On Note Taking, Writing, and Competitive Advantage
Do you want to think better? If so, writing is a good first step. A way to write better is to have a simple system that allows you to to take notes in a systematic manner, letting complexity bubble up from there (Beinhocker, 2006). This system will allow you to accumulate and compound insight, which Sonke Ahrens explains in his book: How to Take Smart Notes.
This system, known as a Zettelkasten, consists of two main components: literature notes and permanent notes. When you read something, have a pen in your hand to take notes on the content, summarizing what you think its important and what you don’t want to forget. You should then capture the bibliographic details in these literature notes so you have something to refer back to. Taking literature notes, in your own words, is a powerful test of concision and comprehension.
In the next step, you should make a permanent note, which is an elaboration or extension of your literature notes. When you do this, look at the literature notes you have just taken, and ask yourself, how can this idea contribute to different contexts (Ahrens 2017, 15), or why did I choose to write this down (84)? Other good prompts for developing permanent notes include: does this contradict, support, correct, or add to what I already have; can I combine two ideas to generate something novel; and what questions come from these ideas?
Over time, taking permanent notes is about making connections to other things you know, which comes from a mix of the theories, rules, mental models, and narratives you know today. Additional probing questions for permanent notes include: how does this fact fit into my idea of (x); can this be explained by theory; do these ideas complement or contradict one another; what is this argument similar to; have I heard this before; and what does (x) mean for (y) (Ahrens 2017, 60)?
When composing literature and permanent notes, I’ve found it helpful to use ideas from George Gopen’s Readers Expectations Approach, or REA, covered in his books: The Sense of Structure: Writing From The Reader’s Perspective & Expectations: Teaching Writing From the Reader’s Perspective. Your notes (both literature and permanent) should pass Gopen’s simple test of good writing: was the message delivered by the writer to the reader? If it was, then the writing was good; if it wasn’t, then the writing wasn’t good (Gopen 2014, 8).
Gopen’s focus on the stress position is also very useful for composing permanent notes as it helps clarify your thinking. He defines the stress position as the part of the sentence, usually at the end, that you most wanted to emphasize. For example, after reading the sentence you just composed, you may realize: there is more than one candidate for the stress position, implying you may be conflating or juxtaposing two separate thoughts; what you wanted to emphasize was not in the sentence, but in an implication hanging above it; or, you may realize nothing was worthy of emphasis, and as such, the sentence (or note) should be reduced to a phrase or clause (Gopen 2014, 14).
When storing a permanent note, don’t use topics and subtopics — you want to keep things as simple as possible and let complexity build from the bottom up. Identify notes in the context within which you may like to see them again, whether those words are in the note or not (Ahrens 2017, 38).
Why is any of this important? I believe both taking notes and good writing, enforces good thinking and can be a competitive advantage. As the world transitions to knowledge work, exercising this writing muscle is essential. Not only can writing confer an individual competitive advantage, but it can do the same in businesses.
For instance, in the book Working Backwards: Insights, Stories, and Secret from Inside Amazon, the authors explain how Amazon relies on the written word and have banned Powerpoint (Bryar & Carr, 2021). They point out that Powerpoint, due to its format, prevents ideas from connecting to one another and makes an audience more passive (83). Amazon instead has its teams draft a six page narrative, complemented by tables, graphics, and numbers, that is read at the beginning of meetings, which they believe allows them to think through issues more deeply, foster better discussions, and finally make better decisions (Bryar & Carr 2021, 83). As the work becomes more complicated and relies more on human capital as an intangible moat (Wu, 2021), writing is must.
Even when it develops new product, Amazon uses a document in the form of a press release and frequently asked questions, known as a PR/FAQ, to develop new products. This is a living document used to ensure a new product will benefit customers, determine whether its feasible, and whom you are reliant on to introduce the product.
In another example, Twilio, in its annual report, writes the following in the context of how it makes decisions: “Write It Down. Our business is complex, so take the time to express yourself in prose (emphasis mine)—for your sake and for the folks with whom you’re collaborating.”
In conclusion, if you want a leg up for yourself, develop a note taking system and take the pains to write clearly. Also, pay attention to organizations that prioritize writing — they may actually have an superior competitive advantage to those that don’t over the long term.
I would love feedback on this and any other examples of companies that focus on writing. Thank you.
How Asia Works, A Summary Rephrasing
I recently finished How Asia Works. Instead of my format I used in the last few post, I tried a slightly different format. I took what I thought were the most important ideas and wrote a brief essay describing the book. In other words, a brief rephrasing. Let me know what you think.
Introduction
How Asia Works: Success and Failure in the World’s Most Dynamic Region, a book by Joe Studwell analyzes the rapid economic development of Japan, Korea, Taiwan, and China. The author analyzes the successful policies of these nations and compares it to the less successful policies in Malaysia, Indonesia, and the Philippines. Studwell argues there is a consistent “recipe” for economic development: 1) developing agriculture as a form of “large-scale gardening” that maximizes output, putting a large and relatively unskilled population to work, 2) making investments in export-oriented manufacturing to encourage technical learning, and 3) developing a closely controlled financial framework in service of agriculture and manufacturing and not deregulating financial markets too soon. The interesting conclusion from this framework is the idea there are two types of economics: economics for early development and market economics for a developed country.
Step 1: Agriculture
A developing nation must first address its agriculture to put its population to work and maximize output. This takes the form of “large-scale gardening” which will not be as efficient as “scale” farming, but seeks to maximize output1. Economic theory tells you “scale” farming is the way to do this as its “efficient”. This may be true if your goal is efficiency, or to maximize returns on capital. In an early development stage, many nations should not focus on this, but rather on maximizing output. Many Northeast Asian nations that reorganized their agriculture did so by employing a land policy based on “land redistribution”.
