It has been almost 2 months since the last post. However, we like the balance as it is, and are hesitant to fall into say-something territory. During Berkshire’s annual meetings, a lot of questions asked by Buffett to Munger were answered with “I have nothing to add. ” There has been a Chinese proverb: 言多必失 which means too much talking is counterproductive and is bound to spoil the quality in general.
Today, I’d like to start with how we should learn from past (investing) mistakes.
How mistakes can become net present value positive
Mohnish remembered selling Amazon shares too soon in 2002–2003:
… At that time Amazon’s stock collapsed. It collapsed down to $10 a share. And I put 10% of my fund at the time into Amazon at $10 a share. And very quickly it got to 14 and I moved on. Okay, … very dumb, okay, …there can’t be things that are dumber than that. That is like a 330x that got blown away. I remember that time I was managing about $70-$80 Mio. Even if $5 Mio. went into at 10 dollars, 300 * $5 Mio. is a billion and a half. It wouldn’t have mattered what happened to anything else. But we live and learn. And so life, life goes on, life is great.
This has been a Wow-moment, comparable to the experience of Warren Buffett’s first stock investment into City Service preferred shares.
Nick Sleep made similar mistakes earlier in his life when investing in Stagecoach and Conseco, but got brighter by
analyzing his mistakes more thoroughly than his success. Stagecoach was a success in the sense that shares purchased at 14p were sold at a high of around 90p. That is until one looks in the Financial Times to be reminded that the shares currently trade above £2.50. The mistake was to leave £1.60 on the table and was also caused by anchoring on the original purchase decision analysis (which required a value above 14p), rather than thinking about the destination for the business in years to come. The opportunity cost of the Stagecoach mistake is broadly U$12m today (and counting). The analytical mistake in both cases was to have a static view of a firm formed at the time of purchase, which failed to evolve as the facts changed. This error was reinforced by misjudgments such as denial (the facts had changed) and ego (we can’t be wrong). … Destination analysis is consciously central to how we analyse businesses these days. It helps us ask better questions and get to a firm’s DNA. What we learnt at Conseco may well have kept us out of the US banks last year, and what we learnt at Stagecoach has helped us continue to own Amazon. These two benefits have been a combined gain in the order of U$60m during 2007 to investors in Nomad. The maths behind this assumption is a little finger-in-the-air and is unadjusted for subscriptions post mistakes, but it is directionally correct and implies that a large proportion of Nomad’s performance in 2007 came from the lessons learnt from mistakes in 2003 and 2004. Think of it as a return on prior year losses.
He partially learned it by observing other investors:
In the early 1970s a then, and still today, large successful fund management company analysed its portfolio and discovered that their sale of IBM thirty years earlier had been a huge error of omission. If they had instead kept their IBM shares for the last thirty years, that stake alone would have been larger than total funds under management. No doubt they all agreed to learn from that particular mistake and, as so often happens, went back to their desks and got on with life as before, as if nothing had happened. It is fun to note that, at about the same time, they also made the decision to sell their stake in Wal-Mart, which, thirty years later, would be worth more than their then-to-be funds under management! In terms of dollars of opportunity lost, it is likely to be the biggest single error this firm will make.
We (strapping on the protective armour of the first-person plural) have made lots of mistakes. (I will be less cowardly) I have made lots of mistakes. Sometimes we made the mistakes ourselves. Sometimes we learnt from others. Sometimes they were direct investment mistakes. Sometimes they were part of growing up (look out for those private mistakes, they are full of investment lessons). But there they are. Warts and all. This is how life is. We do not justify them, but we do not condemn them either. Indeed, they are best not judged. Our model is to learn from our mistakes and what we learn we hope to give to you, in better performance results (in exchange for a performance fee!).
