Archives For Capacity to Suffer

The Future Credit: James Vaughn via flickr

The Future
Credit: James Vaughn via flickr

Not so long ago I spent an afternoon listening to a half-dozen entrepreneurs hawk their ideas for new companies. The event was called a pitch day, and it had an American Idol feel. The presenters stood before massive power point displays in the cavernous auditorium of a converted warehouse, spinning their best stories of why their concepts would attract the most eyeballs, customer subscriptions, or advertising attention. Each wanted to launch a fast-growing business – the next tech rocket ship – and made their case to the judges, a collection of investors spread in front of the makeshift stage in neat rows of plastic chairs. Winning meant the entrepreneurs got a little extra cash, fuel for their rockets, and a chance to turn their concepts into real startups.

The presenters had been honing their pitches for weeks, seeking that right combination of words, images, and dramatic delivery that might persuade the investors to pick them. The event was glitzy. The pitches slick. But the substance?

Of the six proposals, each could be boiled down to “the next” (fill in the blank with Facebook, Twitter or Google) for (fill in the blank with a sliced-up market segment). Each was a derivative concept meant to piggyback in some way off the platforms created by more ambitious entrepreneurs who came before them. These ideas were less about originality than they were about exploiting market niches that were not yet the focus of the platform companies. There was not much stretching for greatness.

This is not necessarily a bad thing. Commerce has long thrived on tweaking others’ ideas, but at some point it seems someone has to push forward the vision thing. I believe it was frustration with a lack of startup imagination that prodded Bruce Gibney of the Founders Fund to pen this missive in April 2011. He called it What Happened to the Future? and attached this brilliant subtitle: We wanted flying cars, instead we got 140 characters. From that letter:

The future envisioned from the perspective of the 1960s was hard to get to, but not impossible, and people were willing to entertain the idea. We now laugh at the Nucleon [a nuclear-powered car] and Pan Am to the moon while applauding underpowered hybrid cars and Easyjet, and that’s sad. The future that people in the 1960s hoped to see is still the future we’re waiting for today, half a century later. Instead of Captain Kirk and the USS Enterprise, we got the Priceline Negotiator and a cheap flight to Cabo.

It’s not a huge surprise why the pitch day ideas were so ho-hum. The entrepreneurs are running towards the money. Venture capital as an industry is more interested in backing the thing that seems most likely to get acquired (and thereby provide quick returns on their capital) than in backing bold bets. That makes sense. We need it. But we also need capital that backs the bold ideas. We need capital for the bets that might take years and years before paying out. I applaud Bruce Gibney and his colleagues at the Founders Fund for attempting to play that role. I applaud Google’s X labs for working on their own initiatives to change the world. My hope is that they prod more investors to take a long-term perspective.

When capital makes itself available for bold ideas, I expect we’ll see entrepreneurs tap into their more creative impulses. I expect we’ll see pitches that will bring promise of this future we’ve been waiting for.

Abe Maslow (Credit: Wikipedia)

Abe Maslow (Credit: Wikipedia)

50 years ago Abraham Maslow embedded himself in a Southern California tech factory to study its managers and culture. He kept copious notes and published his thoughts in 1962 in a sparsely-read tome called Eupsychian Management. The book was republished 37 years later, long after Maslow had passed, under the more accessible title, Maslow on Management. In it the great psychologist makes a distinction between the “doers” of the world and all those people who just talk, talk, talk.

After talking with various students and professors who “wanted to work with me” on self-actualization, I discovered that I was very suspicious of most of them and rather discouraging, tending to expect little from them. This is a consequence of long experience with multitudes of starry-eyed dilettantes – big talkers, great planners, tremendously enthusiastic – who came to nothing as soon as a little hard work is required.

We all know these types. I for one have to work hard to make sure there’s not one staring back at me each morning when I shave in front of the mirror. Someone recently told me I’m a great idea person. I think it was meant as a compliment, but my attention is piqued. I sure hope it’s not a euphemistic way of lopping me into that same category Maslow describes above.

Here’s Maslow’s technique from separating the talkers from the doers:

…I have tested people with these fancy aspirations simply by giving them a rather dull but important and worthwhile job to do. Nineteen out of twenty fail the test. I have learned not only to give this test but to brush them aside completely if they don’t pass it. I have preached to them about joining the “League of Responsible Citizens” and down with the free-loaders, hangers-on, mere talkers, the permanent passive students who study forever with no results. The test for any person is – that if you want to find out whether he’s an apple tree or not – Does He Bear Apples? Does He Bear Fruit? That’s the way you tell the difference between fruitfulness and sterility, between talkers and doers, between the people who change the world and the people who are helpless in it.

These are strong words from the father of Self-Actualization Theory. Here we assume Maslow must be this touchy-feely dude since his ideas are so often associated with kindness and making contributions to society. His views appear ironic even given that Maslow was first and foremost a thinker. I’ve never been quick to put theoretical psychologists into the “doer” category.

But he was also revolutionary. His bridge from talking to doing was constructed with rigorous testing, teaching, and writing. The hierarchy of needs thesis would have gone nowhere if he simply chatted with people about his novel concept. No, he had to go out and battle for respect in peer-reviewed journals. He had to promote it like crazy to earn acceptance and create his legacy. And his respect was not earned easily, nor did it come without wounds. It took years of grinding work that dilettantes are just not capable of.

