Archives For Misunderstood

Mark Spencer 1

Mark Spencer
Photo Credit: Digium, Inc.

Update: I originally published this essay in late-2012. My attention recently drifted back to the topic of disruption in the telecom industry, prompting me to revisit what Mark Spencer achieved with Digium and the Asterisk product. I’m no less impressed today than I was four years ago, and so I put this at the top of the blog list again. What Mark accomplished is impressive and a worthy model for other disruptors to consider.

Mark Spencer presents me with a philosophical conundrum. Before an interview earlier this month I text him to say I’m so excited about our conversation that I hardly slept the night before. (He is understandably cautious of my enthusiasm.) After we spoke, I’m so confounded by the way he chose to tell his tale that I don’t sleep well for several more nights as my mind grapples with what it’s heard.

Mark is chief technology officer and founder of a company called Digium in Huntsville, Alabama. It supports and develops for an open source telecom platform called Asterisk which Mark (for lack of a better term) invented. Digium is to Asterisk what Red Hat is to Linux. And much as Linux evolved into the open source alternative to proprietary operating systems offered by companies such as Microsoft, so has Asterisk become an alternative to closed technology from the likes of telecom giants Cisco and Avaya.

Not everyone likes the open source model, but enough do that Red Hat has made a thriving business out of providing software, support and consulting services to those that do choose Linux. Likewise with Digium. It has found a loyal and growing base of followers who align with Asterisk’s open source philosophy, its price and its flexibility. Some subset of those Asterisk users, mostly small- and medium-sized companies, find value in paying Mark’s company to help them use the platform.

I have little doubt that Mark bristles at my word selection in the paragraphs above.  That I call it “his” company and that he “invented” Asterisk. But those are accurate descriptions. Though he turned over day-to-day operations of the business to professional managers after raising a round of venture capital in 2007, he remains majority shareholder and has de facto voting control over board decisions. But Mark prefers inclusive language. Digium’s success is the result of the efforts of many, not just Mark, he points out several times in our interview. Asterisk’s adoption did not happen because of the code he originated, he adds, but because countless independent developers have committed their considerable energy and intellect to enhancing it and making it a better product for users.

Though its story is still being written, it’s not a stretch to call Digium a success at this point in its existence (which Mark characterizes as being in its late-adolescent or early-teenage years). The same applies to Mark. He has done more in his 35 years than most people could muster the ambition to even imagine accomplishing in their lifetimes. But he lets out a deep sigh when I ask him to tell the story in the context of this success.

Mark rejects my basic premise. “What is success?” he asks with implied disdain but unflinching politeness.

Call it success or call it something else, when he talks about where he is today and where Digium is, Mark has no interest in talking about the things he did. He takes me in a different direction altogether.

Let’s not tell a story about talent or skill leading to success, he intimates. Let’s talk about the importance of luck.

So it is this matter of luck, and its effects on outcomes – success or failure – that has kept me up more nights than I should admit since my last conversation with Mark.

Continue Reading…

I. An Image Problem: Hercules & The Hydra

Hercules was a real jerk. That’s my conclusion after thumbing through the tales of his conquests last night in Edith Hamilton’s Mythology. He’s lionized as the favorite Greek hero, but this dude had a serious case of roid rage, perhaps the first in all of literature.

To illustrate: his most famous adventures come from the “Labors of Hercules” in which he choked-out the fierce lion of Lemea, diverted two great rivers to clear years of accumulated animal filth in the Augean stables, and killed the many-headed Hydra of Lerna, a creature considered immortal until it met Hercules. But why was he checking all these chores off a list? They were part of history’s first 12-step recovery program, penance for a roid-rage fit in which Hercules murdered his wife and three sons. That backstory was conveniently missing from Disney’s cartoon movie. Seriously, we need to reconsider our heroes.

Hercules v. Hydra, Photo Credit:  Eagle Painter Wolfgang Sauber, Creative Commons License

Hercules v. Hydra, Photo Credit:
Eagle Painter Wolfgang Sauber, Creative Commons License

Here’s Hamilton’s description of the Hydra conquest:

The second labor was to go to Lerna and kill a creature with nine heads called the Hydra which lived in a swamp there. This was exceedingly hard to do, because one of the heads was immortal and the others almost as bad, inasmuch as when Hercules chopped one off, two grew up instead. However, he was helped by his nephew Iolaus who brought him a burning brand with which he seared the neck as he cut each head off so it could not sprout again. When all had been chopped off he disposed of the one that was immortal by burying it securely under a great rock.

Let’s refocus this tale from Hercules to the Hydra. Despite its evil reputation, I want to reimagine the creature in a more pleasant light. That ability to grow two heads where one is lopped off has been the source of nightmares, but I want to strip it of fear and turn it into a constructive metaphor for something we should want more of in our local economies. I’ll call them Hydra economies. Continue Reading…

lucyThe Case for Conscious Capitalism

Next week Austin will play host to a group of executives that label themselves “conscious capitalists.” [See consciouscapitalism.org.] John Mackey, founder and CEO of Whole Foods, will provide the keynote address and suitably so. In 2007 he loaned his influential voice to this movement by penning the missive “Conscious Capitalism: Creating a New Paradigm for Business.”

It’s worth the read, and you can download it here. [pdf] The gist is this:

There is a longstanding prejudice that businesses exist for the enrichment of shareholders. While this is technically true, the notion has been interpreted to mean that corporate managers have the fiduciary responsibility to grab profits whenever they are available for the taking, all other constituencies be damned. It is the investor dominated viewpoint, often ignores the other stakeholders in a business, and it can be obscenely myopic. (See my related article, Whom Does Management Serve?)

It also creates, Mackey argues, a zero-sum game that pits investors against managers, employees, customers, vendors and all other stakeholders. By spending more on employee pay and benefits than absolutely necessary, for example, you’re taking earnings off the table that are the rightful property of investors. If employees win, investors lose.

The Conscious Capitalist movement argues for a different framework for understanding the game of business. Rather than a zero-sum dynamic, it suggests viewing it as a system of interconnected parts. By investing more in employee benefits, Mackey says, you get happier employees who better serve the customer…who then buys more products…which leads to higher profits…which can be shared with investors. Treat all stakeholders in a fair manner and the whole system is hoisted ever higher in a virtuous cycle. The sum of the parts, working in unison, become much more valuable than the individual components.

