A Wealth Creation Journal

Category: Business (Page 2 of 2)

Book review: The Everything Store – B. Stone

Before we move on to new books I am reading, I wanted to come back to my favorite read in 2016: The Everything Store. It is the story about Jeff Bezos and the creation of the giant that Amazon is today.

I hope my fallible memory is a great filter to sum up only great and memorable points.

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Big things I learnt

I will largely frame my writing on Amazon’s values:

Customer obsession, frugality, bias for action, ownership, and high bar for talent, innovation.

 

On avoiding competition

Gaining edge initially: the decision to sell books

The thing that impressed me most was Bezos’ superior analytical thinking skills. As a new online store, Amazon needed an edge versus traditional brick-and-mortar stores. One of the ways he could achieve that is by having more customer choice (as brick-and-mortar have limited physical space to show and stock the product). He figured a product that has an immense variety in product offerings would maximize his edge. He went for books, hence the name Amazon, which aims to symbolize the variety of the rainforest. After Amazon became popular for books, he compiled a list of product categories with similar huge variety of choice and went for those as a second step.

There’s less competition for very long-term business plans

Most corporate agents are focused on the next quarter, year or years. A founder can afford to think longer term. There’s much less competition in plans that require patience.

Gaining and keeping edge longer term: market leadership

Gaining market leadership requires foregoing traditional financial metrics like GAAP earnings margins. Keeping market leadership requires relentless client/product focus and continuous cost consciousness. But that’s OK, Jeff knew very early on that market leadership gives you economies of scale in this new online business with huge fixed costs.

On customer obsession

Creating alignment through pricing

Amazon does not earn money on selling Kindles. Amazon earns when customers are satisfied with the Kindle ecosystem and buy Kindle books. This creates alignment.

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We make money when we help customers make purchase decisions […] Merchants have never had the opportunity to understand their customers in a truly individualized way, E-commerce is going to make that possible. – Bezos

Creating customer oriented culture through rotation

Amazon has a mandatory rotation system to make every employee talk to customers through the Amazon.com call service. Engineers passing through customer service has also brought to light IT problems that were subsequently solved.

Obsess over customers, not competitors

On innovation and frugality

AWS and getting out of the way of the customer

Jeff is not a fan of wasting time, so he especially hates the idea that many of his employees would waste time together. Amazon’s culture was shaped early on to avoid meetings (e.g. standing up during meetings, no TV screens). Another slogan was “communication is a sign of failure”. No wonder that Amazon preferred IT systems talking to each other without human friction through good API’s. However, the IT needs for Amazon.com became eventually so big that considerable time of API designers went to asking and interfering with how the internal API clients were going to use the service.

This growing internal demand led Amazon to define basic computational building blocks, or “primitives” and make them really scaleable in order to sell these services to external clients as well.  This way Amazon.com would recoup these large fixed costs to improve internal operations. The initial primitives were storage, computing, payments and messaging. This became what is known as Amazon AWS and the rest is history.

This innovation was based on the idea to get out of the way of developers and provide them all required building blocks with no questions asked. It is reminiscent of electricity generation becoming centralized in the 19th century, removing capex requirements on the consumer side.

When a platform is self service, even the improbable ideas can get tried because there’s no expert gatekeeper ready to say ‘that will never work!’” – Jeff Bezos

Frugality to drive innovation

Although Jeff always loved optionality and funded many long-shot projects, it has to be stressed that he likes cheap optionality by being frugal. Another advantage of frugality on top of lower costs is reflected in the following quote.

We try not to spend money on things that don’t matter to customers. Frugality breeds resourcefulness, self-sufficiency and invention. There are no extra points for headcount, budget size or fixed expense.

On leadership

Leaders are intellectually curious, but commit to execute their decisions

The following is a quote by Bezos that was also covered in Superforecasting that we summarized. It marks the decision-making process of a great leader: be always questioning, but once you decide, show commitment to the execution of your decision.

Leaders are obligated to respectfully challenge decisions when they disagree, even when doing so is uncomfortable or exhausting. Leaders have conviction and are tenacious. They do not compromise for the sake of social cohesion. Once a decision is determined, they commit wholly. – Jeff Bezos

Always keeping the bar high

“If that’s our plan, I don’t like our plan.”

“I’m sorry, did I take my stupid pills today?”

“Do I need to go down and get the certificate that says I’m CEO of the company to get you to stop challenging me on this?”

“Are you trying to take credit for something you had nothing to do with?”

“Are you lazy or just incompetent?”

“I trust you to run world-class operations and this is another example of how you are letting me down.”

“If I hear that idea again, I’m gonna have to kill myself.”

“Does it surprise you that you don’t know the answer to that question?”

“Why are you ruining my life?”

[After someone presented a proposal.] “We need to apply some human intelligence to this problem.”