What can we learn from Maslow’s view on doers versus talkers? My lesson is this: being an “idea person” brings little value to the world if you aren’t prepared to support the idea with all the grinding, thankless work it takes to fight through criticism and gain acceptance. This requires much more than brainstorming a few thoughts and patting yourself on the back because they feel so clever. The real value comes from transforming those thoughts from ideas to some kind of action. Even the tiniest action signals to the world that you’re serious, willing to work for your ideas, able to endure uncertainty, and not just another dilettante.

Last February I got to hear John Mackey give a speech about a better way of doing business. He’s a founder and co-CEO of Whole Foods, and he stopped in at a Raleigh Chamber of Commerce event to promote his book, Conscious Capitalism: Liberating the Heroic Spirit of Business.

John Mackey, Whole Foods CEO Photo Source: Joe M500, Flickr (Creative Commons License)

John Mackey, Whole Foods CEO
Photo Source: Joe M500, Flickr (Creative Commons License)

The book’s premise flies in the face of Milton Friedman’s argument that the business of business is business. While Friedman makes the case that the only purpose of a business is to increase value for shareholders (i.e., maximize profits), John Mackey says its obligations are better understood as a balance among five groups of stakeholders:  stockholders, employees, customers, suppliers and the environment.

Mackey actually takes it one step further. He says companies that serve the interests of all the stakeholders have a competitive advantage. They create more value and are rewarded by the stock market.

After his speech I had the opportunity to ask Mackey a question. “If conscious capitalism is such a good thing,” I asked, “why aren’t more companies doing it?”

He responded by saying, in essence, that it just needed a vocabulary, someone to give it a voice, a demonstration to the world that it is a better way of doing business. “I’m giving all of you a secret formula for building a successful business,” he continued. “It will be copied as others see you succeed with it.”

Whole Foods is meant to be the living example of this better model.

Fast forward to this morning. I’m enjoying coffee with a friend at my local Whole Foods. It seems a good time to reflect on Mackey’s secret formula. Since last year the Whole Foods Market stock price has been cut almost in half, dropping from $65 per share to around $37. It’s been a rough ride. Continue Reading…

Last night Larry Page, Google’s CEO, posted this entry on his Google+ account, “Google Self-Driving Car Project,” with the video below.

“Just imagine,” begins the company’s description a future with self-driving cars,

You can take a trip downtown at lunchtime without a 20-minute buffer to find parking. Seniors can keep their freedom even if they can’t keep their car keys. And drunk and distracted driving? History.

This is bold. It’s exciting. And it’s just one of several projects Google is juggling that could actually change the world. The company calls these “moonshots” and runs them out of its Google X division, an R&D skunkworks charged with making such bold – though calculated – bets on the future.

But the story here is one part fanboy awe over Google’s investments in ground-breaking innovation and one part befuddlement over how  little other corporations are putting into long-term R&D bets. Continue Reading…

Exceptional Business Pic

I’m testing a theory here, the driving question of which is What are the cardinal traits of exceptional software and technology businesses?

The term “exceptional” is as qualitative as it gets. Perhaps we’ll give it more definition as we proceed, but for the time let’s be comfortable with former U.S. Supreme Court Justice Potter Stewart’s threshold test for obscenity: I know it when I see it.

I’m suggesting four criteria and using them as a framework for evaluating various businesses in different stages of development, as early as start-ups and as late as technology that has been retired from companies that have long since moved on. The application for what we learn will resonate most, I think, with young businesses either in their fledgling stages or otherwise still able to mold their cultures and their values.

My early thesis is that the exceptional software and technology companies share some combination of the following traits summarized below in very rough form:

Continue Reading…

The Witch’s Dilemma

The witch gave the man two options. One, he could have a woman that, to him, would appear stunning. But the world would see her as ghastly. Or two, he could have a woman that, to him, appeared hideous. But to the world she would look beautiful.

So goes the dilemma from some fairy tale I recall from childhood, the source of which eludes my most diligent Wikipedia searches.  (If anyone remembers the title, please pass it along.)

Imagine yourself in a revealing moment of brutal honesty. Which option would you choose if the witch forced this decision on you? Switch the genders around if needs be, but be truthful.

I suspect most people would claim option one, confident in their ability to filter out the judgment of people around them. But I think they would be overestimating their capacity to be misunderstood. Disapproval and criticism from our family, friends, and colleagues has a withering affect on our psyches. Even if we put on confident airs, we shiver at the thought of others ridiculing our choices behind our backs. We want to be understood. We want our people to confirm our choices with their support. We want inclusion in the most desperate way.

And so I believe, despite our protests, the vast majority of us would select option two.

Yet there are those with the steely resolve to pull off option one. They are outliers. They have a tremendous capacity to be misunderstood.

Corporate CEO’s, the Capacity To Be Misunderstood, and Decision Making

I’d like to hire a social psychologist to visit the CEO’s of all publicly traded companies, administers the Witch’s Dilemma test in conjunction with a heavy dose of truth serum. I would ask her to use the responses to rate the individual executives’ capacity to be misunderstood. (Perhaps there are alternative questions we could devise that get to the heart of the matter. These CEO’s are emotionally intelligent folks. They didn’t get where they are without developing the ability to read into people’s intentions…the questions behind their questions.)  And I would compare that rating to the CEO’s track record of making bold (albeit sensible) long-term investments in the well-being of their businesses versus managing earnings to keep various constituencies content.