Continue Reading…

Mr. Market is a funny dude. At this writing AMZN is trading up about five percent on the day. The reason? eBay.

Well, eBay plus lofty expectations that Amazon’s current positive trend continues through its Q2 earnings announcement next Thursday. A look over the last few quarters of the relationship among earnings expectations, actual earnings, and Mr. Market’s reaction…let’s just say it shows an interesting dynamic.

The eBay Angle

eBay announced its Q2 results last night and exceeded every consensus expectation on the metrics Wall Street uses to gauge its performance. (See Scot Wingo’s always well-informed discussion of the results at eBay Strategies here.) Mr. Market has pushed its price up over 10 percent on the day, touching – ever so briefly – its own 52-week high.

One of those important Wall Street metrics is eBay’s Gross Merchandise Value (more or less its auction and marketplace revenue) growing at 15 percent, which pretty much matches the growth rate of the overall e-commerce market.

So here comes Mr. Market’s logic…

Continue Reading…

We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.]

Uh-oh, a threat to Amazon’s AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I’m not. It’s more because the challenges keeps me honest.

It reminds me of the verse from Rudyard Kipling’s “If“:

 

…If you can trust yourself when all men doubt you,

But make allowance for their doubting, too…

It’s the only way to keep a kernel of intellectual integrity in his game of investing…look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It’s possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

Continue Reading…

In this my third reading of Taleb’s Fooled By Randomness in the past five years, my attention is drawn to a section he calls The Earnings Season: Fooled by the Results. Its description (below) is reminiscent of (or prescient of) the Shleifer Effect. It creates interesting questions about the model and how/whether it’s tied to randomness.

First, allow me this point: The human brain works in funny ways. I make no claim that the Shleifer Effect is original in any way. I’ve already conceded (here) that its purpose is as a construct is to help me synthesize overlapping ideas gleaned from Benjamin Graham, Sir John Templeton, and Joel Greenblatt. And though I have no conscious recollection of this section from Taleb’s book, I would assume his thoughts have influenced the Shleifer Effect as well.

From pages 164-5:

Wall Street analysts, in general, are trained to find the accounting tricks that companies use to hide their earnings. They tend to (occasionally) beat the companies at that game. But they are neither trained to reflect nor to deal with randomness (nor to understand the limitations of their methods by introspecting – stock analysts have both a worse record and higher idea of their past performance than weather forecasters). When a company shows an increase in earnings once, it draws no immediate attention. Twice, and the name starts showing up on computer screens. Three times, and the company will merit some buy recommendation. 

Just as with the track record problem, consider a cohort of 10,000 companies that are assumed on average to barely return the risk-free rate (i.e., Treasury bonds). They engage in all forms of volatile business. At the end of the first year, we will have 5,000 “star” companies showing an increase in profits (assuming no inflation), and 5,000 “dogs.” After three years, we will have 1,250 “stars.” The stock review committee at the investment house will give your broker their names as “strong buys.” He will leave a voice message that he has a hot recommendation that necessitates immediate action. You will be e-mailed a long list of names. You will buy one or two of them. Meanwhile, the manager in charge of your 401(k) retirement plan will be acquiring the entire list.

Second, in terms of the Shleifer Effect and randomness, it begs some consideration. In his book Inefficient Markets, Andrei Shleifer’s assumption seems to be that chance determines whether a company’s earnings go up or down. He does not concern himself with competitive advantages protecting profits. He is digging through data, and his statistical models (in an attempt to make predictions) cannot spot any sort of rule that demonstrates whether earnings will go up or down for a given business in a given quarter.  So it is chance.

I don’t think that’s his ultimate point, but it needs to be out there whether or not you agree with it. (I do, but only to a degree.)  The interesting part becomes the investor psychology in reacting to what might just be noise or random fluctuations in earnings results. The pattern-seeking human mind wants so badly to find order in the chaos, that we will invent a trend at the slightest hint of its presence. Even if the trend is no more than the chance outcome of random events.

That’s Taleb’s point here, too. I think. He constructs his cohort of 10,000 companies that “engage in all forms of volatile business.” Perhaps I’m reading to much into it (or am so desperate to think that Taleb would find common philosophical ground with my own construct), but I make a distinction between a volatile business and one whose earnings are protected by some sort of competitive advantage.

Either way, the outcome seems to be the same. You get one, two, or three actions moving in the same direction, and people begin seeing patterns. Analysts begin predicting more of the same in the future. Investors start buying in. The result is Shleifer’s predicted overreaction. And it happens on the upside and the downside.

For our purposes, we want to take advantage of businesses whose recent earnings have inspired an overreaction bias on the downside…BUT only if we see that the overreaction is based on misunderstanding the inherent qualities of the business. In other words, the recent earnings are a deviation from a longer-term trend of improved earnings in the future.

Bloomberg reported this morning that Amazon has its own smartphone in development, that the company is working with Foxconn in China for production, and that it has actively been acquiring wireless technology-related patents in advance of the launch. See the story here.

Even more so than its decision to challenge Apple’s dominance of the tablet market by introducing the Kindle Fire, this move into smartphones is likely to leave a lot of consumers and investors scratching their heads. What business does Amazon – a web retailer – have getting into the phone market?

Let me take a stab at that…

Convergence of the Tech Giants

Though Jeff Bezos will deny it until he’s blue in the face, this is a classic move of defense by playing offense.

There’s a convergence going on in technology.  Apple, Google, Facebook, and Amazon are quickly converging on the same base of customers. To be sure, there is a growth imperative at play, too. Each of these companies has become accustomed to growing at a rapid clip, and each has the ambition (and gall) to believe it should continue growing. And as each runs out of room to expand in its core markets, it will seek new growth by introducing services that poach customers from the other tech giants. The spheres in which they operate, once so placidly independent of each other, are beginning to overlap. If you put a Venn diagram of their markets on time-lapse video, the shaded areas of market overlap would grow darker and darker with each passing year. Convergence is happening.

And in a converging marketplace, if you don’t play offense by actively growing into your competitors’ markets, you run the risk that they will grow into yours in the near future. Offense becomes the best form of defense. It compels you to grow, thus the growth “imperative.”

(To put this in the appropriate context, you should take a look at Farhad Manjoo’s The Great Tech War of 2012, published in Fast Company back in October 2012.)