Land redistribution was redistributing land into equal parcels for all as opposed to having concentrated land ownership. While it may seem drastic and unfair, it creates the conditions for perfect competition many economists dream of (Studwell, 2014, 10). This policy results in output growth as competition realigns and removes the perverse incentive of powerful landowners. For landlords, it is easier to raise their return by raising rent than by helping farmers increase yields. This creates a vicious cycle: higher rents result in less money for farmers to invest in the land, keeping yields low. Land redistribution policy breaks this cycle; research in the book explains equal land distribution correlates well with future economic growth (Studwell, 2014, 10). Once output is maximized, this prevents countries from having to import food and creates consumption for industrial development, leading to more political stability and upward mobility (Studwell, 2014, 66).
Step 2: Manufacturing
After developing its agriculture to maximize output, a developing nation should then invest in its manufacturing to promote industrial learning. The author points out these nations should begin with infant industry policy that protects domestic firms, allowing them to learn and grow. This policy highlights another interesting divergence between economic theory and economic history. While many economists will tell you to leave it to the “market”, history shows many economic powers developed with protectionist policies in early stages such as England, France, Germany, and the United States. After nurturing these domestic firms, you must allow them to compete, but not by picking winners or national champions. Instead, you eliminate these underperforming firms by shutting them down or forcing them to merge into more successful firms.
The next effective policy measure is something Studwell calls “export discipline”: the idea that as firms are learning, they should make goods for export to the international market as this is the true test of competitiveness, providing feedback on investments firms are making. To encourage industrial learning, successful nations such as Korea did not enter into joint ventures with multinationals as the arrangement creates technological dependence. Instead, Korea partnered with a Mitsubishi, a weaker Japanese firm, to learn its technology while also seeking out opportunities to learn about technology and processes from many other auto manufacturing firms. In addition, Korean firms did not want to blindly trust technology, but wanted to understand the “nuts and bolts” of how everything worked even if the process was outdated or more manual (Studwell, 2014, 142).
By understanding the basics, getting a variety of perspectives, and insisting on technological independence, Korea became a force in both automobile and steel manufacturing. To summarize, after a period of initial protectionism, a developing nation’s manufacturing policy should seek to spur domestic competitiveness and then international competitiveness via export discipline.
Financial Policy
In order to properly develop agriculture and promote industrial learning, a developing nation must tie its financial policy to these two goals. The simplest way to do this is through the banking system and provide credit based on export performance. Another means is to impose capital controls in early development stages. Some countries took the advice of developed nations that said to deregulate financial markets prematurely. This may help in developed countries but not in developing ones as capital markets are harder to control.
Premature financial market deregulation results in speculation and bubbles, not efficient capital allocation. A key takeaway from this book is that entrepreneurs are very similar while the policies surrounding them are different, yielding different results. This premature financial deregulation advice is another instance in which economic theory and policy do not align in an early stage of development.
Conclusion
In conclusion, economic development policy in early stages and economic theory do not seem to coincide judging by outcomes. In agriculture, a focus on output versus efficiency initially drives the gains to get a population working and productive. In manufacturing, protectionist policies to get businesses off the ground is effective based on history. The “market” cannot cure all: without land redistribution or incentives to export, landlords and entrepreneurs will take the “path of least resistance” to increase their returns, which do not align with national economic development goals in an early stage.
Incentives matter in all these stages and policy helps drive them. Finally, premature financial deregulation results in bubbles and speculation, not in efficient economic development or capital allocation. There are two types of economics: the stages described for development and a market economy based on efficiency, profits, and deregulation (Studwell, 2014, 269).
Expectations Investing, Some Interesting Takeaways
Similar to what I did for Trade Wars Are Class Wars, I wanted to share a few takeaways from a book I recently reread: Expectations Investing: Reading Stock Prices for Better Returns by Michael Mauboussin and Alfred Rappaport.
I will provide a brief summary of the book and share some interesting takeaways I had from reading it. Later this week, I will post my notes from the book. While written in 2001, this book has a flexible framework that is still very relevant for business analysis. On a recent podcast, Mauboussin mentioned he may update the book. Fingers crossed!
Brief Summary
The book has a simple premise: stock prices reflect the sum of investor expectations at any point in time. To achieve superior returns, investors must calibrate and understand the expectations built into a stock price.
The authors advocate using a “reverse DCF” to determine expectations. In essence, a reverse DCF starts with the current price, backing into a set of cash flows that justify today’s price. You can start this forecast by using Wall Street consensus estimates and extend it out until you have enough years of free cash flow to get to today’s price. I would note the book has a website if you want to download the model and see it for yourself.
The book then provides a framework to analyze how a company creates value based on its value factors2. Next, the book goes into several frameworks to analyze both industry economics and competitive positioning such as Porter’s Five Forces, value chains, Clayton Christensen’s Disruptive Technologies framework, and others.
Finally, the book concludes with discussions of how corporate events such as mergers and acquisitions, share repurchases, and executive compensation can signal changes in expectations.
Mental Model for the Stock Market
This book dispels the notion that the stock market is “short-term” and explains that the market values stocks on long-term cash flow expectations. In 7 Powers, Hamilton Helmer says the same thing:
“In public markets, value is determined by and changes based on expectations of future free cash flows”. Just because prices move in the short-term doesn’t mean the market is short-term. This is just the market reacting to what current performance may indicate about future performance, continually reshaping future expectations.
The simple way to think about this is if the market is short-term, every stock would trade at 1x its earnings or cash flow, but they don’t. This implies the market takes a long-term view, but not necessarily the correct view. The difference between what happens and how the market views it shows where money can be made, a point the authors stress throughout the book.
The mental model I formed from reading this is the market values stock on long-term cash flow expectations, but allows investors to make short-term bets on long-term outcomes. The market provides liquidity so a short-term view can be expressed, but its still based on a long-term outcome.
Value Creation & Economics
I often hear words or phrases repeated so often they lose all meaning to me. For example, strategy used to be one of these words, but reading 7 Powers has help me clarify it in my mind a bit.
“Value Creation” is another one of these phrases. What does it mean? To me, creating value means creating benefits for the customer. However, any business can create benefits, but incurs costs to do so. In an economic context I define value creation as creating a positive spread between benefits and costs.