My suspicion is that those CEO’s that could be lumped in with option one (ugly wife) would correlate more closely with making better long-term decisions on behalf of their businesses. The other group would have a more difficult time departing from the expectations of their shareholders, employees, customers, family members, etc. Understandably so. It’s tough to do.

Getting to my point, when I see a business that combines some set of competitive advantages with the potential to grow and compound earnings, I want the leaders of that business to invest in that growth. This should go without saying, but very often it’s a difficult thing to do. Not so much because the operational expansion is daunting (though there is that part, too), but because the company must often take a winding path to secure that growth. It’s confusing. It changes things. It’s easy to misunderstand.

Let’s think a little about how a company grows. First, it must identify an opportunity to a.) expand its current offerings; b.) add new offerings; and/or c.) move offerings into new markets. In most cases, each option requires teams to make a judgment call. On the most fundamental level it is, can we execute that growth in a profitable way? In other words, will the added costs of increasing headcount, ramping up production, expanding infrastructure, investing in R&D, buying equipment, or marketing more aggressively…are these costs likely to succeed AND produce revenue in excess of costs and invested capital?

While executives can learn to mitigate risk (just as we do with investing), there is no crystal ball providing play-by-play of how the future will look. They must use their judgment. And investors hope they bring a certain amount of analytical rigor, management skill, experience-based intuition, and wisdom to the ways they spend the company money. In an ideal scenario, they possess a deep understanding of the strengths of their business – its advantages over the competition, barriers to entry, and moats – and know how to invest behind these strengths. (The better the strength, the easier the planning process!)

But there are no guarantees. Expansion is and always will be an exercise in predicting the future. It is about, after all, believing that additional supply you produce will be consumed by increased demand. A management team will try and fail. They MUST try and fail (at least occasionally) to test the limits of the business potential.

The most bold attempts to grow and compound earnings on behalf of investors – those investments with the greatest possibility for outsized rewards – do not happen in short time frames. They require big investments over long horizons with the real possibility of depressed earnings over the ramp-up period.

This enervates holders of the company’s stock – investors, employees, the CEO, his/her family. While all of them will say they want the earning to grow, each group tends to be averse to the risk and time required to make that happen. If you were to provide them with a slight bump in their dividend payout versus putting the same amount of cash into investments that have a high likelihood of paying out a nice return in, say, five years (but impair earnings growth in the meantime), far too many will forego a better payday for the feel-good immediate gratification.

Worst yet, if the investments are made in growth, they depress earnings for multiple periods, and the market has trouble understanding how and/or when the investments will pay off, the stock price will feel that misunderstanding.

And this is where the CEO’s decision making becomes hard. He must choose between investing in the long-term prospects of the business, a move that will impact earnings next quarter and bring the ire of Wall Street.   Or he can punt. Making timid investment choices; managing the earnings by looking first at whether the next statement will satisfy analyst expectations for the company’s performance. And then deciding how much more to allocate to investment in the company’s future.

If he invests for the future and is misunderstood, the move will generate a share price drop. And a lot of people are affected by the stock dropping. People that are important to the CEO. People he must see everyday. People who influence his life; that invested in no small part because they believed in him.

Back To the Witch’s Dilemma 

So here the CEO is playing out the Witch’s Dilemma. If he goes with option one – investing in the future of the business that impacts short-term results…the woman that looks pretty to him, but ugly to the world – the share price will be hammered. He will be misunderstood. People who have invested with him will be disappointed. They will feel less wealthy as a consequence of his decisions.

And all CEO’s know that if they get labeled with the dreaded letter “U” (Underperformance), many of the constituents they disappointed, along with a new slate of activist investors, will turn up the heat. They will make noise and start demanding change. The pressure will be enormous.

The CEO asks himself…will I even be around long enough to see these bold investments come to fruition? Or will my board bend to the discontented swarm and show me the door?

Being misunderstood is very hard on a person.

Allow me this aside about the concept of learned helplessness…

The psychic punishment of being misunderstood conjures memories of “learned helplessness” a concept belonging to psychology and the term being coined by Dr. Martin Seligman in the late-1960s.

Seligman ran a research lab at Cornell University and spent much of his time experimenting with lab rats. In one particular and somewhat cruel study, he placed a lab rat in a specially constructed box, repeatedly rang a bell, and followed the sound with a mild electric shock. The rat quickly learned to anticipate the shock when he heard the bell. As you can imagine, the rat would become frantic at the sound, running around his box in a futile attempt to avoid the discomfort.

It took very few rounds of this “bell-plus-shock” routine before the rat’s behavior changed. The bell still evoked agitation, but once he resigned himself that he had no control to stop the shock, the rat basically gave up and took it.

This observation led Dr. Seligman to his theory of learned helplessness, a phenomenon as easily applied to humans as rats. When faced with stressors most humans – including powerful CEO’s – that perceive they lack the control to resolve or avoid it end up sucking it up and going with the flow.

And so most CEO’s elect to avoid the discomfort of being misunderstood (if not fired) and choose the Witch’s option two. Even though they know the investments will pay off for long-term shareholders, that they will enhance the firm’s competitive advantages, that they will compound its earnings…the vast majority of CEO’s swallow hard and go with the woman that looks beautiful to the world but that they recognize as unattractive and unsavory.


Anyone For Investing In a Car Periscope?

I’ll conclude with a light-hearted parallel…

Season eight of HBO’s Curb Your Enthusiasm highlights this dilemma in an episode called Car Periscope. By way of quick summary,  Larry David and his agent Jeff are weighing an investment with an inventor of a device you snake above your sunroof in traffic jams to see the source of the slowdown and review your options for getting out quickly.

