 2003 to buy medical equipment. In general, medical professionals are wary of buying used equipment. But the category is up more than 100% over last year.

This is a treasure trove of information: about the medical equipment market, about the market for used cars, the likelihood of success of gubernatorial candidates and sports teams, estimates of the likelihood of power failures, and consumer confidence and spending. There should be a rich aftermarket for eBay auction data analytics.

Designing design reviews

Design reviews are an important part of the software development process. The major goal of a design review is to uncover errors in the design and to improve it before commencing implementation. I just read “Active Design Reviews: Principles and Practice” by Parnas and Weiss that contains a wealth of insights on how to effectively design design reviews and to ensure that the stated goals of the review process are met.

The purpose of all design reviews is to find errors in the design and its representation. The review should be designed to make it easy for the reviewers to find errors. If errors are present, but escape the reviewers’ attention, the review has failed… Errors [may] include unstated requirements, unnecessary requirements, obsolete requirements, and design and implementation decisions stated as requirements.

Here are some of the ways to ensure that the design review meets its stated objectives:

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• Ensure the design is covered completely and in detail by the review
• The design document should be designed to be reviewable: it should list the functional requirements clearly, make assumptions explicit (to avoid subtle design errors escaping unnoticed), should include redundant information (to perform error checking and uncover inconsistencies), etc.
• The reviewers (and designers) should focus, during the review, on trying to uncover errors in the design.
• Reviewers may include the following categories:

o Specialists, such as a person with detailed knowledge about a particular subsystem
o Potential users of the system
o Those who are familiar with the design methodology used, even if they are not familiar with the actual application
o Those who are skilled at and enjoy uncovering logical inconsistencies and who may be used for performing systematic consistency checks, despite not being specialists in a particular area

• When a set of reviewers that can provide complete design coverage is assembled, it is important to ensure that each reviewer focus on those areas relevant to him and that he can identify the decisions made in arriving at the design. It is also important to make the reviewer think hard about what he is reading, rather than skim it for obvious errors.
• Reviewers should be familiar with the goals of the design and the constraints placed on it.
• Reviewers should be aware of and watchful for the following classes of errors (not a MECE list):

o Inconsistencies, i.e., places where the design won’t work.
o Inefficiencies, i.e., places where the design imposes a barrier to efficient programming or use.
o Ambiguities, i.e., places where the design specification may be interpreted in several different ways, or is not clear enough.
o Inflexibilities, i.e., places where the design does not accommodate change well.

The purpose of this categorization is not to ensure that each error found falls into one and only one
category, but rather to guide us in designing reviews that will find as many errors as possible.
• Performing a good job as a reviewer is difficult work. It is important that the review be designed to give the reviewers a sense of participation and accomplishment.

Architectural Innovation

I recently read Henderson and Clark's paper on Architectural Innovation. They provide a useful way to think about innovations in product architecture.

The distinction between the product as a whole - the system - and the product in its parts - the components - has a long history in the design literature. For example, a room fan's major components include the blade, the motor that drives it, the blade guard, the control system, and the mechanical housing. The overall architecture of the product lays out how the components will work together. Taken together, a fan's architecture and its components create a system for moving air in a room.

A component is defined ... as a physically distinct portion of the product that embodies a core design concept ... and performs a well-defined function. In the fan, a particular motor is a component of the design that delivers power to turn the fan. There are several design concepts one could use to deliver power. The choice of one of them (the decision to use an electric motor, for example) establishes a core concept of the design. The actual component - the electric motor - is then a physical implementation of this design concept.

The distinction between the product as a system and the product as a set of components underscores the idea that successful product development requires two types of knowledge. First, it requires component knowledge, or knowledge about each of the core design concepts and the way in which they are implemented in a particular component. Second, it requires architectural knowledge or knowledge about the ways in which the components are integrated and linked together into a coherent whole. The distinction between architectural and component knowledge, or between the components themselves and the links between them, is a source of insight into the ways in which innovations differ from each other.