At a company level, it gets a little more specific. Is it enough to generate a positive spread between benefits and costs? The answer is no. If you borrow or raise money, investors expect to earn a return on that money you will be measured against. That is your opportunity cost of capital. If the return earned on your investments is less than that cost, you are not creating value.
Value Creation in the Company (ROIC)
In this book, the Mauboussin and Rapport explain that a company creates value when it invests at a rate that exceeds the cost of capital. How do you measure that rate? I believe return on invested capital (or “ROIC”) is a good place to start. So, just like above, you aren’t creating value in a business context unless you generate a positive spread between ROIC and the cost of capital.
To understand if a business is creating value you must understand its unit economics. What does this mean? I will let Mauboussin explain in a more recent piece he wrote as he says it much better than I can:
What is in an investor’s control is gaining a solid understanding of a company’s prospects for creating value. This requires a grasp of the basic unit of analysis, which answers the fundamental question of how a company makes money. The basic unit of analysis for Walmart, and other retailers, is the return on investment for a store. Net present value is the tried and true way to conduct this analysis. A store creates value if the present value of future free cash flows it generates exceeds the investment the company makes in it.
Michael Mauboussin, “One Job”
Studying unit economics helps you figure out the return on one store, customer, or transaction.
This book provides a framework to assess company prospects for value creation by identifying its value factors, which drive its value triggers and value drivers. Value factors are the underlying drivers of revenue, cost efficiencies, and investment efficiencies. These value factors determine the value triggers of sales, operating costs, and investments. In turn, these value triggers imply the value drivers of sales growth rate, operating margins, and the investment rate. These variables drive expectations of future free cash flows.
Real Options
Although the authors use a reverse DCF as the basis for investor expectations, they also acknowledge that not all value will be captured in a DCF. Sometimes, a company can have some of its value attributed to real options. Real options are business decisions to expand, defer, wait, or abandon a project which all have economic value.
The authors point out that you can analyze a company’s investing patterns to see if they exploit real options or contain some kind of embedded optionality. The book does a case study on real options using Amazon’s real option to further expand in the e-commerce market. When the book was published in 2001, Amazon had a market cap of $22 billion(!).
Amazon, the Real Options Machine
With the benefit of hindsight, Amazon has been a “real option machine” over the past twenty years. For instance, the birth of Amazon Web Services, reflects the idea of real options well. Amazon was having trouble scaling its IT resources quickly, so it organized its IT infrastructure into compute, storage, and database. It was quite good at it and invested heavily in it.
At some point, Amazon realized it could offer this business as a service, so its investments reflected embedded optionality to create a new line of business. Today, AWS may be the most valuable business Amazon has. They also seem to be in the early stages of doing the same thing with logistics($).
I don’t know if Amazon views it this way explicitly, but I am not sure they view costs as “costs”. What I mean is they look at large cost centers as an opportunity to offer services to others that will create not only offsetting revenue and but give them the ability to scale further, reducing units costs and enhancing scale advantages.
Inputs vs. Outputs
Mauboussin makes the point in this book and other places that multiples are not valuation. I’ve spent time in both investment banking and private equity, and more often that not, valuation is determined by some multiple range (usually chosen in reference to comps) applied to said metric. Slapping on a multiple on a metric confuses inputs with outputs.
What determines valuation multiples are the value drivers: sales growth, ROIC (driven by the operating margin and investment rate), and the discount rate.
Cash flows drive valuation and they can correlate to earnings, but are not the same thing. Earnings have a few weaknesses, with one of the most notable being they don’t account for opportunity costs nor investments in fixed and working capital.
Multiples in the context of M&A and Share Repurchases
Valuation multiples are not only bad for valuation work, but also for evaluating an acquisition or calculating the return on a share repurchase. Just because an acquisition is accretive based on multiples doesn’t mean it creates value. For an acquisition to create value, the present value of synergies must be greater than the premium paid. This makes sense: the present value of future benefits in a combination must be greater than the premium paid.
The same idea works for share repurchase. The return on a share repurchase is not the inverse of the P/E multiple. For example, if a stock has a P/E of 10, the return on a share repurchase is not 10%, or 1/10. The authors stress the return on a share repurchase must consider the cost of the capital and the discount at which the stock can be purchased relative to what management thinks its worth. For example, if a company has a cost of capital of 10% and stock that is trading for $8 a share, but management believes its worth $10, a share repurchase would have an an implied return of 12.5%3.
This framework is more robust as it implies there are diminishing returns to buying back stock. This would be true in cases where it trades above where management thinks its worth. Said another way, if management thinks its stock is overvalued it is probably the time to issue some!
Conclusion
I reread this book after reading it several years ago and came away with some rich notes I intend to post. Although its dated, a lot of the lessons are timeless and I suggest you pick it up.
Please provide any feedback below and I will update this post with a link once my notes are up.
Trade Wars Are Class Wars, A Few Observations
I just finished Trade Wars Are Class Wars by Matthew Klein and Michael Pettis, a book about the history of global trade that I think deserves your attention.
Below, I will provide a brief summary of the book along with some themes that I took away from it. If you are more interested, I will post more detailed notes next week and would also suggest picking up the book.
Brief Summary
The central theme of the book is that inequalities within countries are being misinterpreted as trade disputes between countries via “trade wars”. The current open system of global trade with the US dollar at its center was fine when the United States was large share of the global economy. However, the US economy is now a much smaller proportion of the world economy and the system is showing strains.
The book begins with a history of global trade starting with Adam Smith’s theory of specialization and ending with illustrating the complexity of Apple’s global supply chain. Next, the books goes into trade basics such as understanding that financial flows drive trade flows and how savings, investment, and trade imbalances occur. Next, the book provides historical context for two surplus countries (China and Germany) and a deficit country (United States). Finally, it makes some recommendations on how fix the problems of the imbalances that have occurred.
Next, I share some themes I came away with.