It’s a terrible concept, clearly, and the two are ready to decline the investment opportunity. But they meet the inventor’s wife and are struck by the disconnect. She is somewhat homely while the inventor is a decent looking guy. Larry is unabashedly shallow. He always wants the younger more attractive woman. It’s foreign to him  that a man would ever choose anything less; that someone would subject himself to the ridicule of the guys. This inventor is an outlier. He sees something in his wife that others don’t, and he possesses the capacity to be misunderstood.  Surely this belies some deep-seeded virtue in this inventor. In Larry’s logic, if he has the qualities that permit him to be comfortable and confident with the less attractive girl, perhaps he possesses the tenacity required of an inventor and businessman.

Hijinks ensue. The investment falls through, but Larry believes he has found a new model for gauging the character of men. He meets with his investment manager and, upon seeing a photo of his gorgeous wife, fires him. He selects another adviser on the sole basis of his plain-looking spouse.

This week I’ve been a bit obsessed with the idea that the manager’s job is to represent the interests of shareholders. It brings to mind the Yogi Berra epithet:

In theory there is no difference between theory and practice. In practice there is.

In theory it makes sense. Companies are vehicles for invested capital to find returns. We entomb that concept in law and in corporate structure where the board of directors is explicitly charged with representing shareholders. Managers run the day-to-day and should have investors’ interests on their minds, remaining on constant look out for ways to increase shareholder value.

But we put the idea in play, how does a manager best represent investor interest? Indeed, which investor?

Investors are far from a like-minded group bound together by common interests in the business’ success and united in their opinions on how that success is best achieved. Oh no. To highlight just a few investor archetypes:

There are the hedge fund traders, moving in and out with positions measured in millions of shares and closed out within minutes or hours when the stock moves up or down by a penny or two.

There are the pension funds for (as an example) retired nuns. They hold shares for years but issue measure after measure for shareholder consideration on such social issues as whether you should offer health benefits to your lowest paid employees.

There are the corporate raiders that accumulate massive positions, gain board representation, and then force management to monetize assets and distribute the cash. This pushes the share price up for a time, during which the raiders sell out and move on to their next target.

All are investors in your public company. Each has very specific objectives. And those objectives are divergent and irreconcilable.

So, how does management effectively represent investors when their interests don’t align?

As a frequent visitor of Charleston, South Carolina, I’ve been required to read the works of native son Pat Conroy. My favorite book is his memoir My Losing Season in which he details his time playing basketball for the Citadel.

The Citadel, a military prep college in Charleston, is hard on its first year students (called “Knobs”), believing it must break each of them down and build them back up again in its own disciplined model. Conroy was not spared the hazing rituals. In a particularly poignant scene from the book he recalls being surrounded by several upperclassmen who begin demanding he do a variety of conflicting activities. As I recall, one would get in his face and scream that he do push-ups. Another would degrade him for doing push-ups, telling him he’s supposed to jump up and down. And yet another would scream at him for jumping; he should be reciting the school’s creed.

The demands came rapid fire. After several minutes of this Conroy was a wreck. He instinctively fell into fetal position on the floor, his mind unable to process another command. The older cadets walked away, satisfied that they had broken this cocky Knob.

The human mind cannot process conflicting orders without freezing up. It’s simply not how our wiring works. And so, while the idea that management works for investors sounds good in theory, in practice it’s unworkable. Many an executive has driven himself to exhaustion trying to appease these feckless masters.

What’s a manager to do?

Focus on the business itself.  Use the overall health of the business as a proxy for the long-term investor…that investor whose interests are aligned with the company investing in its advantages, foregoing immediate gratification en lieu of higher earnings further down the line.

These are the businesses I want to invest in. The opposite are those that pledge allegiance to blind total shareholder return, returning cash to investors that could be reinvested in the business to fortify its barriers to entry, improve its offerings, or make itself invaluable to its customers.

I’ll make no claims that the Shleifer Effect is an original construct. Far from it. The denizens of behavioral finance borrowed its academic tenets from social psychology. For investors removed from the ivory tower, the Shleifer Effect pulls from Benjamin Graham’s bi-polar Mr. Market, Sir John Templeton’s suggestion to buy when there’s blood in the streets, and even from Joel Greenblatt’s magic formula for spotting strong businesses that are out of favor.

The Shleifer Effect is a term I coined to be my own mental heuristic, encapsulating all the concepts above while adding a few minor wrinkles of my own. It’s a few different models condensed into one for the purpose of creating mental shortcuts for my screening and evaluations.

This morning Joe Koster of Value Investing World posted the quote below from Warren Buffett (here). It’s an important addition to the Shleifer Effect as a heuristic. Pessimism creates opportunity, but just because investors are selling out of a company doesn’t mean the company is investment-worthy for you. More often than not a business has a falling price and a low market value for a reason. That means you’ll reject most (indeed, nearly all!) ideas produced by screens searching for businesses with bad earnings reports or other such news.

The business must be fundamentally sound, or at least much better off than the market is giving it credit. We’re looking for companies operating good businesses that happen to be misunderstood or unpopular.

There is no extra credit for being contrarian. You must be right!