Let’s close this chapter by sharing Jeff Bezos’ thoughts are making mistakes:
We will have to make many conscious and deliberate choices, some of which will be bold and unconventional. Hopefully, some will turn out to be winners. Certainly, some will turn out to be mistakes. …As proud as I am of our progress and our inventions, I know that we will make mistakes along the way — some will be self-inflicted, some will be served up by smart and hard-working competitors. Our passion for pioneering will drive us to explore narrow passages, and, unavoidably, many will turn out to be blind alleys. But — with a bit of good fortune — there will also be a few that open up into broad avenues.
Many of you have heard me talk about the ‘‘bold bets’’ that we as a company have made and will continue to make — these bold bets have included everything from our investment in digital and wireless technologies, to our decision to invest in smaller e-commerce companies, including living.com and Pets.com, both of which shut down operations in 2000. We were significant shareholders in both and lost a significant amount of money on both.
Scale Efficiencies Shared Model
Amazon has been misunderstood by value investors, just some valuation metrics here from the past decade:
- lowest PE: 50 in 2021
- EV/EBITA almost never < 25
- Operating margin never went above 5% before 2018
But one single metric mentioned by Jeff himself was free cash flow per share, this one has been fairly consistent:
- $0.22 (2013) — $3.04 (2020), if we discard the recent 2 years because of the current bear market.
Once, Amazon was discussed in a Facebook value investing group, and fans of Jeff were identifying Amazon as a value stock. So I thought about it and decided to dive into Jeff’s past annual letters to come up with some reasons. And I was not disappointed. The letters were exceptional and were comparable to those from Mark Leonard and Warren Buffett in terms of quality.
I ask myself, what do Jeff Bezos, Mark Leonard, and Warren Buffett all have in common?
- They read Benjamin Graham’s book.
- They had investing / financial background.
- They were familiar with the power of compounding.
- They understood the value of floats.
- As CEO, they were destined to build a long-term-oriented business.
Now let’s start with a famous quote from Jeff Bezos:
As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way. In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage. With rare exceptions, the volume increase in the short-term is never enough to pay for the price decrease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years. Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long-term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We have made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and — we believe — important and valuable in the long term.
Nick started mentioning Amazon as early as 2004 in his Nomad semi-annual letters. And he’s fond of Amazon’s scale efficiencies shared model, similar to Costco, Ryanair, Berkshire (Geico, NFM), etc. It’s a strategy where a company that benefits from “economies of scale” shares those benefits with its customers, typically by offering lower prices, to gain long-term market share.
How to Grow From a Mouse to an Elephant
So why does Amazon get to grow from a mouse (more like a phoenix rising from the ashes of the dot-com bubble) to an elephant today? Why can’t every internet company grow its revenue with a CAGR of 38% from IPO to 2022 with the lowest growth being 13% in 2001 and 9% in 2022? Instead, most of the internet companies just went bust.
Nick Sleep thinks that it is about the DNA and fundamentals of the company culture. You can see similar patterns in evolution and biology. It is a known fact that a mouse lives shorter than an elephant. And an adult mouse’s number of heartbeats per minute is faster than that of an adult elephant.
A mouse uses up its billion heartbeats in about four years (at a rate of five hundred beats per minute) whilst an elephant uses up its billion heartbeats in seventy years (at a rate of twenty-five beats per minute). It seems that evolution has not changed this basic constraint: a billion heartbeats it is, careful how you use them!
Amazon started with the simplest platform as a POC by selling books
Amazon self-funded its own growth
Amazon’s ROIC and margins (gross + net) have been expanding
Amazon’s barriers to entry increased with size; that way its moat is widened as the firm grows.
the basic building block of the business, its skeletal structure, is probably best kept very simple. In short, we want a skeletal structure that can support growth from mouse to elephant without too much skeletal re-engineering.