[After reviewing the annual plan from the supply-chain team.] “I guess supply chain isn’t doing anything interesting next year.”

[After reading a narrative.] “This document was clearly written by the B team. Can someone get me the A team document? I don’t want to waste my time with the B team document.”

 

TC comment

Defining non-GAAP KPI’s and what it means for investors

The following point relates to my previous book summary “The Outsiders”. I realize that the ability to creatively define the right key performance indicators is shared among great CEO’s and founders. Last post, we covered EBITDA defined by John Malone. Jeff Bezos is definitely another example of a founder who defines success by many unconventional metrics (e.g. long term absolute free cash flow, not GAAP profit margins).

In my opinion, investors trying to identify great CEO’s by checking if they use unconventional metrics is misguided however. Fraudsters are known to be very creative in defining new metrics. Many short-seller reports are full of criticism on creative metrics. Ultimately, the hard task for the investor is to think independently and check if these metrics make sense from a business owner perspective.

The value of a business is ultimately determined by a multiple to its absolute cash flow generating ability, not a percentage of GAAP earnings.

We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.

Our decisions have consistently reflected this focus. We first measure ourselves in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.

Book review: How will you measure your life – Clay Christensen

I made a decision to summarize books that I read to improve retention of the powerful insights.

After reading the phenomenal book The Innovators Dilemma (a review will soon follow), and watching Christensen’s talks on Youtube (see here and here) I was intrigued and decided to read more from this author.

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In the introduction of How will you measure your life, Christensen explains that many “high-achievers” from his Harvard graduation class (e.g. Enron’s Skilling and many others) never properly formulated their life’s purpose, priorities. After allocating most of their life to achieving very domain-dependent “success”, an alarming number ended up in jail, dead by suicide, or divorced.

Christensen lays out his framework, deeply influenced by corporate strategy & religion, to live a good life. Note that some religious anecdotes were difficult to relate with.

Takeaways

  • the trap many people fall into is to allocate their time to whatever screams loudest, and their talent to whatever offers them the fastest reward (and by the way, this is typically not family & friends)
  • Big Data is a buzzword. It is all about collecting as much data as possible. However, collecting more and more data from the past to predict the future is like focusing more on the rearview mirror. To predict the future better, you need powerful theory as well

“Data is by definition from the past” – Clay Christensen (about Big Data)

  • Jensen’s Principal-Agent theory (i.e. aligning managers financially will make them act as owners) is not sufficient to explain many anomalies (e.g. highly motivated NGO founders/employees). Two-factor theory tells us that financials incentives are not the same as true motivation, rather they are part of hygiene factors (necessary conditions for satisfaction, but not at all sufficient): bad hygiene causes dissatisfaction, best you can hope for is no dissatisfaction. True motivation comes from feeling appreciated by community for work delivered
  • management is a noble profession because you are able to help and motivate people
  • personal life lessons from discovery-drive planning: force yourself to articulate what assumptions need to be proven true in order for you to achieve success in a new job (same for happiness). What evidence do you have that makes you think [this job] is going to be something you actually enjoy doing?
    • Blogger James Altucher would answer this by saying you need to discover this by actually doing as much of it as possible beforehand)
  • investing in family and long-term friendship is more roundabout with longer term payoffs: what person do you want to be? Short-term, measurable payoffs lure high-achievers into under-allocating resources to life’s long term payoffs
  • lessons from marketing: many products fail because companies develop them from the wrong perspective: they “target” specific segments of consumers, instead of asking “for which job do consumers hire this product for?” Nobody hires a product because he is an 18 to 35 year old white male with a college degree. Examples: 1) IKEA’s success is partly attributable to doing the fast-furnishing job so well (one-stop shop for the job: fast & cheap). 2) McDonald’s milkshakes
  • if you work from the perspective of what job you are being hired to do (both at work and at home) the payoff will be enormous. One of them is being a spouse. It’s easy to make assumptions about what our spouse might want rather than work hard to understand the job to be done. Divorce often has its roots when one frames marriage only in terms of whether the spouse is *giving* what I want. True empathy & acting on it will make you happier
  • through his long life Christensen found that love for others arises mostly by investing in empathy & making them happy and not the other way around
  • create a consistent & good culture at home like great companies do (resources, process, priorities)
  • it’s easier to act 100% of the times in consistency with your values vs 95% (slippery slope)
  • formulate a likeness, a commitment and a metric for your life

 

“Treat people as if they were what they ought to be and you help them to become what they are capable of being” – James Allworth (co-author) via Goethe

This was a nice to read book. Sometimes the parallels Christensen draws between business and life are genius, sometimes they are a bit odd. In any case, it’s worth to go at least through the business case studies of the book. They are almost completely complimentary to those in The Innovator’s Dilemma.

Best,

TC

Book review: HBR Guide to Buying a Small Business

I just finished reading HBR Guide to Buying a Small Business.