Global Trade Today
Before reading this book, I naively assumed low trade barriers were good for all. Unfortunately, that doesn’t seem to be the case. Open systems have benefits as well as costs. The open system of global trade today is subject to imbalances and bad incentives. These imbalances cause tensions between countries that really reflect inequality within countries that most can’t seem to square. Said another way, we like our cheap stuff, but it may be cheap because workers in other countries are not getting a fair shake.
For example, consider China and Germany, two economies that are export driven. They export more because their goods are cheaper. However, the authors argue this is not because they are more efficient, but rather the reflection of inequality within their countries. This inequality is a result of a domestic policy that subsidizes production at the expense of consumption. These countries suppress consumption of their workers to keep goods cheap. The value that doesn’t flow to workers instead flows to business owners who do not consume but rather save the capital they accumulate.
To compound matters, the wealthy people in these countries do not invest it domestically but abroad accumulating foreign exchange reserves. In effect, those countries overproduce for domestic needs, and export the difference to the global market. Even now, the two countries I mentioned above are now at odds ($) as they compete for export market dominance.
Unfortunately, these actions affect other countries as well. For example, from 2000-2010, the United States closed 66,000 manufacturing facilities as they are no longer competitive with global imports. Countries who force workers to under consume deindustrialize the countries that absorb the excess production.
Advances in technology have made global supply chains more efficient and complex, increasing profits, but also compromising both resilience and optionality. Make no mistake, optionality has value as we have seen during the COVID-19 pandemic. In an ironic twist this pursuit for efficiency has come at the cost of global supply chains being “weaponzied“, creating a modern day hold-up problem. Advanced economies always move up the chain into higher “value added” activities, but that doesn’t mean value chain activities such as manufacturing aren’t important, and in fact may be matters of national security.
Finally, this book pointed out that analyzing trade data and bilateral trade imbalances are not effective. Trade data is not useful because the country exporting the finished goods gets credit, but often raw materials and components originate in other countries. Bilateral trade data is also not useful given all the differences balance out on a global level. This means the imbalance between two countries is reflected somewhere else. Stated simply, viewing the US / China trade imbalance does not give you the whole story. Only global relations matter. This makes policy such as tariffs a tool that either has no impact, or the cause of additional harm.
Infrastructure & Innovation Drive Development
Initially, global trade was simple, consisting of raw materials and finished goods. There was really no infrastructure or ability to trade intermediate goods. The development of infrastructure, better communications technology, and the shipping container changed all of that. These advances spawned strong growth in global trade and led to complex global supply chains.
I thought I heard this story before, and I was right. The opening chapter of Economics of Strategy analyzes the business environments of the United States in 1840, 1910, and today to show that advances in infrastructure and technology reduced coordination costs. This allowed firms to develop from small businesses with a local presence to become large corporations who sought to expand markets and exploit scale and scope economies. The same thing has happened with global trade, but the markets are not going from local to national, but from national to global.
Capital Allocation
Capital allocation is a topic I often think about, but usually at a firm or even individual level. This book helped me realize capital allocation also occurs at the national level, which is really a sum of the individuals, business, and governments decisions.
At the national level, capital allocation is influenced by a country’s economic development priorities expressed through its monetary and fiscal policy choices. This book also highlights, much like people, nations are not always rational capital allocators. This of course makes perfect sense given countries are made up of people who make the decisions.
The authors point out that many countries accumulate US reserves not because they represent the best investments, but as a form of self-insurance against catastrophe. This is not to say it doesn’t make sense within the current system, but it is certainly not the most rational use of capital.
In other cases, ideology can trump logic and cause countries to misallocate capital. The authors point out that Germany likes a balanced budget and abhors public debt. They also contend Germany should have taken on public debt to improve its infrastructure instead of investing its excess savings abroad. This idea may have some merit.
Capital flows from other countries seeking safety have to go somewhere. If the government chooses not to issue debt, that capital makes its way to businesses or even individuals and this has been the cause of many recent bubbles, both historical and present day as the book explains.
Scarcity vs. Abundance
A theme I run into a lot is that of scarcity versus abundance. Ben Thompson argues in a world of scarcity, distribution power served as a moat for many companies that the internet has decimated. Now, value in the value chain has accrued toward the ends which he aptly explains how the internet is best defined by the smiling curve.
The authors make a similar point, but in terms of an age old tradeoff between savings and consumption. Delaying consumption to fund investment and increase production is not as important as it once was now that resources are abundant.
The takeaway here is more value will come from increasing consumption (demand) than by saving money that ultimately goes to find safety. The authors posit that consumption and production can push one another forward in the form of a positive feedback loop. Greater production, if transformed into higher wages for workers, would encourage them to consume more, which would help expand production. We often hear global growth is slow which makes this idea interesting to me. Is it because there is not demand, or that we are artificially suppressing demand through policy?
Conclusion
This book was an excellent primer on the system of global trade and provided great historical context that has led us up to today.
It also gave me a better understanding of how interconnected our world is and how choices made in one place can affect others far away. I am glad I read it as I feel we will hear a lot about global supply chains going forward.
Update: I posted my book notes here.
Cost Structure Impacts What Firms Do
This seems obvious, but physical and digital goods have very different cost structures.
That said, it still warrants further examination and explanation for the layman. Today, I’d like to address distribution and production costs.
Distribution Costs
Distribution costs get your product to market. For physical goods, the marginal cost of selling one more unit are high. Physical products have higher marginal costs as they involve real world “frictions” such as shipping, storage, and retail / placement fees given the physical limits of warehouse and shelf space.
These costs can decline as a business gets larger. In other words, as you ship, store, and sell more products, costs should decline from Scale Economies. Eventually, these costs will reach some point at which they don’t decline anymore. This is know as diminishing marginal returns.
Now, consider digital goods. Examples of a digital good include an e-book, a software product, or a Netflix subscription. These goods have lower marginal costs of distribution. Typical distribution costs for digital products include website hosting fees and platform fees.
Website hosting fees are fixed and platform fees run about 30% of the retail price. Some think that 30% is high and that is why Epic Games has gone to war with Apple over this fee charged in the App Store. Ben Thompson has written a great article on Rethinking the App Store that I recommend you read.