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

Reported Earnings Overstated – The Impact of Restricted Earnings

Owner earnings are those that can be extracted from the company for the benefit of shareholders (dividends, buybacks, debt reduction), plowed back into the business to create even greater earnings in the future (growth capex, investments in expense infrastructure, acquisitions, etc.) or held as surplus cash. They are “unrestricted” in that management has significant discretion on how to use them without damaging the current earnings ability of the business.

Reported (GAAP) earnings do not discriminate between the portion of earnings that are unrestricted and the portion (“restricted”) that management has no option but to plow back into the business just to keep things current. Examples are replacing obsolete equipment, refreshing old stores, responding to a competitor’s pricing tactics, or ramping up customer service because clients are threatening to leave without it. They are all necessary investments, but they don’t create incremental earnings. At best, they prevent the erosion of existing profits.

Reinvestment of the restricted portion of earnings creates the unpleasant sensation of running to stand still. You can expend a lot of energy without taking the business anywhere.

You won’t find a line on the income statement called restricted earnings. As Buffett said in his 1986 letter to shareholders, determining which portion of earnings are unrestricted versus which are unrestricted is tricky. Indeed, it’s quite different from industry to industry. For a manufacturer in a highly competitive market, a large chunk of its reported earnings may not be available to reinvest for growth or to pay out to owners. Why not? Because every five years it must spend tens of millions to retool factory assembly lines to accommodate new designs, to engineer more efficient production techniques, or to begin construction of new products that replace obsolete models.

Reported Earnings Understated – Making “Productive” Investments in Expense Infrastructure

But the idea can cut both ways. Most businesses will report earnings that exceed the actual dollars available to benefit owners. But some businesses (particularly those in growth mode) will report earnings that dramatically understate the amount of cash being plowed back to grow future earnings ability.  For example, they may report $1 million earnings but in reality they plowed $10 million into marketing to acquire new customers that will produce more earnings power in the future. That is certainly the case with GEICO that Tom Russo talked about at the Value Investing Congress last year (and which we discussed here).

In that scenario, do we value the business based on the $1 million in reported earnings? Or do we value it based on the $11 million it would have generated if not for the investment in acquiring more customers?

Well – no surprise here – it depends.

The dilemma is that we don’t want to use this idea to rationalize investments by bloating the target company’s earnings. It can be a slippery slope…you can argue with yourself to exhaustion trying to justify buying a company with a great growth story at its current high price-to-earnings ratio. One must err on the side of caution.

When considering this sort of situation, the first filter I might apply to the decision is how confident you can be that the increased expenses that lead to lower reported earnings are actually investments with the high likelihood of paying off in the future. And in this thought process, apply a high burden of proof on the company. One is wise to evoke the wisdom of Richard Feynman…The first principle is you must not fool yourself, and you are the easiest person to fool.

Another useful filter is to ask whether the increased spending (or whatever caused the reduced earnings) comes from the company playing offense or playing defense. This is important. Is the increased spending a result of the business understanding its competitive advantage and investing heavily in it? Or is it a reaction to a competitive move in the industry where, if the company doesn’t respond, its business is harmed?

In the former, it’s likely (though not conclusive) that the company is spending in a manner that creates future value for shareholders (again, like the GEICO example) even if it reduces reported earnings today. It’s fair to consider those investments as unrestricted earnings and count them among owner earnings when valuing the business.

In the case of the latter, the defensive spending, I would argue that this is likely an example of restricted earnings that are rightfully withheld from reported earnings. Increasing Spend = Offense or Defense?

Let’s bring this back to Amazon. The business clearly operates in a market with growing demand for its products and services. Year-in and year-out, Bezos et al must make educated guesses about consumer demand one-, two-, three-plus years in the future and invest in their infrastructure accordingly. Sure, they could stop those investments today by declaring their wish to optimize throughput of existing assets, pushing more sales across existing infrastructure (fulfillment centers, technology, marketing efforts, personnel, etc.) and probably create sizable profits for investors. But that would be choking the golden goose, seriously affecting its ability to lay more golden eggs in the future. Instead they build out in anticipation of what’s to come.

Here are several categories of that type of investing…were they offensive or defensive in nature?

A. Subsidized shipping to pull more shoppers to the web and away from traditional retail.

In the beginning, Amazon treated shipping as a source of income. Later, its goal was making shipping a break-even proposition. Now, the company proudly uses shipping as a loss-leader, accepting the glad trade-off that quick-and-cheap shipping translates into wider consumption from customers who would otherwise give the business to Target or Best Buy.

From 2010 to 2011 Amazon plowed $1.1 billion into subsidized shipping, increasing its net shipping costs 76 percent…far above the additional shipping revenue that came in with 41 percent overall sales growth.

Should we expect this to change? No. This is the ultimate offensive move in two ways.

First, consumers are quick to tally shipping charges into the total bill when comparing costs of buying online versus bricks-and-mortar. Amazon recognizes that much of its growth will come from prying shoppers from trips to Wal-Mart and the mall. One way to achieve this is to provide a lower “landed” price than what they would get when getting in the car to shop with competitors. Shipping is part of that landed price, and Amazon is willing to invest in making it cheaper and cheaper for buyers.

It’s important to note that shipping is included in Amazon’s overall cost of sales calculations. In 2011, COS was about 78 percent of revenue. For Wal-Mart, COS was about 76 percent of revenue…and Wal-Mart has a tremendous overall advantage in its purchasing in that it carries far less selection and buys in volume that’s easily 10x that of Amazon. Its COS should reflect much cheaper product acquisition costs. Yet its advantage over Amazon is negligible.