An Aside on Google

Google has been the most interesting case study for both the growth imperative and how a company reacts to convergence. For the time being, Google is spinning like a dervish. It seems to believe it must compete with each of these giants…and NOW. Its rivalry with Facebook has been well-documented with Google+. (See James Whittaker’s Why I Left Google blog entry.) That’s a competition for the future of advertising dominance, and I think it makes sense.

What makes far less sense to me is Google’s foray into retail with its “Prime” one-day delivery deal with bricks-and-mortar shops (see this WSJ blog description and the best overview from amazonstrategies.com here). Google benefits from competition among lots of retailers selling the same products and bidding up adword search prices to get premier listing on the search engine. But with Amazon becoming the ubiquitous web retailer, more consumers are skipping Google altogether and just going straight to Amazon for searches. This is costly for the search engine. And so it goes on the offensive, putting its considerable clout (and resources) behind an attempt at a competitive retail offering.

According to a Walter Isaacson (the Steve Jobs biographer) HBR.org essay back in April, Larry Page visited Jobs in his dying days looking for advice. Jobs asked him…”What are the five products you want to focus on? Get rid of the rest, because they’re dragging you down. They’re turning you into Microsoft. They’re causing you to turn out products that are adequate but not great.”…FOCUS! Isaacson credits Page with taking the advice to heart. I think there’s plenty of evidence to the contrary.

Amazon Devices to Prevent Apple iTunes Dominance

But back to Amazon and the smartphones. Amazon dips its toes in the water a lot. It’s renown for its constant A/B testing and its devotion to running with winning concepts while ditching the losers. So once it decides on a strategy, Bezos brings the company all-in.

In that regard, the smartphones can viewed as an extension of the reasons Amazon developed the Kindle Fire. A sizable chunk of its business is electronic media (songs, games, apps, movies, and books), and that media is being consumed more and more on mobile platforms. Apple gained an early lead in the market for those platforms with iPod, iPhone and iPad, creating a close-looped ecosystem of content to boot. Jobs and company might let others sell their content on iTunes, but they extracted a pound of flesh in return. This was problematic for Bezos and Amazon. To prevent total dominance by iOS, he had to present an alternative.

So we received the first iteration of Kindle Fire. But we know that electronic media is consumed on other devices as well, so it’s only logical that Amazon continues its all-in philosophy to ensure it gets a piece of that action, too. I would expect more (and better) tablets in the future. I would expect better links into television sets (Amazon branded set-top boxes). I would expect music players. And I’m not surprised by the smartphones.

So What Should We Anticipate from the Amazon Move?

First, lots of hiccups. We saw this with the early Kindles and with the Kindle Fire. It’s unavoidable when entering a sophisticated new market with complicated electronic technology. Amazon was not a device manufacturer a few years ago, but it is nothing if not a learning organization. Expect it to build on its experience, constantly improve, and ruthlessly eliminate defects. So, hiccups at first, but Amazon will only get better.

Second, a low price. Amazon is committed to the low-margin/high-volume business model. It has the capacity to suffer, a willingness to take losses on the early batches of inventory while it grabs market share and improves its cost structure.

Third, potential volatility in its stock price. Going all-in on phones – while juggling lots of other growth initiatives simultaneously – has the potential to move Amazon from profits to losses. And Bezos is not afraid of letting his company lose money for a while if he believes it will pay off in the long-term. The market, however, will not take kindly to this. It’s reasonable to anticipate bad financial press and a hit to its stock price if the company sports losses over multiple quarterly earnings reports.

Return of the Land Rush Metaphor

In 2001 Bezos told Charlie Rose (here) that Amazon understood the early days of web retailing (especially 1998 through 2000) through the heuristic of a land rush metaphor. That era was also dominated by a growth imperative. If Amazon didn’t move at an almost reckless pace to establish scaled operations, expand its product selection, and improve its technology, it risked another retailer – fueled by a steady stream of venture capital cash – converging on its markets and earning the trust (and the habits) of customers.

Bezos recognized the risk of being outflanked, so he engaged in the land rush. He bought into every niche retailer that sold a product that he thought Amazon might want to sell someday, better to bring your enemies close than let them flourish outside your control. He invested heavily in technology and distribution infrastructure. He priced his selection as aggressively as he could to attract customers. He bled cash, almost recklessly, because it kept Amazon in front of the pack and reduced the risk that another retailer could gain a toehold in its market.

That land rush mentality came from Bezos’ survey of the landscape at the time telling him that a convergence was afoot then, too. We see what he did to ensure he came out of the convergence as the dominant power.  Indeed, he came out of the dot-com bubble burst as the sole hegemonic power of web retailing. Despite the Amazon stock price falling from $106 to $6, despite losing countless hundreds of millions in equity investments in competing web retailers, and despite losing upwards of $500 million in personal fortune as the stock plummeted…the bursting of that bubble took all the outside cash out of the web retail industry. Everyone had to fend for themselves, and Amazon was the only one that could. Bezos did alright through it all.

If he’s reading the current technology situation with a mind to his experience in the early days of web retailing, I think we can expect him to turn to a page from his old playbook. He will compete ferociously, bordering on recklessness. He will lean heavily into his investments. He will play to dominate the markets.

Profits As Marshmallows

June 25, 2012 — 1 Comment

Let’s continue the thought from our last post regarding the profitability bias

Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.

This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer’s 2009 article Don’t from The New Yorker.  By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two.

This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you’ve spent much time around young children, you’ll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel’s experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence.

Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths – getting that immediate surge of sugar energy – even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.

Next, let’s talk about what those competitive advantages are…

People continue saying Bezos is secretive, and I continue to contend that he simply hides his secrets in places where everyone can find them…but leaves the thinking part (to understand the secrets) up to them. The result? People continue saying Bezos is secretive.

Amazon provides a lot of information about how it works inside of its SEC filings. If you’re interested in understanding what the business is doing over the long haul, the filings are very informative. If you’re just eager to get a scoop on the next piece of technology, next partnership, or next earnings results…you’re going to be disappointed. Bezos continues to be very hush on specifics.

Here’s a piece included in the 2011 10-K that provides a high level view into the strategy of running Amazon.

