Archives For Profitability Bias

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…

An essay in which I consider Whole Foods CEO John Mackey’s response to my question, “if Conscious Capitalism is such a good thing, why aren’t more companies doing it?”

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)

John Mackey Speech in Raleigh // Conscious Capitalism // Asking Why?

John Mackey stares at the running faucets in the men’s room just moments before his talk. He shakes his head incredulously, muttering to no one in particular, “That’s an awful lot of wasted water.”

The co-CEO of Whole Foods is a man of medium height and possesses a slight build. A tight haircut has tamed the unruly locks of curled hair I’ve seen in so many of his media headshots.  He’s in Raleigh this chilly February morning for a breakfast talk sponsored by our chamber of commerce. Mackey is promoting his new book Conscious Capitalism: Liberating the Heroic Spirit of Business.(1)

He looks around for an air dryer for his wet hands and finding none seems to ponder briefly whether to just slide them across his tan slacks. He opts for a single paper towel instead. Those who want to greet him this morning with a handshake will just have to endure his damp fingers.

Moments later Mackey is giving his spiel before an attentive crowd, a set of remarks unburdened by notes, spilling freely from a mind that has spent much time mulling over the subject. Then he opens the floor for questions. I sneak one in just at the end. It went something like this:

If Conscious Capitalism is such a good thing, why aren’t more companies doing it? Continue Reading…

lucyThe Case for Conscious Capitalism

Next week Austin will play host to a group of executives that label themselves “conscious capitalists.” [See] 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…

Tom Pirelli ESI Baby

I caught Tom Pirelli on his mobile phone one morning last week. He was near his house in Jupiter, Florida preparing his thoughts for an afternoon meeting about his latest venture, (something to do with using therapeutic lasers to manage chronic pain). He immediately strikes me as a man overflowing with energy, though he is not so young anymore.

I learn that he made a noble attempt at a leisurely retirement after selling his software company, Enterprise Systems, 15 years ago. But it would seem retirement did not fit his constitution. He has since started an ambitious foundation to provide better affordable housing options to impoverished communities in Mexico and Haiti. He has worked with USA Rugby, and took great pride in seeing his favorite sport included on the roster for the 2016 Olympics in Rio. And, of course, he has involved himself deeply in this new laser therapy business.

Tom is a success through and through with the sort of bona fides that might just turn a less humble man into a braggart. Yet despite his litany of accomplishments, this is the picture for which Tom is best remembered:

We’ll return to that later…

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…

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…

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…

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there’s money left over, it’s a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you’re using a framework to understand and assess businesses, it’s fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time.

But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.

Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor.  Your business suddenly looks less valuable as the profits from yesterday don’t translate into profits tomorrow.

We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business.

Enter the competitive advantage. That post is next…

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I’m offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company’s earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you’ll get five percent; 15 percent gets you 15 percent; 30 percent…whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It’s all legit in this little magical mystery market of mine.

So, let your mind wander. If you’re freed from the constraints of price…if you get to pick any company you want that trades in the public markets…let your brain get excited and greedy over the exercise, and decide…what five companies would you pick?

The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely…

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it’s not losing business to the competition) and/or margins (competitors aren’t finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can’t buy companies that grow in unprofitable ways…though I doubt many of these could last ten years.)

What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I’ll keep a running update on the blog.



You can email me at pauldryden (at) gmail.


Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

– Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)


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.

Next on the impact of expense investments on Amazon’s earnings, we consider this…

C. Content to encourage more customer loyalty via Amazon Prime membership.

I joined Amazon Prime last month for $79 a year. I promptly dropped my Netflix membership in favor of Prime streaming videos, found a book I wanted to “check out” for free on my Kindle this month, and went looking for items I could put on “subscribe and save” status. Oh yes, I’ve ordered several more things this month than I ordinarily would as a test to see how extensively I could use Amazon Prime as a replacement for my family’s weekly (or more) trips to Target and to revel in the close-enough-to-instant gratification provided by its two-day shipping at no additional cost.

We’re hooked, and I have no doubt we’ll spend a lot more money at Amazon as a result…which will translate into less money at Target and even fewer reasons to visit other web retailers at all.

Growth At Too High a Cost?

A site called singled out Amazon last month as its “secular short of 2012.” It makes a reasonable comparison to bubble company Kozmo when considering the cost of cheap delivery:

Back in the bubble there was a company called that offered free 1 hour shipping of array of small goods like books, videos, magazines, etc. To my amazement, I tried the service and ordered a pack of gum. Within an hour someone was at my door to deliver it. The company reported amazing revenue growth. Obviously investors should have discounted that sales growth as it was an “uneconomic” business model.