In other words, Amazon is earning comparable gross margins despite subsidizing shipping. As Amazon improves other drivers of its COS (e.g., volume purchases leading to product acquisition cost discounts), I expect it will subsidize shipping even more. And as Amazon builds more fulfillment centers nearer to its customers, its costs of shipping will go down.

One can easily imagine a day when Amazon subsidizes the full cost of shipping, retains product cost advantage over traditional retailers, and provides overnight (or even same day) delivery. All the while maintaining a gross margin sufficient to cover its operating expenses and provide a tidy profit.

Second, the subsidized shipping presents a formidable challenge to other online retail competitors. Amazon is the trend setter. The more they set the standard for low-cost shipping, the more consumers expect it in all online transactions. If the competitor cannot provide it – and the consumer can purchase the same or similar item from Amazon for a cheaper price – the competitor loses the business.

This creates a powerful barrier to entry. Smaller operators that can’t match Amazon’s scale (and none can) will only be able to subsidize shipping by charging a premium purchase price. And if the buyer can get the same item at Amazon…

(As an aside, online retailers that find ways to compete with Amazon in this regard – Quidsi’s and Zappos both come to mind – are quickly neutralized. Amazon offers their inventory, undercuts their prices, attempts to replicate their service advantages, or acquires them. See the Business Week story of Quidsi here. The moral of the story: Amazon is deadly serious about preventing other retailers from gaining a toehold in their business…they want complete web retailing ubiquity.)

Conclusion: Definitely offensive. An investment in long-term competitive advantage that hurts competitors, garners greater share of online and traditional retailing markets, and leads to accelerated scale benefits. 

This post is getting too long, so I’ll split it up. Next, we’ll consider whether lowering prices is an offensive or defensive move.

One of my college professors revered Abraham Lincoln, seeing him not only as a remarkable leader but also placing him among the pantheon of great political thinkers.  As such, this professor enjoyed sharing anecdotes and insights gleaned from the life of Lincoln.

I recall one insight in particular.

Aesop’s Fables was one of the few books to which Lincoln had access as a child. And so he read it assiduously for years, memorizing his favorite tales and ruminating on the meaning of each. According to my professor, the stories shaped Lincoln as he carried the morals with him throughout life. But perhaps more importantly, Lincoln internalized the practice of narrow-yet-deep reading in which he allowed his mind to fumble through the many layers of nuance in what he read, struggling with the material in an effort to internalize its lessons and understand it at the deepest level.

The professor urged us to develop the same skills, assigning us the task of writing papers on the briefest excerpts from Plato, Thucydides, or Montesquieu. We were not allowed to go to other sources for hints at what the philosophers might have meant. Our job was to struggle with the original text, fumble through the possibilities, and dig deep to explain its meaning in our own words.

This was torture! My skill – refined by much practice – was making a cursory run through the material, pulling in quotable commentary from published scholars, flowering my prose with SAT vocabulary words, and punching the essay home with a nice summary. I became quite good at writing long papers with very little actual thinking required.

I still struggle with going deep. My attention span still prefers wide-and-narrow reading versus Lincoln’s narrow-yet-deep approach. But every once in a while I’m pulled back to learn and re-learn from old pieces. So, without further ado, here’s the segue…


Buffett Defines Owner Earnings (1986)

If ever there were a single piece of valuation wisdom worth revisiting again and again to internalize its lessons, it just might come from Warren Buffett’s 1986 Letter to Shareholders in which he outlines the case for owner earnings versus those required by GAAP reporting. Berkshire Hathaway’s purchase of Scott Fetzer provides the example. (Scroll to the appendix, entitled Purchase-Price Accounting Adjustments and the “Cash Flow” Fallacy.)

Buffett writes:

If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c).

Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”

…Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists – that is, when (c) exceeds (b) – GAAP earnings overstate owner earnings. Frequently this overstatement is substantial…

“cash flow” is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, (c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment – or the business decays.

When one first reads this passage, one is tempted by the variables. One is eager to plug them into a simple formula, the values for which one might pull straight from an accounting statement. One hopes the quick calculation yields the secret of the true value of the business.

Owner Earnings = (A) Reported Earnings + (B) Various Non-Cash Charges – (C) Capex and Working Capital Necessary to Retain Current Competitive Position 

(A) and (B) give one much hope. But alas, (C) is confounding. It requires tremendous knowledge of the business and the economics of the industry to come up with even a reasonable guess of that value. Even managers of the company can be very wrong when trying to determine what portion of the earnings must go back into the assets or working capital just to keep the business from losing ground.

Owner earnings are those that are available to be plowed back into the business in order to create even more earnings in the future (capital investments, investment in expense infrastructure, or acquisitions) or paid-out (dividends, share buybacks, debt repayment) to shareholders.  They are the only portion of earnings that provide economic value to owners! If you owned the business outright, they are the portion you can strip from the business for different purposes while remaining confident you have left enough that it keeps laying golden eggs for you year after year. 

In his 1984 letter, Buffett calls these unrestricted earnings. In essence, the managers can use their discretion when deciding how to use this money without fear of injuring the competitive position of the business.

By way of contrast, restricted earnings – which are the same as (C) and which Buffett calls ersatz* – cannot be pulled out of the business without causing damage. (It’s like running to stand still. By continuing to reinvest the restricted earnings, the prize is standing your ground…not ceding market share to your competitors; keeping earnings at the same level as today. But if you don’t reinvest, your business decays over time.)