Within this framework, there are two axes along which innovation could occur: at the level of components and at the level of architecture (linkages between components). This allows us to distinguish four broad categories of product innovation:
* Incremental innovation: Improvements at the component level only, while leaving the architecture unchanged. "Incremental innovation refines and extends an established design. Improvement occurs in individual components, but the underlying core design concepts, and the links between them, remain the same."
* Radical innovation: "Radical innovation establishes a new dominant design and, hence, a new set of core design concepts embodied in components that are linked together in a new architecture."
* Modular innovation: "innovation that changes only the core design concepts of a technology and innovation that changes only the relationships between them ... such as the replacement of analog with digital telephones. To the degree that one can simply replace an analog dialing device with a digital one, it is an innovation that changes a core design concept without changing the product's architecture."
* Architectural innovation: "innovation that changes a product's architecture but leaves the components, and the core design concepts that they embody, unchanged."

They consider the consequences of such innovations on firms based on an understanding of organizational capabilities and competencies that come to be embedded in the firms. Since incremental innovation introduces relatively minor changes to the existing product and fits within the existing architectural model, it presents relatively minor challenges to established firms, requiring evolution of existing competencies, rather than the acquisition of new ones. As a result, it can often reinforce the dominance of established firms. Radical innovations, by contrast, "often creates great difficulties for established firms ... and can be the basis for the successful entry of new firms or even the redefinition of an industry." The implications of architectural innovation are subtler:

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[Architectural innovations are] innovations that change the architecture of a product without changing its components. Architectural innovations destroy the usefulness of the architectural knowledge of established firms, and since architectural knowledge tends to become embedded in the structure and information-processing procedures of established organizations, this destruction is difficult for firms to recognize and hard to correct. Architectural innovation therefore presents established organizations with subtle challenges that may have significant competitive implications.

Much of what the firm knows is useful and needs to be applied in the new product, but some of what it knows is not only not useful but may actually handicap the firm. Recognizing what is useful and what is not, and acquiring and applying new knowledge when necessary, may be quite difficult for an established firm because of the way knowledge - particularly architectural knowledge - is organized and managed.

One of the core ideas in the analysis is that once a dominant design has emerged, organizational knowledge and information processing structures come to mirror the architecture of the product. This creates an organizational resistance/inertia to change which tends to hinder the successful adoption of future architectural innovations.

Layaway programs

The NYT writes about wage stagnation and the double-edged sword that is Wal-Mart:

"Wal-Mart is a double-edged sword, and both edges are quite sharp," Mr. Bernstein of the Economic Policy Institute said. "On the price side, consumers wouldn't flood Wal-Mart if there wasn't something there they liked, the low prices. On the other hand, by sticking solidly to the low-wage path, they create tons of low-quality jobs that dampen wage and income growth, not just for those who work in Wal-Mart but for surrounding communities as well."

It is a cycle that sustains itself. Edward Wolff, a professor of economics at New York University, said the shift to discount stores "reflects the growing financial strain on families." He added: "Part of the growth in Wal-Mart and discount stores in general is being generated by the stagnation in wages." As the economy has slowed, discount stores gain sales, often at the expense of department stores and specialty retailers.

In an era of stagnating wages, programs such as Wal-Mart's layaway plan (pay 10% down and pay the remainder over 60 days before being able to take the purchase home) are enjoying increased popularity with the discount-shopping demographic. More discussion of discount retailers offering layaway programs here:

Layaway shoppers put down a deposit and make payments but don't pick up the goods until they have paid in full. That's an increasingly quaint concept in a buy-now-pay-later society.

Still, layaway is far from extinct. The old-fashioned service attracts a small but ardent following. Among the big discount chains, Wal-Mart and Kmart offer layaway, but Target does not. Nowhere is layaway more popular than at Wal-Mart. By paying a 10 percent deposit, customers can put almost anything on layaway other than clearance items and hazardous materials.

Layaway appeals to people who like to do their holiday shopping early but don't have the cash in hand to pay for it. Some people use layaway because they don't have a credit card or because the cards they have are charged close to their limits. Many others just don't like paying credit card interest.

Mispricing in information aggregation markets

I recently read a survey paper on behavioral finance (written by Nicholas Barberis and Richard Thaler at the U of Chicago and available here). One of my key takeaways from reading the paper was the idea of limited arbitrage (subject of my previous post). The basic idea is that mispricing may persist because arbitrage is costly and/or risky.