The key here is marginal costs. Website hosting fees and platform fees can be very high in the aggregate, but low at the margin. In other words, variable distribution costs are higher for physical products than they are for digital products.
Production Costs
Like distribution costs, production costs differ for physical and digital goods. Physical goods are comprised of raw material inputs. To sell more products, you need more raw materials. This expense is variable. Variable costs change with output and fixed costs do not.
For physical products, the production process involves some mix of machines and people. These costs are actually semi-fixed in that they are fixed within ranges of output and variable between ranges of output. As a business grows its volumes, these costs will increase in steps. Just to recap, physical goods incur a mix of variable and semi-fixed costs to get the product through production.
Digital products do not incur variable production costs. They can be duplicated at essentially no marginal production cost. Digital products are developed by people such as software engineers or authors in the case of an e-book. There is a cost for sure, but this cost is fixed. The fixed costs of production may be higher for digital goods, but there is very little in the way of marginal costs.
Conclusion
Above, we have described how the cost structure of both distribution and production is different for digital goods. The composition of the cost structure has changed and resulted in much higher fixed costs and much lower variable costs.
Companies have more operating leverage than ever before. It is easier to get larger and there is more incentive to do so.
Bundling
This is how and why technology companies get so big. It is simply much easier to scale. Lower marginal costs have spawned bundling strategies and made them feasible and possible. Bundling allows companies to leverage the cost structure we allude to above of high fixed costs and low marginal costs. Bundling also allows companies to accommodate heterogeneous tastes and customer acquisition costs. Amazon Prime is a “super bundle” of physical and digital products.
The “Pie”
Economic policy decisions often face a trade-off between “enlarging or shrinking the pie” and “splitting the pie”. Technology companies face a similar trade-off with many decisions. Consider the Apple and Epic situation mentioned above. With low marginal costs, decisions to enlarge the pie will almost always be better than decisions about increasing your slice of it. Why? Because your dollars of profit will always be greater. The cost setup we mentioned above makes this trade-off easier than ever before.
Industry Economics, Business Model Design, and Destiny
We have all heard something like this before: the restaurant business is a tough business. Restaurants are tough because there is a lot competition, changing tastes, and a fixed cost structure, with food, labor, and rent eating up a lot of the margin.
This post really isn’t about restaurants, but to highlight there are many industries with a reputation for average or even poor economics, yet there are businesses in those industries that thrive. It is valuable to understand why. This was in part motivated by a passage Eugene Wei shared in a recent post on TikTok:
They say you learn the most from failure, and in the same way I learn the most about my mental models from the exceptions.
Studying exceptions helps us realize that industry economics are not destiny. You can do well in an industry with average economics if you approach things differently that everyone else. One way to do this is to choose a business model that will position you differently than the competition. This will also lead to you performing different activities to create value.
I will highlight two examples, one in retail with a well known business and another in the lending space that is a start-up.
Retail
Like restaurants, retail is a tough business and for many of the same reasons. Lots of competition, changing tastes, and a high fixed cost structure. Yet, there are exceptions and the one we will discuss here is Costco. I read this piece on Costco from 2005 in which investment manager Nick Sleep lays out his “Scale Economies Shared” thesis and why the business is a perpetual growth machine. He was obviously right given its market capitalization is up 7x from $21 billion from where it was in 2005! Costco has created a tremendous amount of value and captured some along the way.
Costco is able to do this because it does things differently. It can do things differently because its business model allows them to do so. This business model both drives value creation for the customer and allows them to capture some of that value. Retail industry economics are not destiny because of how it is positioned.
Most retailers try to profit on the spread between the price they buy from suppliers and the price they sell to customers. Costco does something different. They intentionally keep gross margins low and do not mark up anything more than 10-15% above what they pay. This both aligns interests with customers when negotiating with suppliers and creates a ton of value for the customer as Costco passes the savings to them. The piece I link to raises an important distinction: supermarkets make money buying from suppliers whereas Costco makes money selling to its customer. Its a subtle distinction, but an important one.
We’ve addressed how Costco creates value, but how do they capture it? It doesn’t make money on marking up goods, but on memberships fees. Costco has applied a subscription model to retail that Amazon copied with Amazon Prime. The annual membership fee is $60 and they have 98,500 members as of the last 10-K which equates to around $6 billion in revenue. It is also important to note this revenue requires very little marginal cost and is almost all profit.
The membership fee model and its low markup in which it passes its purchasing savings to customers enables strong retention. After all, Costco may sell goods, but its real business is to add new members and retain them. Costco earns good returns with this model as its goal is to continually grow sales volume and its membership base. It earns a decent return on invested capital (ROIC) not because of its margins but because of its turnover (Sales / Assets). This enables a very strong business model that is hard to compete with. Not to mention, its scale is now large and its margins are low making it very defensible.
Costco succeeds in retail because they play a different game enabled by a different business model. Its strategy to grow sales volume and its business model are very complementary to one another, each pushing the other forward.
Lending / Payments
In a recent piece, Marc Rubinstein gives a great overview of both the lending and payments businesses and how they are different. I suggest you read it in full.
He explains that in lending you are not only in the lending business but also the funding business. The interesting thing is these two businesses are not really complementary to one another. So, its tough to scale and expensive to get and retain customers making the economics average or even poor.
He then explains how the payments business is more complementary which allows for better economics. The payments business has a consumer and merchant side that mutually reinforce one another. Also, the payments business has more frequency than that of lending, allowing for lower customer acquisition costs and higher retention. The two sided network of consumers and merchants combined with this frequency allow for both high growth and more predictable economics.
The contrast between lending and payments is interesting as companies pursue novel business models taking elements of the payments business but applying them to the lending business. The two firms Marc mentions are Afterpay in Australia and Affirm in the US. I had not heard of Affirm until bought a Traeger Grill this summer. I probably should have – they are planning to IPO at at a $10 billion valuation. That is a large valuation so they must be doing something interesting and it seems they are.