 

We seek to reduce our variable costs per unit and work to leverage our fixed costs…Our fixed costs include the costs necessary to run our technology infrastructure and AWS; to build, enhance, and add features to our websites, our Kindle devices, and digital offerings; and to build and optimize our fulfillment centers. Variable costs generally change directly with sales volume, while fixed costs generally increase depending on the timing of capacity needs, geographic expansion, category expansion, and other factors. To decrease our variable costs on a per unit basis and enable us to lower prices for customers, we seek to increase our direct sourcing, increase discounts available to us from suppliers, and reduce defects in our processes. To minimize growth in fixed costs, we seek to improve process efficiencies and maintain a lean culture.

Very dry stuff, right? Yes, but in the appropriate context, it’s incredibly meaningful. The first thing to understand – points driven home by Bezos on any interview that includes the topic of Amazon’s business model – is that ecommerce is a scale business. (See what he said here in a 2001 Charlie Rose interview.) Businesses operating on small- or medium-scale cannot compete against those operating on a large-scale. Scale comes into play with the size and complexity of the software, the purchasing power of the business, the distribution capabilities (among other factors). These are fixed costs.

Growth is a tension between timing your increase in fixed costs (in a way that is necessarily messy as you increase headcount, expand your fulfillment centers, improve your software, etc.) with the additional profits those investments should bring. Proponents of Economic Value Add (EVA) insist that growth must show a quick return by way of earnings boost that demonstrates higher value added than the cost of the capital invested to generate it.

It makes me think of Yogi Berra’s “In theory there’s no difference between theory and practice. In practice there is.”

Messy growth requires extended time frames. That’s not to let management off the hook. They still must make good decisions with allocating capital. But it would be plain silly to avoid investments that take several years to develop and mature if, at the end of the investment period, they provide strong returns and are protected by some sort of competitive advantage. That’s the whole idea of having a franchise.

The interesting part of this comment in the 10-K is that it tells anyone willing to pay attention, exactly what happens as Amazon starts cleaning up the messy part of its growth. When it grows into a new geography or with a new category of products, Amazon does it with a mind to win customers. It builds selection quickly. It prices the products competitively. It uses sheer effort to make up for what it lacks in systems. It markets more heavily than usual, rewarding its affiliates with a higher percentage of sales for referrals. All of this to build the customer base quickly and help them create the habit of buying those specific products from Amazon. This is the messy part.

Then, as the main thrust of the growth subsides, Amazon circles back and cleans up the mess. Among the most important things it does is cozies up to product suppliers. Where it has been going through middlemen to source new products, it hammers out deals directly with the manufacturer to cut its price. Where it has been buying in small lots as it attempts to learn its customer’s demand for products, it aggregates its purchases and demands better pricing for the higher volume. And then it just reduces defects.

When we look at the Amazon numbers, we must ask: what is hidden in the expenses? Amazon is that rare business that has long demonstrated an ability to grow customer demand as quickly as it expands its own capacity to service that demand. And if that growth is messy and costly (showing up in the expense category, thereby reducing earnings; or showing up on the balance sheet, thereby increasing invested capital)…just how profitable would this business be if it slowed down its growth?

I don’t know the answer. It’s probably impossible (even for Bezos) to come up with a precise response. But it’s fair to say owner earnings are much higher than reported earnings.

This is why Amazon trades at such a high multiple to its earnings…a good chunk of its expenses are investments in growth. These value of these investments will compound with time, and those earnings will grow as a result.

Sales, Gross Margin and Expense Infrastructure

From Bezos’ 1999 shareholder letter:

 

In part because of this infrastructure [having expanded its distribution capabilities by 300,000 square feet], we were able to grow revenue 90 percent in just three months…As far as we can determine, no other company has ever grown 90 percent in three months on a sales base of over $1 billion.

And now, from the 2011 annual report:

“North America sales growth rate was 43%, 46%, and 25% in 2011, 2010, and 2009…Increased unit sales were driven largely by our continued efforts to reduce prices for our customer, including from our shipping offers, by a large base of sales in faster growing categories such as electronics and other general merchandise, by increased in-stock inventory availability…”

That sort of growth would impressive for any small- or medium-sized business. That sort of growth would be impressive for a business that could scale with a very elastic infrastructure (like cloud computing).  But for a business to grow at those rates when starting from a base of many billions ($19 billion to $25 billion to $34 billion to $48 billion) AND selling mostly physical goods that must be procured, stored, and shipped…It’s absolutely unreal.

It brings a few thoughts to mind. First, it demonstrates how the demand for Amazon products outstrips its ability to satisfy customers willingness to do business with them. I can’t think of any other example of a large business with the proven ability to grow like this. Every time they open a new product category or expand their geographical reach, they find welcoming customers that want to buy more.

This is a testament to the tenets upon which the business built. Low price, widest selection, and good customer experience is a good place to go.

My second thought anticipates what the critics have to say about the growth…Amazon bought the growth. It came at the expense of profitability with earnings dropping from $1,152 million to $631 million. It came from subsidizing shipping even more heavily. It came from every category of expense increasing as a percent of revenue: fulfillment up from 8.2 to 9.2%; marketing up from 2.9 to 3.5%; tech and content up from 4.4 to 5.4%; and even general and administrative is up from 1.1 to 1.2%.

These are very fair criticisms. Let me address the fulfillment matter first. In 2011, Amazon’s shipping revenue (charges for shipping) was $1,552 million while its costs were nearly $3,989 million for a net loss of $2,437. That’s what Amazon pays to subsidize shipping for its customers. The subsidy increased by almost $1.2 billion from 2010.

Interesting to me, fulfillment is filed under Amazon’s cost of sales. Despite all that extra money plowed into the fulfillment subsidy (read: a lot more Prime Members ordering a lot more stuff), Amazon’s gross margins held steady around 22% for the third straight year. I interpret that to mean that Bezos and company like that 22% margin for now. It feels right to them. They’ve demonstrated the ability to make it better (and their process of shoring up their purchasing processes and reducing defects in their overall operations has to be reducing other pieces of their cost of sales), which leads me to believe they’re practicing the art of off-setting. My guess is they’re sticking to the 22% margin and giving back any cost off-sets by way of price reduction and subsidized fulfillment.