The trick, for managers and investors alike, is figuring out what portion of capital expense and/or increased expense structure is needed to maintain the current earnings versus how much is going toward promoting earnings growth in the future.

***** In This Context

In a previous post we noted that is being criticized that its torrid pace of revenue growth has not been matched by proportional earnings growth…at least not over the past few quarters. Its expenses are soaring as it leans into its growth and into shoring up its competitive position in key markets.

This is the question I want to explore…

Is Amazon increasing its spending – and thereby reducing its profits today – because

1.) It has no choice and is acting out of defense to preserve the current stream of earnings? In other words, Amazon has increased its spending in order to hold off competition and maintain market share. If it weren’t investing in price reductions, subsidized shipping, content, engineering talent, etc. competitors would be stealing customers, market share, etc.


2.) By design, it is on the offensive? It’s making investments in gaining market share or otherwise strengthening its competitive position with the objective of expanding earnings in the future?

We’ll consider those questions next.

*Ersatz Earnings…Restricted vs. Unrestricted (Buffett’s 1984 Letter)

…allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential…

…Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.

This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.


Tom Russo of Gardner, Russo & Gardner delivered an insightful speech at the 2011 Value Investor Conference in Omaha. While thinking about and its heavy reinvestment in the company’s expense infrastructure, I revisited portions of the presentation. I’ll draw heavily from it below. (You can access the full speech in pdf format here.)


It’s Hard to Make a Dollar Bill Grow…You Need the Capacity to Suffer

It’s hard to make that dollar bill grow, that’s the problem. And in public companies typically it’s the case that managements are not prepared to invest as fully as they could in pursuit of the growth of the dollar bill…So what I’ve looked for are businesses that for one reason or another are willing to invest hard behind their growth. And what that means is they have the capacity to suffer. 

When you invest money to extend a business into new geographies or adjacent brands or into other areas, you typically don’t get an early return on this. And this is a very important lesson. 

Most public company managers worry about…[what]…they may encounter…if they invest heavily behind a new project, they may show numbers that are unattractive and they worry about the loss of corporate control. 

Suffer Through Reinvestment Case Study One: GEICO and Net Present Value of Adding New Policy Holders

He [Buffett] told management at GEICO just to grow the business even though each new policy holder that was put on the books cost an enormous amount of losses the first year. They had high net present values and you’ve seen the history. I think the number insured at GEICO, because of Berkshire’s willingness  to show the losses up front, have grown from just under a million policy holders to almost ten million. And his spending to drive that growth that just burdens operating income up front has grown from $30 million a year to almost $900 million….

…But the fact is by spending up front, having the elasticity, the willingness, to burden your income statement and then getting the results in the future is a very nice trade off. 

 Suffer Through Reinvestment Case Study Two: Starbucks in China

One of the examples that comes to mind…is Charles Schultz, the chairman of Starbucks, who several years back spoke to investors, and there was one nettlesome young analyst who kept asking the head of Starbucks when they would show profits in China. 

And the dialog went back and forth: When will you show profits? He said, how big do you want us to be? When will you show profits? How big do you want us to be? And it went back and forth like this. 

And the answer was – and I think it’s the true one – if you want us to dominate China, then let us not show profits for a long time. And if you permit that, we will end up at the final analysis with a dominant position in an important market with moat-like characteristics. If you try to establish, as so many American companies did, a base in China and do it without impacting earnings, you’ll do it with a very small business that won’t have a competitive franchise. 

And that trade off is just as clear an expression of this notion of the capacity to suffer. Now Schultz  isn’t going to lose Starbucks because he has enough stock to keep it on the course that he chooses. But there are many companies that don’t have that control. Most don’t. And so they favor short-term results versus the long term. 


Capacity to suffer. I like that. To Russo’s point, there is a common thread that unites his GEICO and Starbucks examples, a thread which can extend to our evaluation of Amazon. That is, an ownership structure that keeps investors at bay because someone (or some entity) has enough control to keep to a strategic path that offers long-term benefit despite short-term suffering…trading the opportunity to build a franchise for less profit (or losses) today.

With somewhere around 20 percent of Amazon shares under his control, CEO Jeff Bezos remains firmly in control of business strategy and is willing to forego instant gratification as he builds a franchise for the long haul. He is hailed as a genius when revenues grow but panned by the financial media when there are signs of slowing down. All the while, the dude abides. He stays the course of his longer term vision for the franchise.

It would be easy enough to straddle the fence between investing for the future and satisfying the call for ever improving profits. It’s called earnings management. Most managers of guilty of it to varying degrees.

Though I’ve never sat anywhere near the catbird’s seat in a publicly traded company, I can imagine the temptation to do this is profound…that there’s always a nagging itch from employees with options, shareholders, your own net worth measurements to make a little compromise here, hold back on some needed investment there…to feed the earnings machine, pacify Wall Street, and prop up the stock price. Just scratch the itch a little bit. It will feel so much better.

But once you scratch it, does the itch actually ever go away? Doubtful. You end up getting caught up in the endless game of analyst expectations. By bowing to it, you become complicit, and it’s hard to tap out.

I expect plenty of managers have a strong sense of where they can invest their dollars to fortify their competitive advantages, expand their moats, and grow their franchise. But they are too invested in the earnings management game to take the short-term hit that’s likely to follow.  Or they know it could threaten their tenuous hold over strategic control. Or they suspect they would lose their job if Wall Street says results are in decline. Even if they had the intestinal fortitude to suffer through the tempest, their job could be pulled from them before they had the chance to show that ability.