I've also been watching information exchanges and information aggregation markets (such as the Hollywood Stock Exchange, the Iowa Electronic Markets, the aborted terrorism futures market, etc.) with interest and the problem of mispricing is an especially important one in this context. This raises the following question: Is it possible to create controlled market environments (either through the intelligent design of tradable securities or through qualifying traders who are allowed to participate, etc.) such that the probability of enduring mispricings is reduced significantly? This would seem to be an important question. From reading the survey paper it would seem that reducing implementation costs, making substitute securities available, reducing the number off noise traders, etc. are obvious ways to reduce the effects of mispricing. Anyone out there know of any pertinent research?

Limits to arbitrage

I recently read a survey of behavioral finance by Nicholas Barberis and Richard Thaler at the University of Chicago – the paper is available here. What follows are some of my notes:

Traditional finance seeks to explain and understand financial markets using models in which agents are “rational”. Rationality means two things:

1. When they receive new information, agents update their beliefs correctly, in the manner described by Bayes’ law.
2. Given their beliefs, agents make choices that are normatively acceptable, in the sense that they are consistent with Savage’s notion of Subjective Expected Utility (SEU).

Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational and analyzes what happens when one or both of the assumptions about agent rationality are relaxed. There are two building blocks to the theory: limits to arbitrage (the price of an asset may not equal its fundamental value – this represents a mispricing. However, this mispricing may persist for long periods of time because arbitraging it away may entail significant risks and costs) and psychology (if agents are not rational, in what way are they irrational? What is the theoretical framework for describing the deviations from rationality? How can experimental psychology inform the construction of economic models for agent behavior?).

In this post I will discuss (what I understand of) the notion of limits to arbitrage, mostly drawing from the review. But first some background on market efficiency, etc.

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In the traditional framework (rational agents, no friction), a security’s price equals its fundamental value (i.e., the discounted sum of all future returns). The underlying hypothesis – that prices reflect fundamental value - is known as the Efficient Markets Hypothesis (EMH). If the EMH is true, it follows that there is “no free lunch”: “no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk.”

Behavioral finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value brought about by the presence of at least some traders who are not fully rational. A well-known objection to this argument (attributed to Friedman) is that even if irrational traders were to create such deviations, this effect would quickly be undone by rational traders arbitraging away the deviations. The authors of the survey use the following example to illustrate Friedman’s argument:

Suppose that the fundamental value of a share of Ford is $20. Imagine that a group of irrational traders becomes excessively pessimistic about Ford’s future prospects and through its selling, pushes the price to $15. Defenders of the EMH argue that rational traders, sensing an attractive opportunity, will buy the security at its bargain price and at the same time, hedge their bet by shorting a “substitute” security, such as General Motors, that has similar cash flows to Ford in future states of the world. The buying pressure on Ford shares will then bring their price back to fundamental value.

This argument, while superficially compelling, has some weaknesses. In particular, it is built upon two assertions: (1) that such mispricings create attractive investment opportunities, and (2) that rational traders will quickly snap up the opportunity and thereby correct the mispricing. Behavioral finance takes issue with the first of these assertions: it is argued that “even when an asset is wildly mispriced, strategies designed to correct the mispricing can be both risky and costly, rendering them unattractive. As a result, the mispricing can remain unchallenged.” This is the key explanation for the survival of mispricing – that it can be risky or costly to correct.

The authors point out a corollary of this line of thinking: while there can be no free lunch in an efficient market, the same may be true in an inefficient market – “just because prices are away from fundamental value does not necessarily mean that there are any excess risk-adjusted average returns for the taking.” The relevance of this observation is the following: “many researchers still point to the inability of professional money managers to beat the market as strong evidence of market efficiency. Underlying this argument, though, is the assumption that “no free lunch” implies “prices are right.” If this link is broken, the performance of money managers tells us little about whether prices reflect fundamental value.”