Note also that Walmart sports a 25% gross margin. Let’s assume it marks up its products the same as Amazon – very little. That’s makes for a surprisingly small difference in gross margin between the company that is not only considered world class in driving the meanest bargain for every item they buy from suppliers…but also buys upwards of ten times more merchandise than Amazon AND sells fare fewer individual SKU’s than Amazon. Is it not surprising that such a higher volume of spend across fewer items of merchandise does not translate into a wider cushion of margin points over Amazon? Walmart should have huge advantages in buying costs over Amazon! I suspect the difference is made in distribution, with Walmart’s need to get goods to its hundreds of distribution centers and many thousand stores being much more expensive than Amazon’s costs to stock 70 fulfillment centers.

So, Amazon can afford to subsidize shipping without being too far from Walmart’s cost structure.

The other criticisms about Amazon’s expenses growing faster (in every category) than its revenue…they’re fair, too. When revenue increases but profitability declines, our PROFITABILITY BIAS leads us to conclude that the company is just buying new business. It’s lowering prices too much. Or marketing too hard. Or providing too many incentives like coupons. And that’s not a sustainable economic model, right?

That depends on the reasons the company is increasing expenses. I wrote extended series about the idea here, but it really boils down to this: if the company is increasing its expense infrastructure in a way that leverages its competitive advantages while turning the screws on the competition, there’s no reason to look at the higher expenses as anything other than an investment in the future earnings of the business.

In that view, yes, it is buying new sales. But it’s doing it in an intelligent way (e.g., encouraging shopping at Amazon as a habit), and that will pay dividends (literally) in the future.

On the Q4 earnings call, CFO Tom Szkutak made it clear that Amazon likes its investments in Prime, AWS, expanding its media content, and expanding its fulfillment infrastructure. All will continue in 2012 and beyond.

Growth and Earnings

A lot of people get nervous watching those Amazon earnings. While the revenue goes up, those earnings have not been on a predictable trend. This drives analysts and investors batty! We’ve discussed before how they have a mean PROFITABILITY BIAS when it comes to businesses, and therefore far too little patience with businesses investing for long-term growth. Why?

2011 earnings $631M. Down from $1,152M in 2010. Which was up slightly from $902M in 2009. Which was up impressively from $645M in 2008.

And now Amazon is telling us that earnings might actually drop to zero or below in the next few quarters?! (See guidance from quarterly results reported here.) This drives them crazy.

From Amazon’s 2011 10-K filing:

 

More than half our revenue is already earned in jurisdictions where we collect sales tax or its equivalents.”  [But new state taxes] “…could result in substantial tax liabilities, including for past sales, as well as penalties and interest.

This will be interesting to watch over time with Amazon. The sales tax issue has the potential to create a Shleiffer Effect flash point in that so few people understand what it means to Amazon’s business if (once) they are required to collect sales tax in all U.S. states. There exists a sentiment that it will curtail demand for Amazon products since consumers will no longer get the benefit of a tax-free subsidy, raising the price of Amazon products compared to traditional retailers.

So when the tax issue finally hits, there’s a good chance that it produces an overreaction, a load of negative press, and a falling stock price drops. In other words, classic Shleiffer Effect and a buying opportunity.

Amazon’s strategy has been interesting. Nothing short, actually, of brilliant negotiating born of dividing your enemies state by state. And I think it will continue: fight state by state attempts to force Amazon to collect sales tax, pushing for federal legislation that provides a blanket approach to collecting sales tax from online retailers as opposed to a patchwork approach. This buys Amazon time, helps it influence any such federal legislation (especially because Amazon will want it to include an amnesty provision that protects it from any historical liability for uncollected taxes), and allows Amazon to strike opportunistic deals on a state by state basis in which it will agree to collect those taxes in exchange for building distribution centers there.

One is reminded of old Br’er Rabbit. Please sir, please! Don’t throw me into the brier patch!

The coalition pushing so hard for Amazon to collect sales tax is likelyto get a mean taste of unintended consequences. When Amazon begins collecting in a state, it then has full liberty to build and run operations there as it sees fit. Its late-2011 deal to collect taxes in California allowed the company to immediately break ground on new distribution centers there, meaning it will soon be able to deliver its packages to San Diego, Los Angeles, and San Francisco much (MUCH) more quickly than before.

These are huge and important markets for all retailers. I suspect Amazon had been serving them out of its Nevada and Washington fulfillment centers, and still getting pretty good two day turnarounds for delivery. The retailers pushing for the sales tax must now ask…what does it do to our business if Amazon can deliver packages overnight to our customers’ doorsteps? What if having a dense network of fulfillment centers near these population centers means Amazon can deliver the same day?

Please, says Amazon, throw me into that sales tax brier patch.

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide much of what you need to understand the retail business of Amazon.com. We featured it originally in a post here. (And you can watch the full broadcast of the video here.)

To remind you of the context, the interview corresponds with the steepest part of the dot-com collapse. Amazon’s stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn’t end until shortly after 9/11 when it hit a $6 bottom. Bezos own net worth dropped by half a billion dollars (reference here).

And yet Jeff Bezos was doing all he could to hide his ebullience.

Bezos welcomed the end of the internet-telecom bubble of 1998-99 for the simple reason that Amazon had reached scale and achieved a level of capital self-sufficiency that meant the company no longer depended on the goodwill of Wall Street for cash to grow operations. It was sitting on plenty of it and could generate more from operations.

The same was not true for other web retailers in the process of scaling up. They needed more funding to sustain themselves and grow. They had received a steady flow of it from venture capital firms willing and able to invest large sums in unproven businesses, confident they would recoup by bringing their seedling companies public in short time. But with the bubble popping, that all went away. It took down pets.com, wine.com, toys.com and countless other companies with which Amazon competed and (more interestingly) in which Amazon had made investments.

Bezos had this to say about it with Charlie Rose:

So all these companies could get funded. And that’s what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time…many of those companies might have been able to build the scale to be successful.

Losing its investments in online competitors hurt Amazon, but only in the most superficial and temporary sense. Amazon invested in these businesses as a hedge. Bezos was already working toward the lofty goal of being the ubiquitous force in online retail…the only place people would shop. That meant he would expand Amazon into every conceivable product category, offering universal selection. Of course he couldn’t get there immediately. He had to prioritize where the company invested its money and time. So he adopted the land rush mentality, investing in a broad swath of developing web retailers in early stages of growth.