Let’s consider traditional high street retailing. Goods are sent from the supplier to the retailers’ central warehouse, where they are stored until demanded by the shops. Goods are then sent to the high street stores. These are expensive pieces of real estate and have high operating costs. Price aside for a moment, the quality of service the consumer perceives is largely a function of staff levels, staff helpfulness, product range, shop furnishings and so on. So, there are lots of constantly variable elements to service quality at the most expensive end of the distribution system. It seems to us that the skeletal structure is highly complex, and many things can go wrong.
Contrast this to the internet model. Goods are sent from the supplier to a central warehouse, but often only after the order has been taken. The goods are then sent direct to the customer with the expensive high street real estate missed out. The quality of service perceived by the customer is the speed of delivery, the feel of the web site, functionality of the web site, such as recommendations (discovery features like “customers who bought this item also bought”) and faq, breadth of product range and so on and these factors are inherently more controllable. They are fixed in terms of expense and also customer experience (a web site viewed in New York looks the same as the same website viewed in London or Hong Kong). So, whilst quality is inherently patchy at most high street retailers, it is fixed at Amazon. This is important as it is complexity that is one of the main reasons firms fail as they try to grow.
It seems to us that the basic building block of internet retailing, its skeletal structure, is far more robust, scalable and cheaper than the high street equivalent. In other words, its power law is very high, and implies that businesses with the simplicity of operation as say, Amazon.com, have a shot at being far bigger, quicker and more profitable than their high street equivalents.
A business becomes your best investment, if you know it is one of the best in the world and you never consider selling it
If the idea of never selling is new to you, I advise you to read this post.
After the doubling in the share price of Amazon and the weighty resultant position in the Partnership it would be easy for Zak and me to claim victory, high five, and sell our shares in Amazon. However, the high weighting makes sense given our understanding of the destination of the businesses and the probability of reaching that destination. In previous Nomad letters we have argued that the biggest error an investor can make is the sale of a Wal-Mart or a Microsoft in the early stages of the company’s growth. Mathematically this error is far greater than the equivalent sum invested in a firm that goes bankrupt. The industry tends to gloss over this fact, perhaps because opportunity costs go unrecorded in performance records. For example, our greatest error was the sale of Stagecoach (which has risen ever since sold), not the purchase of Conseco! We wonder, would selling Amazon today would be the equivalent mistake of selling Wal- Mart in 1980 (a similar time period after both companies’ IPOs) or Moutai in 2001?
During the trough in the dotcom bubble and GFC, Amazon’s stock price just went decoupled from its fundamentals.
Dotcom era:
As the famed investor Benjamin Graham said, ‘‘In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.’’ Clearly, there was a lot of voting going on in the boom year of ’99 — and much less weighing.
As Jeff correctly cited Graham in his 2000 letter, there was hype for internet stocks in the late 1990s. While revenue growth tripled in 1998, AMZN’s stock price went 8x, during all that time Amazon has yet to make a dime of profit. No wonder the stock declined to where it was in 1998, -80% in 2000, and -30% in 2001.
But the company was still growing in 2000 and in 2001 it become operating profitable for the first time.
Amazon.com the company is in a stronger position now than at any time in its past. So, if the company is better positioned today than it was a year ago, why is the stock price so much lower than it was a year ago?
For people that never understood stock investing, this might be new to you. A stock could decline in a fairly short period of time because the fundamentals got worse or it just got so overvalued, just like Amazon between IPO in 1997 and late 1999.
GFC:
During the GFC, Amazon was already profitable, but this shows the essence of a sentiment-driven market, it is driven short-term by momentum, not revenue or profit growth. As Jeff put it perfectly:
It’s All About the Long Term
We believe that a fundamental measure of our success will be the shareholder value we create over the long term.
Just like Microsoft tried to copy from every competitor out there, Amazon’s capital allocation has been splendid in the last 2 decades.
When Amazon copies from Costco Membership Model
If you are a fan and a shareholder of Costco then you should take a look at Amazon.
After meeting Jim Sinegal, the former CEO of Costco, Jeff introduced the Amazon Prime membership model in 2005. Since then the float of membership fees improved the moat and the predictability of Amazon’s future cashflows. More cashflows meant more smart acquisitions.