Amazon is doing a similar thing by subsidizing free shipping. Anecdotally I am hearing customers who have Amazon Prime feel compelled to order small items to take advantage of the free 2-day shipping benefit. They are ordering batteries, Listerine, toilet paper, water bottles, etc. all with free 2-day shipping, which is goosing Amazon’s revenue without helping their bottom line.

If you sell $1.00 of value for 99c, you will show amazing revenue growth. It’s all fine and dandy until your free shipping offering hits critical mass with take-up accelerating and the losses start ballooning.

The author makes good points, and it’s hard to disagree that Amazon shouldn’t put itself on a slippery slope of economic destruction via cheap delivery. We must, of course, consider Amazon’s rationale for embarking on this program and its capacity to continue it without overwhelming the business economics.

First, the Prime program is several years old at this point. If I recall correctly, it started at $99/year before Amazon started dropping the price (as it has a habit of doing). Management has had time to review the data and look at its impact on the business. Unless we have reason to believe that Bezos et al. are irrational or such brinks-men that they would double-down on a value-destroying initiative, I think it’s fair to give them the benefit of the doubt and assume they’re seeing some positive things coming from the effort.

In 2008 Bezos did this interview with Businessweek in which he commented on the benefit of being big when you want to try innovative things:

One of the nice things now is that we have enough scale that we can do quite large experiments without it having significant impact on our short-term financials. Over the last three years the company has done very well financially at the same time we’ve been investing in Kindle and Web services – and all that was sort of beneath the covers.

Remember, Prime is part of a marketing tactic for Amazon that presumably fits within the context of a much larger strategy. Inexpensive (or free) shipping is not a business model for them as it was for

Second, I’m reminded of a story from Built From Scratch, the autobiographical book from Home Depot’s founders. Early in the company’s history they began offering no-question refunds to their customers. Anyone could bring in any item purchased from Home Depot and get a full refund without any flack from the store. It should be no surprise that this practice invited abuse and fraud which really irked some employees. They couldn’t stand the idea of being fleeced by freeloaders and fraudsters. When they complained to Bernie Marcus and Arthur Blank, the founders told them to suck it up. Despite the handful of jerks eager to take advantage of them, the lenient returns policy was driving more business to their stores and away from competitors who would wrestle with customers over each return. In context of the big picture, the losses were tiny compared to the gains from all the additional business.

The Amazon Prime Impact

Last December, Ben Schachter of Macquarie Research put together a piece of homespun research called The Amazon Prime Impact: A Self-Portrait Case Study. (Hat tip to for that link.) He looked at his own buying habits pre- and post-Amazon Prime membership. His data demonstrated these points:

  1. Increasing Order Activity: His annual number of orders was up 7x and dollar spend up 500 percent.
  2. Declining Order Size: His cost per order dropped from $70 to $54.
  3. Gross Profit Benefit: Overall gross profit dollars to Amazon were up though percentage margin was down.
  4. Loss Leaders: 33 percent of his orders lost money for Amazon.

The key points are that he increased his orders and dollar spend with Amazon, AND while its margins were lower, Amazon likely netted higher overall gross profit dollars from Schachter using Prime membership so extensively. He says his margin percent dropped from 25 to 18 but because he did so much more volume, the overall gross profit generated went from  $322 before he joined Prime to $816 in 2011.

It’s critical to understand that absolute gross margin dollars generated by sales trumps the gross profit percentage in Amazon’s business model. Why? I wrote this last year when evaluating (here):

I go so far as saying that I don’t necessarily care what a company’s gross margin percent is. I want to see the dollar amount covering the expenses. After expenses are paid for, I’m all for selling more product or service at any gross margin percent as long as that doesn’t hurt the franchise, the business’s long-term prospects, or increase expenses. Why? After your expenses are paid for, each additional $1 of gross profit drops straight to the earnings box regardless of whether you sold it at 20% or 1% margin. Percentages be damned! That’s cold, hard cash.

Back To My Own Experience

I considered myself an Amazon consumer fan for years, and yet I didn’t join Prime. As Amazon expanded the Prime experience, however, it became a no brainer to do it. (Indeed, it paid for itself twice over when I canceled my Netflix subscription.)

Amazon is creating another virtuous cycle by plowing hundreds of millions into content for Prime members. But it’s not going to show short-term earnings benefits. Over the long haul, however, I expect my experience will mirror the overall increased adoption rate. At some point the value becomes so high, many more Amazon customers will do it because it’s just dumb not to.