If the competitors could reach any sort of scale – with their software, merchandising expertise, and distribution capabilities – they could begin expanding into adjacencies. It didn’t matter what product niche they specialized in to launch themselves, they could use the infrastructure to expand. They could threaten Amazon’s objective to be ubiquitous. So Bezos bought the competition or invested in them, holding his enemies closer than his friends.

One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren’t the ones we were going to do first…Pets.com, wine.com, etc….there were a bunch of things that we were invested in that didn’t work out. We knew we weren’t going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by…a land rush mentality…It’s hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we…behaved that way.

Then the crash came. The talking heads wanted to focus on Amazon’s foolish investments in all these dot-com bombs, the value of which evaporated in a slew of bankruptcies. No doubt it hurt Bezos, but he had confidence in the bigger picture of what was happening. Why weep over these investments gone bad? They were hedges. The bigger bet was paying off. Your competition was gone, you didn’t need Wall Street for more money, and you had scale.

Bezos was ebullient because he recognized, despite the stock price going down in flames, that he had just won the most significant battle in Amazon history. He was the last man standing.

And so we can understand the confidence behind his statements in the closing minutes of the interview with Rose (emphasis is mine):

In the early days, that’s when the company’s destiny is really not in its own control. At this point in time, with the brand name that we have…we have so many assets now, now it really is under our controlWe don’t worry about externalities now. What we worry about now is that we don’t do our job. And I’ll tell you one of the things in this period that I kind of like is that it’s a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn’t lose.

And this conclusion:

 

Charlie Rose: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What’s the odds of the first being true versus the second?

Jeff Bezos: Let’s put it this way: we get to decide, nobody outside the company can decide that. 

Jeff Bezos was history’s happiest man for losing $500 million in personal fortune in 2001. He had long ago separated the concepts of the value the stock market places on his business versus the value contained within the actual operating business…the intrinsic value. Bezos knew how temporary that loss would be and the great path it set for Amazon’s future.

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide what you need to understand the retail business of Amazon.com. You can watch it here. I’ve included some transcribed remarks below with a little color commentary.

For some context, this corresponds with the steepest part of the dot-com collapse. Amazon’s stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn’t end until shortly after 9/11 when it hit a $6 bottom.

Bezos Can Distinguish Between Stock Price and Business Fundamentals

Charlie Rose (CR): Two years ago you were Time Magazine’s man of the year. What are you this year?

Jeff Bezos (JB): It’s internet poster boy to internet pinata in 12 months! Not an easy thing to do.

CR: Let’s talk about it. How’s the business?

JB: Actually, the business is better than ever. This is one of those things that is so hard for people who are seeing it from the outside to really understand and internalize. but if you look at 1999, which is the year that the stock was booming, we had 14 million customers shop with Amazon. In the year 2000, when the stock was busting, we had 20 million people shop with Amazon.

…But I do think it’s typical for people to separate the stock prices of internet companies (which have obviously come way, way, way off their highs) and the fundamentals of those companies which are actually getting better and better.

CR: What are the fundamentals of Amazon, and how are they getting better?

JB: For example, in Q4 of 99 when our stock was at or near its peak, we had an operating loss of 26 percent of sales. A year later, when the stock was near its 52-week low, we had an operating loss of seven percent of sales. So the operating losses got much, much better. The number of customers…got much, much better. You can basically go through and look at every important operating metric in the company and they’ve all improved.

[Paul: As we discussed here, there are some very capable CEO’s – leaders of important and successful businesses – that seem incapable of separating stock price and the performance of the business. At the very least, they have an emotional and financial tie to the market’s price…a tie they have a difficult time unraveling.]

Growing the Business

CR: …why stray from books?

JB:  Charlie, one of the reasons that we’ve expanded into these new categories is because our customers have asked us to do it.

CR: What kind of relationship do you have with Sony, for example?…Do you have the kind of relationship that an authorized dealer does so you can offer Sony products competitively?

JB: Well we do offer products competitively, but in some cases that doesn’t necessarily mean that we’re buying them directly from the suppliers. We started our electronics business two years ago, and we’re now direct with over 340 different electronics suppliers. We have by far the largest selection of electronic items…in the world…We have over 125,000 items…compared with a huge electronics superstore that might have 5,000 items. We’re so new in the business, over time and patiently, we hopefully get relationships with every manufacturer.

[Paul: This is remarkable to think about. In 2001 Amazon was already an important player in  electronics retail. But big players like Sony weren’t yet dealing with them directly. Amazon makes it a priority to offer the highest selection possible at the lowest price available. One can only imagine the costs they were eating by sourcing through electronics distributors, paying those mark-ups while simultaneously selling cheap. 

This has been the Amazon modus operandi…buy your way into the market even if it means taking losses while you help customers learn the habit of buying from you. Then, when you have the customer buying power behind you, go direct to manufacturers for procurement, get better pricing, and enjoy improving margins. 

Remember that: growth is expensive for Amazon. It always has a lot of clean-up duty after opening new stores and expanding into new geographies. It hurts corporate profitability. But then, inevitably, Amazon owns the category, has power to buy cheap and in bulk, and becomes profitable while continuing to sell at the low price point.]

E-commerce Is All About Scale…  

CR: Looking at the experiences you’ve had over the past three years, was part of the business plan simply to grow faster? [Bezos nods his head, yes.] Would you change it? In hindsight…would you have had a different business model or strategy?

JB:  I don’t think so. I think we have…made the right set of trade-offs. One of the things that you have to know about e-commerce is that it’s a scale business. What that means is that it’s very, very difficult to be a small- or medium-sized e-commerce company.

The difficulty there is because there are big fixed cost investments. You have to write a bunch of software, and it’s just as expensive to write that software if ten customers use it as it is if 20 million customers use it…It’s difficult to build software that scales and is feature rich…[But] we like things to be hard because then you can get competitive advantage from it.

…And We Had to Manage The Land Rush

CR: The biggest mistake you’ve made so far?

JB: …We started investing in a series of smaller- and medium-sized e-commerce companies. Of all the companies that perhaps, in hindsight at least, could have know better, it’s probably us. Because we did know that the fixed costs in the business are high.

CR: So what happened?

JB: One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren’t the ones we were going to do first…Pets.com, wine.com, etc….there were a bunch of things that we were invested in that didn’t work out. We knew we weren’t going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by…a land rush mentality…It’s hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we…behaved that way. But that started to transition after a certain point, and we didn’t see it at the time it transitioned. And it took us a couple years too long.