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My interest was piqued by Patrick O’Shaugnessy’s podcast episodes on permanent capital/equity (see here for example). Later on, the authors of the HBR book came on the podcast (see here). It was clear from the interview that the authors had much practical experience in the field.

The book is definitely useful for acquirers of small businesses all over the world. It had some insights for public equity investors as well. Primarily, this is because many small business investor insights are applicable to public stock investors too:

Investing is at its best when it is most businesslike. – Benjamin Graham

General insights

  • a recurring statement was that small businesses (sub two million dollar in annual pre-tax income) are “generally” acquired for 3-5x EBITDA
  • equity partners in small business buyers typically require +25% IRR over a ~5 year span
  • small businesses are typically 60% debt financed: 35% senior bank debt, and 25% junior seller’s debt
  • seller debt aligns incentives with the buyer somewhat (as earn-outs do as well). Be wary of sellers that strongly object to a proposal to at least finance a small part of the purchase with seller debt (is the business going to fare well in the near future?)

Insights with parallels to value investing in stocks

  • Direct versus brokered search dilemma: just like in public equity investing, brokered search saves a lot of time in the initial phase (sell-side research) but one has to search longer before finding a cheap anomaly as the businesses are already “on the market”. Direct search might yield exclusive outliers.
  • Just like sell-side research, private company brokers first send out “teaser sheets” that are built to pique interest. Still, these documents can be a useful first source of data
  • Honing the skill of filtering: doing great business deals is always a trade-off between looking for more (and potentially even better) deals and doing more good deals more regularly. This ideas relates to the concept of decision making under uncertainty and bounded rationality (see here and here). In public equity investing, filtering is one of the most important skills to save money time. Investing, be it in real estate, businesses, bonds or stocks, is always primarily a negative art: avoiding losers. Having the right filters in place in each phase of investigation is very important. For example, you might want to throw 80% of teaser sheets in the bin immediately (having only lost 10 minutes per sheet). In the next phase you will invest more time calling the prospects and looking into more detailed financial data.
    • focus on not wasting time in the first phase: look for reasons to disregard a deal
    • each phase will become more time consuming. Make sure to not do the more time consuming detail tasks in the first phases (e.g. first call the seller, only meet in a later phase)
  • good returns are possible because there are many natural sellers (death, disease, divorce, partner disagreements) but not much natural buyers (private equity and other institutionals have to large a cost base to investigate <2M pretax p.a. businesses)
  • search for a business, not a job: try to find businesses that work well without a good operator
    • stocks: avoid key man (employee) risk. Note that Warren Buffett has been on record to choose good businesses over good managements any day
  • focus on enduring profitability:
    • preference for high recurring customer base: small businesses vanish faster than large businesses. This is why this quality is even more important.
    • slight yet profitable growth, avoid fast growth: it comes with new clients and these are less loyal and come with new demands which we might not understand (by definition we do not know churn rates of new clients)
    • if the company is enduringly profitable due to sticky customers/industry structure, its primary growth should not come from market share gains (this contradiction should be investigated in due diligence)
  • one of the first stages in due diligence is to check how much EBITDA the company is able to keep in free cash flow (i.e. cash flow conversion ability). Given two companies with identical EBITDA, the company that doesn’t need to reinvest in working capital and depreciating assets is clearly superior.
    • stocks: indeed, this is one of the treats of quality companies as defined by public equity investors as well (see for example Quality Investing)
  • the due diligence process has much in common with researching stocks (e.g. check accrual versus cash flow accounting for timing issues, check if company has been saving in maintenance Capex or employees in recent years to fetch a higher price). Some useful ones to add to a research checklist:
    • interview customers (what causes clients to switch? satisfied? key qualities of the product?)
    • interview employees: “what do you do here” (check also for capabilities)
  • the debt raising process: assets with values that are easy to determine fetch cheaper asset-backed debt.
    • stocks: the inability to lever up is a drawback for (typically high) ROIC service companies versus asset heavier businesses

Book examples of great small businesses

  • the importance of being unimportant
    • insect control chemicals provider for local governments, cost is only a couple of percent of the labor cost to spray the chemical. The cost is so small that even negotiating these deals is significant. Result: multi-year contracts.
    • a company treating metal tubes: the treatment cost is 45$ versus 1000$ manufacturing cost. The tubes are so heavy that it costs six times more to transport them to the end client (or nearest competitor). Other barriers to a competitor entering their region: finding a great location that facilitates transport near a railroad and highway, licenses to treating tubes, and lastly specialized workforce in a rural environment)
  • safety & reputation: a longstanding reputation is important when the service has a safety aspect or the product is crucial as an input to the client
    • high-rise building window washing service (own note: this business has friendly middlemen as the building facility manager is typically not the payer, being typically either an employee of the company or a third-party company facility management company. Friendly middleman have other incentives: they prioritise their own reputation and time consumption over cash cost. This is why they will take reputable companies and prioritize customer satisfaction, low hassle and safety over costs, see also Quality Investing)
    • Party equipment rental business: this is my favourite example as it is pretty counterintuitive. On first sight this looks like a commodity business. However, clients that organize 200+ people parties require speed and excellent execution for a party not to be spoiled. Spoiled parties carry immense reputational risk. Price is therefore not the prime consideration (note: this business has a local advantage as well as the parties need to be close to the base to be able to react fast to problems at a party or shortages, to minimize transport cost for heavy equipment). This business therefore has a good answer to the question: if this business is so good, then why is it so small/local?
  • emotional switching costs: nurse car for elderly people. Clients become attached to their nurse.