Smart acquisitions
These are some well-known acquisitions from Amazon:
- Alexa
- Touchco (merged with Kindle)
- Zappos
- Other companies that merged with AWS and Amazon Prime
- Whole Foods market
Mr. Market went crazy on the day Amazon announced to acquire Whole Foods:
- Walmart -9%
- Sprout Farmers Market-14%, closes -6%
- Costco -7%
Food stocks like Hershey, Campbell Soup, Conagra Brands also declined ~2%.
Superb Management
If you are still unsatisfied with Jeff as the CEO then the following quotes may change your mind, because some of them remind you of the GOAT Mr. Warren Buffett himself:
We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.
When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
Word of mouth remains the most powerful customer acquisition tool we have
When I interview people I tell them, “You can work long, hard, or smart, but at Amazon.com you can’t choose two out of three.”
The current online shopping experience is the worst it will ever be.
In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine. Clearly there was a lot of voting going on in the boom year of ’99 — and much less weighing. We’re a company that wants to be weighed, and over time, we will be — over the long term, all companies are. In the meantime, we have our heads down working to build a heavier and heavier company.
Limiting share count means more cash flow per share and more long-term value for owners. Our current objective is to target net dilution from employee stock options (grants net of cancellations) to an average of 3% per year over the next five years, although in any given year it might be higher or lower.
Long-term thinking is both a requirement and an outcome of true ownership. Owners are different from tenants. I know of a couple who rented out their house, and the family who moved in nailed their Christmas tree to the hardwood floors instead of using a tree stand. Expedient, I suppose, and admittedly these were particularly bad tenants, but no owner would be so short-sighted. Similarly, many investors are effectively short-term tenants, turning their portfolios so quickly they are really just renting the stocks that they temporarily “own.”
Shortly after launching Amazon.com in 1995, we empowered customers to review products. While now a routine Amazon.com practice, at the time we received complaints from a few vendors, basically wondering if we understood our business: “You make money when you sell things — why would you allow negative reviews on your website?” Speaking as a focus group of one, I know I’ve sometimes changed my mind before making purchases on Amazon.com as a result of negative or lukewarm customer reviews. Though negative reviews cost us some sales in the short term, helping customers make better purchase decisions ultimately pays off for the company.
Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com.
as I frequently quote famed investor Benjamin Graham in our employee all-hands meetings — “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren’t 10% smarter when that happens and conversely aren’t 10% dumber when the stock goes the other way. We want to be weighed, and we’re always working to build a heavier company.
Nineteen years ago, I drove the Amazon packages to the post office every evening in the back of my Chevy Blazer. My vision extended so far that I dreamed we might one day get a forklift. Fast-forward to today and we have 96 fulfillment centers and are on our 7th generation of fulfillment center design.
We took two big swings and missed — with Auctions and zShops — before we launched Marketplace over 15 years ago. We learned from our failures and stayed stubborn on the vision, and today close to 50% of units sold on Amazon are sold by third-party sellers.
Customers complete 28% of purchases on Amazon in three minutes or less, and half of all purchases are finished in less than 15 minutes. Compare that to the typical shopping trip to a physical store — driving, parking, searching store aisles, waiting in the checkout line, finding your car, and driving home. Research suggests the typical physical store trip takes about an hour. If you assume that a typical Amazon purchase takes 15 minutes and that it saves you a couple of trips to a physical store a week, that’s more than 75 hours a year saved. That’s important. We’re all busy in the early 21st century.
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This blog belongs to the Global 10 to 1 series, see you next time!
Disclaimer:
This article is for informational purposes only and represents the author’s own opinions. It is not a formal recommendation to buy or sell any stock, as the author is not a registered investment advisor. Please do your own due diligence and/or consult a financial professional prior to making investment decisions. All investments carry risk, including loss of principal.