…That’s part of what created the land rush…the huge market cap of the internet sector. So all these companies could get funded. And that’s what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time…many of those companies might have been able to build the scale to be successful.

[Paul: This makes even more sense in light of a “systematically eliminate risk” comment below. Amazon was broadly criticized for all the investments it made that went bust. The assumption was, I think, that Amazon was spreading its dollars as a way to capitalize on the mania of so many dot-coms being valued higher and higher by the market. Not at all, says Jeff Bezos. Amazon was making the investment with a specific objective in mind…control the expansion of various categories and wield your influence or risk another company getting scale (number of customers, sophisticated e-commerce software, and distribution capabilities) and threatening your chance at achieving ubiquity (more on that topic in a later post). 

And what’s old is new again. Amazon hasn’t really changed their view on preventing viable competitors by bear-hugging them. But because their scale is so much larger, they feel more confident in their ability to just compete upstarts out of business. For those that pose a larger threat – e.g., Quidsi and Zappos – Amazon co-opts by purchasing. You can read a bit more about that here.]

The Amazon.com Model

CR: [Something to the effect of…] Does the Amazon.com economic model work?

JB: I think the model has been demonstrated. If you look at our U.S. books, music and video business, that business has been profitable for quite a while now…And our electronics business, I think one day, is going to be one of our largest and most profitable businesses.

[Paul: I’ll write more on this at a later point. Sometime around 2000, Amazon proved that it could turn a profit quite easily. The secret? Just stop growing. As I mentioned above, there are some incredible inefficiencies inherent to growth. When you start selling electronics, it takes time to be a big player. So you don’t get to source directly from giants like Sony. But you must have the selection, so you buy it from an expensive middleman and endure losses so you can continue earning customers by selling at the low price point. Then, one day, you reach the tipping point…you have scale, you can purchase directly (and with negotiating power), and you iron out inefficiencies. Now you have customer loyalty, the ability to sell at low prices, and low costs to produce gross margin dollars. Voila! Profitability and competitive advantage!]

Moore’s Law & Its Derivatives: The Internet As Superior to Physical Retail

JB: One of the things that’s totally different about e-commerce versus physical world commerce is that real estate doesn’t obey Moore’s Law. Moore’s Law says that microprocessor performance doubles for the same price point every 18 months. That’s held true for more than a decade. What you’re finding now is disk space is getting twice as cheap every 12 months. And bandwidth is getting twice as cheap every nine months. So if you take the bandwidth doubling every nine months and assume it holds constant for the next five years, that means that we can spend the same amount of money on bandwidth per customer that we spend today five years from now but use 60 times as much bandwidth. That’s a big, big deal.

Innovation

JB: I am a dyed in the wool optimist. We live in an era of incredible invention, and what drives the economy is invention…A long time ago people thought it was raw materials that drove the economy, and whichever country had more gold was the richest country.

That’s not true anymore.

What drives economies is the education of the people and the innovation that they can then create. And I see a world which – in part because of the internet – is about ready to explode with innovation everywhere.

…It used to be that if you were a genius and you lived in India, it was a little bit harder for you to make an economic contribution to the world. What you do now is create the next great software, and you do it from wherever you are, and you communicate with the world community of software engineers. This is a big deal. And so if you believe fundamentally, and I do , that innovation is what drives world prosperity, I say hang on to your seat.

[Paul: Bezos is often derided as a technocrat. Everyone respects his intelligence, but many see him as just a metric-driven geek who brings no passion to building a vision for the business. Watching and hearing this statement would cause those critics to think twice. Jeff Bezos is driven by big ideas and has passion about enabling the masses with platforms that fuel innovation.]

Confidence to Say…Check & Mate

CR: What could destroy that dream for you? What’s the terror?

JB: [Responding unflinchingly and without breaking eye contact.] When I first met John Doerr, who’s the person at Kleiner-Perkins who invested in Amazon.com, one of the things he said really stuck with me. It was, “What start-up companies do is they take their precious early capital dollars and systematically eliminate risk.” That’s what they do; the successful ones.

What people often get wrong, when you’re a start-up company, 99 percent of whether you make it to be a more established company is luck. This company, Amazon, we’ve worked incredibly hard. We’ve cared for our customers. I’d put us up there against any other company in how much we have bled and sweat for our customers. but we had the planets align for us so perfectly in those early days in terms of the timing and many other things; decisions that we made that were poor decisions that turned out to be the right decision anyway.

In the early days, that’s when the company’s destiny is really not in its own control. At this point in time, with the brand name that we have…we have so many assets now, now it really is under our control. We don’t worry about externalities now. What we worry about now is that we don’t do our job. And I’ll tell you one of the things in this period that I kind of like is that it’s a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn’t lose.

CR: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What’s the odds of the first being true versus the second?

JB: Let’s put it this way: we get to decide, nobody outside the company can decide that.

[Paul: I don’t see many ways to interpret this confidence. Bezos is saying that – AND THIS IS WAY BACK IN 2001! – absent screwing up internally, we’ve already won.  We’ve eliminated the worst risks. We’ve eliminated luck as a variable in this. The model is that bullet-proof. It’s our to screw up.]

 

The Jeff Bezos Approach to Stock Price

In April 2008, Peter Burrows of Businessweek sat down for an extensive interview with Amazon CEO Jeff Bezos. The article, Bezos On Innovation, featured this piece of quotable wisdom on how to teach your employees to think about the value of the stock they own in your business:

We have three all-hands meetings a year, and I’ll tell people that if the stock is up 30% this month, please don’t feel you are 30% smarter. Because when the stock is down 30% a month from now, it’s not going to feel that good to feel 30% dumber.

The salesforce.com Contrast

I thought of the quote early this morning while drinking coffee and reading Behind the Cloud by Marc Benioff. The salesforce.com CEO has this to say about the morning the company listed on the NYSE:

 

The elation I felt on the morning we went public lasted long beyond the opening bell. It was incredibly gratifying to watch the stock climb; you can’t help but take it very personally. We ended our first day of public trading at $17.20, a 56 percent gain – making salesforce.com the best-performing tech IPO 2004 had seen thus far.