I’ve been thinking a lot about lately. The business is in an interesting place. 

Few would argue against it being the dominant web retailer (let’s call this Amazon’s Business One), a market which provides plenty of runway to grow by expanding into new product lines and new geographies. Few would argue that its competitive advantages in web retail are not pronounced and formidable. 

Yet a huge chunk of its revenue comes from media (Amazon’s Business Two). Indeed, books and music and video and games, these provided the foundation for Amazon as a fledgling business and still (for 2011 at least) account for nearly 40 percent of sales.  The manner in which each of these products is consumed (and sold) is in major flux, transitioning from tangible inventory to digital formats. Where does Amazon fit in the world of digital media? Can it manage the cannibalization of its strength in the domain of physical media and segue into digital?

And now a growing chunk of its expense structure is devoted to a relatively new business, Amazon Web  Services (AWS/Cloud Computing…Business Three), which seems to produce paltry revenue compared to the resources the company throws its way.  At least for today.  Amazon is convinced that cloud computing represents tremendous growth potential and that it’s a market whose economics lend themselves to one of the company’s strengths…namely, the capacity to drive high volume through low margins to earn nice cash returns. Amazon believes it can dominate this market.


In 2011, Amazon’s revenue grew $13.8 billion over the previous year while operating expenses grew $14.4 billion. Management is plowing cash back into all three of the businesses.  As a result, net income dropped in half. 

For most of 2011 Amazon was riding a multi-year wave of do-no-wrong sentiment from investors. Since 2006, revenue grew from $10.7 billion to over $48 billion. The business was stringing together five consecutive years of EPS growth, an increase of more than 5x from 2006 through 2010.  Media coverage was effusive in its praise; the story was a good one. The stock price soared from $38 at the end of 2006 to a high of $246 last October as investors were rubbing their palms together in eager anticipation of a trend line pointing forever north-by-northeast. 

Now Amazon was not necessarily cultivating this investor mentality. By most accounts, CEO Jeff Bezos is inclined to take a stoic view of the stock price, abiding to his long-term goal of building an enduring franchise and leaning into investments today to achieve market dominance tomorrow.

But as the Shleifer Effect teaches us, investors have a tendency to get excited by what they perceive to be a trend, and five straight years of EPS growth taps into that tendency to generalize a trend far into the future.

Here is the progression of headlines from the previous five quarters:


The Shleifer Effect suggests that a few tenets of behavioral finance might be in play here. First is the representativeness heuristic.  Investors get so excited about the uninterrupted revenue and EPS growth between 2006 and 2010 that they infer a growth trend that will continue. They conclude that it’s worth paying a premium for Amazon shares, and over time the share price grows from $38 to $246.

The second is the conservatism heuristic. The idea of the trend is set in the mind of owners of the stock and the idea has been reinforced with impressive performance quarter over quarter. Now they run into the first signs of evidence to the contrary.  What do they do? Nothing. They are defensive in their views. They aren’t going to change their minds at the first sign of storm clouds. So, even as Amazon guides toward lower earnings quarter after quarter, they hold steady. They keep their wits about them and perhaps even buy more shares. The stock price actually hits all time highs despite reduced EPS and guidance suggesting lower earnings to come.

The third part of the Shleifer Effect now comes with overreaction. After two or three consecutive quarters of guidance toward lower EPS, shareholders begin changing their minds. They see net profit cut in half from 2010 to 2011 and they lose their resolve. They begin subscribing to a new representative heuristic, i.e. after several consecutive quarters of declining performance, the new trend must have a down slope. Sell! The stock price ultimately falls to a multi-year low.  

When observers begin to believe a new down-slope trend has set in, the long knives come out. A company and its executives can quickly fall from media grace. One day all stories are written to extol their virtues, the strength of their business, the genius of their vision, the wisdom of their philosophy. And the next day, a barrage of criticism roles out…

In February, Barron’s says It’s Time to Rein In Bezos

The blogs call Amazon a “secular short,” calling out initiatives to grow market share (like Amazon Prime) and doubting the strategy of making investments in the expense structure in anticipation of growth.  

Others note the exodus of guru investors like George Soros and Julian Robertson. 


So, back to my opening point: Amazon is in an interesting place. For five years it showed the world an ability to grow sales at a blistering pace without much damage to EPS. In 2011, that has changed. On the surface it would seem that Amazon believes it can accelerate investments now to solidify its place as market leader in web retailing, digital media, and cloud computing.  And it’s very willing to sacrifice quarter-to-quarter results by leaning hard into these investments. 

All investors, existing and prospective, should be on the edge of their seats to see how this plays out. 

On the one hand,  there is reason to believe Amazon is preparing to take its current owners on a bumpy ride by going all in with Amazon Prime (shipping subsidies and freeby services like streaming movies), Kindle devices, and building a bigger-better-cheaper AWS. EPS are very, very likely to suffer. Current owners must develop a steely resolve and recognize this will be turbulent. The Shleifer Effect is in play.

On the other hand, it’s not a stretch to interpret these investments as bets with pretty decent odds behind them. They have the hallmark of informed managers investing in their moat…recognizing their competitive advantages and spending heavily in their defense. Sure, that will lead to a short- or mid-term reduction in earnings, but it should create significantly more value over the long-term. 

Next, I want to explore whether it makes sense to forego those profits today for the possibility of even greater profits down the road.