Technology, Venture Capital, Private Equity

The preceding posts on Infy have set a good base for me to discuss something that I had intended to, which is the concept of “value creation” in a capitalistic system. We often come across this phrase “value chain”, a common platitude that we get to hear all the time being – “we are trying to move up the value chain”. It is important to therefore understand what this “value chain” means, who defines it and how one really moves up this “value chain”. I’ll need to delve a little into the fundamentals of economic theory here to make my point and like to apologize beforehand for the atypical long post.
 So, what is this notion of “value”? The only real meaning of value in a capitalistic system is that which gets defined by the market – what is the customer willing to pay for your product or service. There is no other definition of “value”. Therefore, if the customer is willing to pay more for a product as against another one of the same category, it is more “valuable”. The implication of this is also the fact that “value” is therefore a completely relative concept. There is no absolute meaning to it. What could be “valuable” at one point in time or in one circumstance could be less valuable at some other point in time, or circumstance. For instance, lets take the labour market. The single factor that determines who is more “valuable” or skillful in a labour market is the remuneration that he earns. There is no other yardstick for measuring skill level. A person could possess some extraordinary skills that an average human may not possess. But, that doesn’t mean he is more valuable, unless a buyer is willing to reward him for those skills. No better way of saying this than Warren Buffet, who succinctly sums it up here - “I personally think that society is responsible for a very significant percentage of what I’ve earned. If you stick me down in the middle of Bangladesh or Peru or someplace, you find out how much this talent is going to produce in the wrong kind of soil… I work in a market system that happens to reward what I do very well – disproportionately well. Mike Tyson, too. If you can knock a guy out in 10 seconds and earn $10 million for it, this world will pay a lot for that. If you can bat .360, this world will pay a lot for that. If you’re a marvelous teacher, this world won’t pay a lot for it. If you are a terrific nurse, this world will not pay a lot for it. Now, am I going to try to come up with some comparable worth system that somehow (re)distributes that? No, I don’t think you can do that. But I do think that when you’re treated enormously well by this market system, where in effect the market system showers the ability to buy goods and services on you because of some peculiar talent – maybe your adenoids are a certain way, so you can sing and everybody will pay you enormous sums to be on television or whatever -I think society has a big claim on that.”
 In a way, the above definition of value is almost stating the obvious. But, here’s the twist. The buyer is not the only one who is responsible for defining value in a market system. The seller also can and does influence the notion of value. In other words, if a seller can convince a buyer that his product/service is more valuable, the buyer will be more willing to pay him more for what he’s offering. The examples of various premium brands such as Apple or Nike are examples of how otherwise relatively lower value products can be positioned as more valuable and hence dictate the buyer to pay a price. Then, came along John Nash (of A Beautiful Mind fame), who through his game theory concept went on to say that not only do sellers influence buyer behaviour, they also influence one another and in doing so help define the “final” equilibirium value of the market (technically called the Nash Equilibrium). Especially important in this context, is the behaviour of the leaders in defining market structures.
The other important thing to also understand here is that laws of economics state that with time, all frictionless free markets settle to a low rate of return on capital employed. And the role of managements is just one – to create “friction” in the market and prevent that eventuality from happening or at least postponing it. This is not too different from the Efficient Market Hypothesis in financial theory, which states that ultimately, in a free market, all investment opportunities will finally tend to zero NPV. However, investors (like myself) are attempting to fight just that and trying to locate opportunities that do have a positive NPV. In other words, smart managers (general or financial) get paid for just one thing – beat the laws of economics to earn supernormal returns.
With this extremely quick and brief description of economic value, lets move to the issue on hand, which is the Indian IT services industry. As I have menioned ad nauseum, the Indian IT industry is now at a point of inflection and if allowed to drift along, will inevitably be dictated by the laws of economics to find a low margin equilibrium state. It is the job of smart managers and leaders in the industry to prevent just that. For long, the Indian IT industry has defined itself on the particular theme of cost arbitrage driven low cost service model. However, now, there is a definite need and IMO, a window to change that “value” definition of the Indian IT industry. There are examples from history of industries which have done that. The Swiss watch industry, which at a point in time faced a severe threat from low cost electronic watches was able to rebrand itself and successfully transition to the premium category. This what I meant when I said that Infy needs to “grow up” and take ownership to help make that transition happen. The test of their mettle will be whether they will enable the industry to maintain the hallowed status it has enjoyed till now, or whether it will go the way of many industries in the past that have fallen “victim” to the laws of economics and be reduced to a commoditized status. I don’t for a moment proclaim that it will be an easy task. But, I suppose the mission at hand should be clear to everyone.

PS: The analysis could have been much more elaborate and detailed, but with brevity as an objective in mind, I have tried to condense it.