Affirm is a point of sale lender with a different business model than that of a typical lender. They appear at the point of sale, so its cheaper for them to acquire the customer. The customer is ready to buy. Another interesting thing is they are not paid by the customer, but rather the merchant. The merchant pays around 4-6% of the transaction versus the 1-3% they pay to credit card companies. The fee is higher, but if Affirm can increase sales conversion it may be worth the higher cost. These business model elements of being at point of sale and paid by the merchant take elements of the payments business and apply it to lending making the economics potentially better.
From the customer vantage point, Affirm takes all the best elements of a credit card and debit card. It offers an installment plan where you can pay down the cost in four installments over two months. We use credit cards to delay settlement but hate that pesky interest. Affirm doesn’t charge interest as long as you pay. We use debit cards to avoid interest, but you need to pay right away. Affirm lets you have your cake and eat it too. It combines the best elements of both.
Affirm’s business model offers a lot value to both the customer and the merchant. As more merchants sign on more customers will know about it. As more customers know about it, they may ask more merchants to add Affirm as an option. If Affirm increases conversions for merchants they will likely be happy to use to them. Each side could push the other forward, like in payments. In addition, Affirm will likely get better at making payment plan offers as they collect more data as they grow. This seems powerful, but I am not sure how power yet.
Affirm offers an interesting substitute to paying with a credit card or debit card. When this S-1 comes out, I will be sure to read it to better understand the economics. They may not be the next Costco, but they have created an interesting business model that is worth our study.
Conclusion
A business can alter its economic destiny by changing its business model. Industry economics are a powerful force, but business model choices can allow a business to both create and capture value differently to become exceptions to the rule.
Studying those exceptions help us figure out why that business may be doing better and will hopefully make us smarter.
First Essay – Sunk Costs
7 Powers, a practical Strategy read
I recently re-read an excellent business strategy book, 7 Powers: The Foundations of Business Strategy, by Hamilton Helmer. I read it about two years ago, but it really didn’t stick with me back then. Part of this may be that I didn’t have a great system for absorbing what I read, but I *think* I have a better one now. Please note I intend to write about my evolution of reading, learning, and note taking in a future post.
I was a bit conflicted in writing this up in that there has been a lot of good coverage of this book. That said, I intend to keep it short and sweet. I will link to that coverage at the bottom, including a podcast interview with the author.
I will explain i) Why I liked the book, ii) Describe the 7 Powers, and iii) List Takeaways from the book.
Why I liked the Book
I really liked the book because up front provides a clear and consistent framework for terms that have always seemed “foggy” to me. These terms are Strategy, strategy, and Power. A lot of Strategy textbooks will define terms and give anecdotes, but when I finish the book I’ve never connected it to concepts I discover later. Going forward, I feel like I have a path now. Helmer states the framework is meant to be simple, but not simplistic and I think this is useful. Lets jump right into the terms:
Strategy: the study of the fundamental drivers of business value.
This was useful me in that it differentiates between the study of a discipline and what a company should be “doing”. We can say Strategy is studying what drives business value and this seems important. Next, lets define the concept of strategy.
strategy: a route to continuing Power in significant markets.
Note this is different from the above. Strategy is a study of strategy. Is that confusing? Perhaps, but it is meant to separate the study of a general discipline from what a company’s mission should be. And what should companies be doing? They should be looking for sources of Power they can wield to create and maintain a competitive advantage.
Power: a set of conditions that create and allow for persistent, differential returns.
For a business to have a true strategy it must have Power. This usually involves recognizing a source of Power and then seeking to exploit it. Helmer emphasizes Power must have a benefit and barrier component. The benefit serves to increase cash flow through some combination of higher prices, lower costs, or lower investment needs. We come to a key point: many companies can create benefits and increase value (to customers), but they need a way to capture some of the value they create. So, that means the barrier is the key; a company needs a way to not only capture value, but keep competitors at bay. Taking the benefit and barrier a step forward, the benefit determines the magnitude of free cash flow and the barrier determines the duration of the free cash flow. The combination of these two discounted to the present determines value.
Finally, I like how Helmer divides the book between the “statics” and “dynamics” of Strategy. Statics describe the “being there” of strategy after you’ve attained Power. It describes the end state of where you want to be and we will cover the types of Power in the next section. He then spends the last two chapters of the book explaining the dynamics of strategy, or the “getting there”. He does this because sometimes describing the statics may give you a mistaken conclusion about what you need to do. For example, based on statics, you may decide you “need to get big”. Scale may be important, but you want Power and merely getting big doesn’t guarantee it.
Description of the 7 Powers
Next, we will touch on the 7 Power Helmer identifies as statics of “being there”. The goal is to be both brief and informative. Again, if you want to dig in, reference some of the links at the bottom as they do an excellent job providing more depth.
Scale Economies is a decline in unit cost with increased volume. The benefit to the leader is a cost advantage that results in increased cash flow. The barrier to the competition is that it will be painful for the challenger to gain share while the leader has this cost advantage. A good example of this is Netflix’s Power with its cost per subscriber given its large subscriber base. Scale Economies is an exclusive source of Power in that only one can have it. A key consideration for this Power is how much of the industry cost structure is fixed. In other words, having a large variable cost structure won’t help you here. Asset-light logistics companies have very variable cost structures which they tout, but that implies this Power is hard to come by.
Network Economies is when the value of a product increases as the installed base increases. The benefit here comes from a price premium the leader can charge, increasing its cash flow. The leader charges for it directly or indirectly in its advertising rates (i.e. Facebook or Google). The barrier to the challenger comes in the form of losses to try and catch up. Like Scale Economies, Network Economies is an exclusive source of Power so there may be no challenger as its “winner take all”. Network effects can also exist, but without Power. Finally, attracting complements (i.e. application developers) can be an indirect network effect that’s important depending on the industry.