What are the possible risks and costs associated with correcting a mispricing? Here are a few (exemplified in the context of the example of Ford, whose fundamental value is $20, but which has been pushed down to $15 by pessimistic noise traders):
• Fundamental risk: the most obvious risk facing the would-be arbitrageur is new information that causes the fundamental value of Ford’s stock to fall – negative news on earnings, for instance. The arbitrageur can insure against this risk by shorting a substitute security (such as GM stock). While this insures against risk that equally affects all industry players, it doesn’t insure against idiosyncratic risk specific to Ford. In other words, there may not be perfect substitutes that can be used as insurance.
• Noise trader risk: This is risk associated with the fact that the effects of the mispricing might worsen, in the short run, but not due to a change in the fundamental value. “Once one has granted the possibility that a security’s price can be different from its fundamental value, then one must also grant the possibility that future price movements will increase the divergence.” Noise trader risk matters because this worsening of the mispricing may force the arbitrageur to liquidate early and sustain steep losses. Here it is relevant to note that there may be agency effects (the arbitrageur may be managing someone else’s money and may face pressure to liquidate underperforming holdings or face withdrawal of funds) and time-horizon effects (if it takes several months for the mispricing to correct itself and the arbitrageur needs liquidity in a month, this risk may dissuade him from the investment). This source of risk was first pointed out by De Long and others (Bradford De Long maintains a blog, BTW).
• Implementation costs: These include transaction costs (bid-ask spreads, etc.), short-sale constraints (financial as well as legal (“for a large fraction of money managers – many pension fund and mutual fund managers in particular – short-selling is simply not allowed”))

When such risks and costs are present, the mispricing may persist because arbitrage is too risky or too costly. This is known in the theory as “limited arbitrage”.

Given these sources of cost and risk associated with attempts to correct mispricings, what are the conditions under which we can expect such mispricings to persist? Here are a few scenarios:
• No close substitute: in this case, the arbitrageur is exposed to a good degree of fundamental risk.
• Short horizons: Even if there exist perfect substitutes and there are no implementation costs, a degree of risk aversion combined with short investment horizons on the part of the arbitrageurs can imply that the mispricing will persist due to noise trader risk.

The survey paper also has several examples (twin shares, index inclusions, carve-outs) of systematic and large mispricings that persisted for long periods of time.

Passive monitoring of FM reception

The NYT profiles a technology for passively monitoring FM reception , with applications in smarter billboards and more targeted advertising:

Does it sometimes seem as if the billboards you pass on your daily commute are targeted to appeal to people exactly like you? Well, depending on where you drive, it could be that the billboards are listening in on your car radio as you drive past. Using a specially equipped dish manufactured by Mobiltrak, a Phoenix company, advertisers are now able to detect which radio stations drivers are listening to and then alter the messages on their electronic billboards to match the demographic that clusters around those stations.

There are only a handful of these responsive signs in operation so far. Smart Sign Media, based in Sacramento, is using Mobiltrak technology on five billboards in California. One is near Future Ford, a car-and-truck dealership off I-80 in Roseville, Calif. Using the information collected by the Mobiltrak device, Future Ford knows that on weekdays that stretch of I-80 carries a lot of drivers who listen to country-and-western stations, so that's when the dealership advertises the Ford F-150, a popular pickup truck. Evening drivers, Mobiltrak has found, are more apt to listen to talk radio and adult contemporary, so they see ads for Tauruses and Escorts.

Mobiltrak, the company mentioned in the article, has patented technology for passively monitoring FM radio reception. A Mobiltrak receiver is a small unit that can be pole-mounted facing a section of the freeway. The demodulation of the FM radio transmission (by the car radio receiver) involves generating a local oscillator (LO) signal at a frequency that is offset from the FM station's frequency. The Mobiltrak receiver (equipped with a directional antenna) can pick up these weak LO signals and infer the channel the radio is tuned to. A little searching on the USPTO website turned up this patent (which I'm guessing is assigned to Mobiltrak). From the disclosure:

Radios detect broadcast stations through a well known demodulation process which requires radios to generate local oscillator (LO) signals having frequencies near the broadcast signals' frequencies. For FM broadcast stations, an LO signal oscillates at a frequency around 10.7 MHz above the frequency of the broadcast signal to which a radio is currently tuned. Thus, the frequency of a broadcast signal to which a radio is tuned can be identified by detecting the presence of the tuner's LO signal and identifying the frequency of the tuner's LO signal.