Amazon found my tipping point, and now I’m a Prime member who spends more money with them and has even paid to rent a few videos for my daughter to enjoy on the Kindle Fire during long car rides (something I would not have done if i weren’t already enjoying the “free” streaming videos courtesy of Prime).

Moreover, I’ve canceled my Netflix subscription and am actively looking for more ways to spend my shopping dollars with Amazon instead of making trips to Target.

Conclusion: If Amazon is not locking itself into a uneconomic business model and is, as Schachter’s self-analysis suggests, building in higher overall gross dollars to cover its expense nut…AND…it’s building customer habits and loyalty…AND…it’s taking business away competitors. Well, i think this counts as an offensive move.

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.

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.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. 

– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

The following exchange took place during the Q&A portion of the 2011 Berkshire-Hathaway Annual Meeting. It is paraphrased from this account provided by Ben Claremon of The Inoculated Investor blog.

QuestionThe only option for a shareholder nearing retirement to get income is to sell shares of Berkshire-Hathaway stock. This is because the company doesn’t pay a dividend, even though you like to collect dividends. So, when would you consider paying a dividend?

Warren BuffettCharlie and I will pay a dividend when we have lost the ability to invest a dollar in a way that creates more than a dollar in present value for the shareholders…Every dollar that has stayed with Berkshire has grown much more than it would have if it had been paid out as a dividend. As such, it is much more intelligent to leave a dollar in…There will come a time – and it may come soon – when we can’t lay out $15 billion a year and get back something that is worth more than that for shareholders. The stock will go down that day. And it should because paying a dividend means the compounding machine is dead.


Like all businesses, Amazon has decisions to make about what it does with its cash. There really are only a handful of choices: pay it out to investors (dividends, share buybacks, and debt pay-off), plow it back into the business (capital investment, expense investment, and acquisitions), or let the cash accumulate.

If Amazon management has good reason to believe that plow-back investments are likely to produce greater earnings power in the future – and by that I mean the returns on the investment are in excess of the cost of the capital, or what a reasonable investor might expect to earn on the cash if he were to deploy it outside of Amazon – then they should reinvest in the business. If they believe that the plow-backs will allow them to create a franchise with enduring competitive advantages, I would go so far as saying they have a fiduciary responsibility to continue reinvesting in the business.

Many value investors like companies that are quick to return cash to shareholders. I understand that. There’s security to getting that cash out. It creates warm and fuzzy feelings, and it lets you deploy it for other purposes like consumption (that new iPad or the bracelet your wife wants) or alternative investments. 

Theoretically speaking, when businesses return cash to shareholders they’re confessing to one of two things. 

One, that they can grow earnings without reinvesting more cash. They simply don’t need the cash. These businesses are gems and equally as rare (or at least too pricey for value-minded investors to consider).

Two, that they cannot reinvest that cash in a way that produces satisfactory returns. They are running out of profitable growth opportunities. And in that case, returning cash to investors is the responsible thing to do. 

(I write “theoretically” at the outset because oftentimes managers return cash to shareholders irrespective of reinvestment opportunity because they have a history of paying out dividends and any change to that history will cause much consternation in the shareholder base. They don’t want the stigma of being the managers who cut the dividend, ticked off legacy investors, created concerns – legitimate or not – about the business health, and caused a dip in the stock price.)

When we wish for the security of dividends, it usually means we’re wishing the companies we have invested in have run out of markets for profitable reinvestment. It means we don’t want them to grow as much as perhaps they could. It means we’re welcoming the day the compounding machine died.

Should current owners of Amazon wish the company stopped its investments in…

  • subsidized shipping to pull more shoppers to the web and away from traditional retail?
  • lower prices on products and services to entice more consumers into utilizing Amazon and becoming repeat customers? 
  • content to encourage more customer loyalty via Amazon Prime membership?
  • increased fulfillment capacity in warehouses whose proximity guarantee faster delivery of an even wider selection of products?
  • software that makes buying easier, faster, and more secure?
  • devices like Kindles which encourage consumption of high margin digital media as well as increased shopping on
  • technical talent to extend market dominance over the burgeoning field of cloud computing?
  • more server and hardware infrastructure to attract more cloud computing customers?
  • little (expensive!) orange robots that will drastically reduce the company’s dependence on (expensive!) manpower (and air conditioning) over time?

In business, as in life, there are always trade offs. If we want Amazon to show us more earnings now, or to share the cash with us, we must be willing to give up the long-term advantages created for the business by making the investments listed above. We must trade future earnings for immediate cash.

The question becomes…how much do the investments above enhance the value of the business by allowing it to generate greater earnings in the future?

Quick answer: I don’t know…but it’s still worth thinking through some possible scenarios.