Counter-Positioning is when an entrant adopts a new business model that is superior and the incumbent is unwilling to respond because of collateral damage to its existing business model. The benefit to the challenger is that the new business model is superior and results in higher cash flow. The barrier actually comes from incumbent’s fear to abandon or shift its existing business model. This fear comes from some combination of sunk costs, opportunity costs, and high margins embedded in the existing business model. Again, Netflix is the example here as we discussed in this post in its fight with Blockbuster. Unlike the first two powers, Counter-Positioning is not exclusive source of Power as others can adopt the new business model. For Netflix, they had Counter-Positioning relative to Blockbuster, but they needed to Scale Economies to have a viable long-term strategy.
Switching Costs occur when a customer determines a greater loss than value gained by switching to a competitor. The benefit allows the company with Power to charge a higher price. The barrier is that the challenger must compensate customers for switching costs to induce them to switch and its usually uneconomic to do so. A firm can grow its switching costs by launching new products and making acquisitions. Like Counter-Positioning, Switching Costs is not an exclusive source of Power and can lead to other Powers such as Network Economies and Branding.
Branding is an asset that conveys information to consumers and invokes positive feelings, increasing their willingness to pay (WTP). The benefit is a price premium for the brand that stems from a combination of positive feelings, associations, or uncertainty reduction. The barrier to the entrant is the time, costs, sunk costs, and uncertainty it takes to build up a brand. This Power type is non-exclusive and is typically stronger in consumer markets than in business to business markets.
A Cornered Resource is access to an asset on attractive terms that enhances value. The benefit comes from having a superior deliverable that results in price or cost benefits. It comes in the form of a person, patent, or access to some resource. The barrier depends on the nature of the resource, but it could be personal choice (if a person), property rights (if access to a resource), or patent law (if a patent) depending on the nature of the asset. For example, Helmer considers the Pixar Animation “Brain Trust” of Steve Jobs, Ed Catmull, and John Lasseter a Cornered Resource. This access needs to come at a non-arbitraged price meaning the holder of Power does not pay “market value” for this asset.
Process Power is a compounding of company activities to improve product benefits or lower its costs. The benefit to the company is driven by improvements in quality and cost that persist even if employees leave. The barrier is the time it takes to build these improvements. Also, these activities may not be copied because the process is complex and opaque. A key point to make is operational excellence is not Process Power. Operational excellence is table stakes and not a strategy. Helmer gives the example of the Toyota Production System as an example of Process Power.
Takeaways
Any discussion of strategy must address a path to Power. If management tells you about a “strategic acquisition”, you should pause. Ask yourself: does this lead to Power? If so, how? I believe the definitions given above along with the Powers provide a good filter for industry analysis. Any time the word strategy is mentioned, I hope this book primes me to pause.
A Power’s exclusivity dictates the pace. With Scale Economies and Network Economies, the goal should be to build scale or the installed base quickly. Branding, Switching Costs, and Process Power all take time to build up so its about careful decision making.
Invention is powerful in that it not only opens the door for Power, but can also expand the market size to create more value. Value is when a customer gets more for less. Invention leads to the potential for Power, but you need a barrier to obtain Power. Industries in flux is a good place to search for Power.
Power comes from invention, adaptation, action, and risk taking. A strategy cannot be planned but only crafted over time. It usually end up being come combination of leadership, timing, execution, and luck.
Supplemental Reading:
Business Ironies
If you were to make a list of desirable traits for a business to have, I think the following would be at the top of the list:
- A large total addressable market (or “TAM”) with a high growth rate
- High gross or net margins
I believe the value of a business is the present value of all its future cash flows discounted back to today. In determining that value, two factors regarding that cash flow are very important: both the magnitude and duration of those cash flows. The two factors I mention can give some certainty to the former, but not necessarily the latter. In fact, they may even be factors that make the duration of those cash flows harder to achieve. In this piece, I’d like to take a closer look at both of these traits and make us think a little more deeply about what they mean for businesses and competition.
Large TAM / High Growth
I have opened countless investor presentations that state they are in a large and growing market. This is thought to be a good thing and it may be, but in order for that to be true the business needs some sort of moat to be able to fend off competition to actually create value, or in this case durable free cash flow. There is a concept in economics called minimum efficient scale (or “MES”) and its the smallest level of output at which scale economies have been exhausted. This basically means what is the smallest market share a company needs to be able to have as efficient of cost structure as that of the market leader. The reason this is relevant is essentially the market size divided by the MES will determine how many competitors you may have. If a business is in a large market but has a small MES, there will likely be many competitors and fights for market share. This will be a tough market to generate sustainable free cash flow without some sort of barrier to protect the company or differentiation in its product or service.
Now, lets consider the market growth angle. Paradoxically, a higher growth market signals a larger opportunity to competitors and it could encourage entry. Additionally, consider above when I stated the number of competitors is the market size divided by MES. Well, if the market is growing that creates more “room” for competition it could dilute the MES advantage the incumbent has. So, in certain case, a small TAM coupled with a slower growth can actually insulate a company from competition. In most cases, what actually ends up happening is as a market grows, there are niches created in that market a company can focus on to survive and generate profits.
A good example of the small TAM coupled with slower growth is Shimano, the bicycle gear maker. It has over 70% market share in bicycle gears and breaks with large profits to boot. Why do they have such large profits? Most likely because they have a large MES relative to this market size. A competitor could enter this market, but it is not economically rationally for them to do so so they don’t and Shimano enjoys an enviable position in this market.
A large and growing TAM may only be good if a company has a moat to protect itself or has discovered some niche in which it has strong relative scale to the market size.
High Margins
A business with high margins certainly has more options than a business with lower margins. A company with high margins can do a lot more in terms of reinvesting in its business or can possibly return cash to shareholders via dividends or buybacks. High margins may even indicate the presence of a moat. However, high margins can also come under attack without a moat. There are many businesses with low margins that actually generate a lot of free cash flow such as Amazon, Walmart, or even Costco. The fact these companies have low margins serve as a competitive barrier to new entrants as its difficult for them to make the economics work without scale. In short, high margins may be a nice feature, but if they are not defensible they could make you a target.