Note that the best businesses mentioned have combinations of advantages.

Own musings

  • the risk-diminishing property of control: assuming you are managing your own company, there is no principal-agent misalignment of interests. I assume this is the reason that small business buyers are able to use more debt in their transaction without taking on much more risk than public equity investors. Indeed, given some common sense, grave misallocation of capital is less likely as empire building and short-termism play less of a role for an owner-operator

Lastly, the book has much more useful practical advice to actually buy small companies that is not in scope here.

Weekend reading: essays by Paul Graham

I can recommend the very thoughtful essays of Paul Graham, co-founder of YCombinator. His essays were bundled in the book Hackers and Painters.

The Great Refragmentation

Along with giant national corporations, we got giant national labor unions. And in the mid 20th century the corporations cut deals with the unions where they paid over market price for labor. Partly because the unions were monopolies. [10] Partly because, as components of oligopolies themselves, the corporations knew they could safely pass the cost on to their customers, because their competitors would have to as well.

Economic Inequality

Inequality has no limit when the cause is providing wealth to society (as opposed to zero-sum games)

And while it would probably be a good thing for the world if people who wanted to get rich switched from playing zero-sum games to creating wealth, that would not only not eliminate great variations in wealth, but might even exacerbate them. In a zero-sum game there is at least a limit to the upside. Plus a lot of the new startups would create new technology that further accelerated variation in productivity.

So if you made it impossible to get rich by creating wealth in your country, people who wanted to do that would just leave and do it somewhere else. Which would certainly get you a lower Gini coefficient, along with a lesson in being careful what you ask for.

Notes on package holidays

We recently took an interest in the business Dart Group plc “DTG”.

My notes on the Package Holiday industry, as the high growing segment of DTG is Jet2holidays:

  • Necessary adjustments – the package holiday industry suffered as new tech competition (e.g. Booking, Expedia and later Airbnb) grew offering customers more choice:
    • Assimilation – One key advantage of online competitors for customers is customization (exact holiday length, start/end date, type of hotel room). The industry adjusted by offering more choice.
    • Consolidation & bankruptcies – TUI and Thomas Cook have increased their market share since the financial crisis. Size has brought some two-sided power on price.
    • Control – Recent strategy has been to increase control over customer experience by expanding assets on the balance sheet (hotels, planes). Large package holiday firms might scoop up a low-cost airline like DTG to increase control. Note: Jet2Holidays is very focused on customer experience (e.g. see news on unique resort check-in).
    • Differentiation – package holidays to remote places where booking websites are not as penetrated yet (First Choice’s strategy as early as 2005). A move away from commoditised package holidays boosts margins. In 2012, 3/4th and 2/3rd of TUI’s Nordic and British customers respectively booked such highly tailored holidays (2/3rd of German customers was “still” buying mass-market packages).
  • Renaissance – In part because of these adjustments, there has been a renaissance since ’08. Mintel forecasts a further 10% rise in demand by 2020. As of 2016 however, total package holiday demand is down 25% since its peak in the early 2000’s.

 

On all-inclusive package holidays:

  • value proposition
    • being spoiled by free lunches
    • peace of mind
      • holiday sorted out
      • no unexpected expenses
      • being looked after if holiday goes wrong (e.g. terrorism)
  • Growth  all-inclusive grew from 8% of worldwide holidays to 12% in the period ’10 – ’13 (PhoCusWright via Economist)

 

One last remark: Booking/Expedia/Airbnb charge quite high commissions (10-20%). This offers leeway for existence to others. It could also be a risk down the road if these commissions fell.

Notes on the European airline industry might follow.

 

 

References

A history of package holidays – Independent

A new package  – Economist

Tour operators are down but not out – Economist

Horrible holidays – Economist

Travelling on the same ticket – Economist

The return of the free lunch – Economist

From satanic mills to sundecks – Economist

Tour operators are down but not out – Economist

Thomson and First Choice to merge – FT.com

Different Towels – FT.com

Travel groups brace for holiday booking decline – FT.com

Tui to sell Hotelbeds Group for €1.2Bn – FT.com

 

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