I don’t fault him for being excited. He just realized a long-held professional ambition for himself, doing so at the helm of a business that was ushering in a paradigm change (and that is not hyperbole, I can’t overstate what salesforce.com has done to software) in the way an entire industry operated. Elation is a natural and justifiable emotional response.

He does represent, however, the starkest EMOTIONAL contrast to Bezos’ highly RATIONAL approach to what the stock price of your business actually means. It’s tempting for CEO’s to interpret it as a sort of validation of their ideas and performance; that a high multiple of price to earnings means you’ve done something intelligent and virtuous to earn the trust of Wall Street.

They understand you, and you yearn to be understood.

But what have you committed yourself to? What happens when you have to make a decision that you know is in the best long-term interest of your business but that hurts short-term profitability, up-ending your string of quarter-over-quarter earnings growth?

Now you’re misunderstood. Wall Street punishes you. That stock price, trading at such a high multiple to profits, suddenly seems way too high to the analysts and existing investors. It plummets.

How do you feel now? More importantly, how do you explain that to your employees who shared your excitement but don’t really understand that stock price and business performance are often disconnected?

Jeff Bezos earned his perspective the hard way. Later, in the same article as above, Bezos has this to say:

When the Internet bubble burst, our stock went from over 100 a share to a low right after September 11 of 6. Throughout that entire period, the fundamentals of the business continuously improved. You can see the stock price going in the opposite direction of the fundamentals. So it wasn’t that worrisome to us.

 

I didn’t intend this to be a series, but it has quickly turned into one. The original idea, from this post, is that holding up company managers as “shareholder friendly” (in that they do a fine job representing shareholder interests) can be like a backhanded compliment. Which shareholders, exactly, are they representing? Because it’s a certainty that few of the company owners share the exact same interests or desires for the business.

The most stark contrast might be between investors with an interest in the business showing short-term gains to impress the market, increase the stock price, and provide an opportunity to exit with a profit. They will want managers to work over their accruals as best as possible to show higher earnings. Or to just stop making investments in the business and let the lowered expenses generate a bigger bottom line.

Their objectives are not going to mesh with the investors hoping to stick around for the long haul. This group will not be excited by elaborate accounting to increase GAAP earnings. Nor will they want executives to neglect important expenses (like marketing, talent acquisition, research and development, etc.) in order to show a fatter profit next quarter. These expenses are investments in spurring growth and/or maintaining strong barriers to entry, both important in maintaining long-term profitability.

And even reasonable, level-headed investors can disagree with each other and therefore have diverging interests.

 

Case in point: Joel Greenblatt versus Michael Burry, a disagreement Michael Lewis brought to light in his book, The Big Short.

Joel Greenblatt, of value investing fame for his various books and tremendous track record with Gotham Capital, seeded Michael Burry’s hedge fund and benefited from multi-year period of impressive returns. Then Burry made his big bet against sub-prime lending, a complex and hard to understand investment, but one with a high likelihood of success (in Burry’s estimation at least).

Burry’s fund was down 18 percent in 2006. It was making his investors very edgy, and most of them – while being perfectly happy with his extraordinary returns in the years leading up to this – pushed him hard to ditch the strategy. As they threatened to pull their capital from him, he locked it up.

From the book:

In January 2006 Gotham’s creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name is favorite “value investors,” had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career.

Listen…there is a certain fog of war to these things. This stuff is not black and white. What seemed such a low-risk, high-return investment to Burry appeared quite different to Greenblatt. Perhaps Burry did a poor job communicating his ideas to the Gotham Partners. Perhaps the partners did a poor job listening. Regardless of the reasons, here we have two very intelligent investors and reasonable people disagreeing over how the money should be invested.

What is the shareholder friendly move in this dilemma? Should Burry try to liquidate his bets to give Greenblatt his money back? Not only would that go against a thesis Burry held with deep conviction, but it would ensure a loss as the strategy had not yet matured.

Or was the the shareholder friendly move the very action that Burry took? In other words, protecting Greenblatt against himself by locking up the money (no redemptions) and handcuffing him to the trade.

History tells us Burry was right. Greenblatt made off like a bandit by getting stuck with his former mentee. But this is just one example. I have no doubt there is no shortage of counterpoint examples in which hedge fund money is locked up, promptly lost (Philip Falcone anyone?), and investors are left holding the pittance that remains.

If reasonable, intelligent people (even value investors) can have diverging opinions and interests in a hedge fund example like this, surely the conflict only broadens when you have a wide base of investors in a public company.

So, what exactly does it mean to be shareholder friendly? Does it mean paying out a fat dividend to keep pension funds happy even when you have an expansion opportunity to plow that cash into growth? Does it mean cutting your marketing staff during a down turn because you know your margins will be pressured and you don’t want to disappoint Wall Street with a down earnings period? Does it mean cutting off a research initiative after two years of losses when you have high conviction that it will pay off in a big way if you just suffer another two years of losses to get it going?

*****

I’m a big fan of Joel Greenblatt. His books have helped my thinking tremendously, and he is serving an important role as he spends time educating people about his investing methods. And while I use the story of Michael Burry to illustrate my point, I want to make sure Greenblatt has the chance to make his case.

He did so in an October 2011 presentation to the Value Investing Congress (courtesy of Market Folly here).

In a Q&A Greenblatt was asked about Lewis’ account of events. His response was witty (and I suspect true), but more importantly he provided some balance to the whole affair…

Michael Lewis has never let the facts get in a way of a good story. What they got wrong in the book is Burry wanted to side pocket both mortgage and corporate CDS… we did not want him to side pocket the liquid corporate CDSs … only reason we took money from him was we were getting redemptions.

Greenblatt was not the unreasonable ogre Lewis made him out to be. He had his own pressures. This doesn’t contradict my point. In fact, I think it strengthens it. Sometimes a manager must be able to ignore the panic of his investors. He just might be protecting them in the long-run by sticking to his strategy despite their immediate needs. We know this happens in publicly traded companies, too. Large investors (hedge funds, pension funds, mutual funds) get calls for redemptions that force them to sell their holdings to generate cash to pay out departing investors. They must sell irrespective of the investment prospects.

The CEO of a publicly traded company can’t, of course, stop investors from selling. But in understanding that investors will often have interests that diverge from those of the business itself, one can see that it does make sense – sometimes – to vest enough authority in managers to let them ignore their shareholders and keep plugging away for the long-term benefit of the franchise.