Paradoxically, high margins can also be a deterrent that sinks the incumbent in certain situations. In his book, 7 Powers, Hamilton Helmer identifies a concept called “Counter-Positioning”. It is when an entrant adopts a superior business model and the incumbent is unwilling to respond because of collateral damage to its existing business model. In this example, an entrant comes in with the new business model and the incumbent will wait to respond and often by the time they do respond it is either a half-hearted effort or too late. For example, Netlfix’s DVD subscription business model had the Power of Counter-Positioning over Blockbuster’s brick and mortar model. Blockbuster’s choices were either to 1) respond to Netflix directly and waive its late fees, or 2) continue to lose customers to Netflix. I am sure the high margin revenue provided by late fees was part of the reason Blockbuster did not respond aggressively.
Helmer notes that in Counter-Positioning the incumbent may not respond because of its high margins. A lot of companies do not want to kill the golden goose. The problem is if the entrants business model gains traction, you will not only lose your market share, but also you will lose those margins eventually. Essentially, high margins create an opportunity cost and deterrent to act when you need to.
Conclusion
I would like to conclude by saying that a business in a small market with slow growth and low margins is not better than the opposite type of business. What I am trying to explore is that large high growth markets and high margins are subject to competition without a moat, so having a defensible business is what creates value, not just those characteristics themselves.
In addition, when thinking about value, you must not only consider magnitude of free cash flows driven by the factors we discuss above, but also duration of those free cash flows which is driven by a moat. Most things in life are trade-offs, so even if the magnitude of free cash flow is lower because of a smaller market size, growth, and lower margins, the duration of cash flow may more than make up for that allowing for more value creation in the aggregate.
This piece by Andreessen Horowitz really made me think more deeply about this and I suggest you give it a read.
Please let me know what you thought of this piece. Thank you.
SPACs, Market Savior?
We knew the COVID pandemic would have an impact on the markets, but one I did not anticipate was its effect on the SPAC (or “Special Purpose Acquisition Companies”) market. The boom part has been well covered, but what I wanted to describe is some of the interesting “uses” of SPAC’s and the real substitute its providing to the traditional IPO market.
What is a SPAC?
Also known as a “blank check company”, a SPAC is a company that actually is a pool of public money that is looking for a company to buy. It is similar to the private equity model in that it is money looking for an acquisition, but the money is actually public and the target “reverse merges” into the money. Essentially, it is a backdoor way of going public that can be done much quicker and with more certainty than in the traditional IPO process. All SPACs go public at $10.00 per share and have two years to find an acquisition or it returns the money to its shareholders. If you are interested in learning more, this article provides a good summary. One thing to point out there is certainly an incentive issue here in deploying capital especially when the SPAC gets close to the end of its two years.
Established SPAC’s
The first time I encountered a SPAC was when I was an investment banker working on a sales transaction for a restaurant chain. It was one path we pursued in addition to potentially both selling to private equity and even going public. At that time, SPAC’s seemed like a non-standard route to getting a deal done and ultimately we didn’t pursue it. I’d say since then I’ve been casually interested but I think the market has a bit of a stigma attached to it. However, in 2019 SPAC issuances were $13.6 billion, and 2020 year to date raises are at $12.3 billion and we are a little more than halfway through the year. Many somewhat successful companies have gone public via a SPAC recently such as Nikola Motor and DraftKings. Now, Goldman Sachs is getting in on the action, raising a $700 million SPAC and famed investor Bill Ackman has raised the largest SPAC ever ($4 billion!) to buy a “mature unicorn”. Previously, this market has experienced its ups and downs but it seems like its attracting sophisticated players.
Advantages of SPAC’s Today
There are a few interesting reasons why SPACs are hot now and why companies may want to pursue this path over a traditional IPO.
- More certainty of getting a deal done as the IPO market can be volatile.
- More certainty around proceeds.
- A less complicated negotiation.
- Potentially a cheaper cost of capital as compared to a traditional IPO.
Byrne Hobart of The Diff has a really nice breakdown of SPACs here. I recommend subscribing to his newsletter – its fantastic.
Uses for SPACs?
In getting a little more familiar with this, I have noticed three specific uses for SPAC’s that are worth highlighting.
“The Tech Public Reset”
Shift, a player in the used car market, that lets people buy, sell, and finance cars on its platform went public via a SPAC. It has a similar business model to Carvana and Vroom, who are both public companies themselves. Shift was hurt by the COVID-19 pandemic and had to make some painful moves to make it through the pandemic. The SPAC route gave it the cash runway it likely needed to continue to scale its business and make it work. Moreover, another private fundraise was probably not feasible given the pandemic and given the cuts they had to make. It was time to raise cash as quick a possible and the best way to do that was via a SPAC.
“The Stalking Horse”
I think almost everyone knows that Uber bought Postmates, but I don’t think everyone knows the other bidder was a SPAC, so in a way this IPO option via SPAC represents an interesting option to the Company accepting an acquisition offer it does not like. Ultimately, the merger with Uber will be easier for Postmates to realize its potential, but it doesn’t hurt to have other options.
“The Compelling Spinoff”
Tilman Fertitta, the owner of Golden Nugget Casinos, Landry’s, and the Houston Rockets spun off his online gaming business and is using some of the proceeds to pay off some loans taken out as a result of the COVID-19 pandemic. He will have voting control in this SPAC, but I find it interesting he would spin off a business with arguably a higher valuation and upside in the future. Perhaps he looks at Draftkings success and is seeking to capture some of that upside. In the SPAC model, you can likely execute a spinoff more quickly and at a lower cost than in a normal IPO process. I’d also point out that in a post COVID world, I’d argue online gaming is an economic substitute for going to the casino and not a complement, so perhaps he is spinning off the business which has some potential to cannibalize his core business at what he feels is an attractive valuation?
Conclusion
The SPAC market definitely is serving some purposes in this market and is growing significantly. It will be interesting to see how this market develops. As I see other interesting cases, I will flag them. I would also love some feedback on this post if you wouldn’t mind commenting.