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Apr 2021: Reflections on a mental model: Scale Economics Shared

April 29, 2021

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Reflections on a Mental Model: ‘Scale Economics Shared’ – Jeff Bezos’ next job: Head of Holland Marketing!

Apr 2021

 

Many of you, we are sure, will have read Jeff Bezos latest Amazon shareholder letter[1]. We attach a few extracts from it below that those reading our own research might find interesting. Any of you that read our recent piece on JD Wetherspoon, we hope will notice very strong similarities in both Bezos’ and our attempts to quantify a business moat! Neither of us were original but whilst we called-out the source of inspiration (Buffett’s 2005 shareholder letter), Mr. Bezos did not. However, that Bezos chose to share this analysis and insight as he steps down as CEO of Amazon we think is very telling. Taking a step back to calculate the scale of benefits that have accrued to all different stakeholders in business is a very powerful way to demonstrate its moat we think. What Bezos is employing is a very powerful mental model that we ourselves have used extensively for a long time.

“I want to invest in companies that are a win–win for their entire ecosystem” – Buffett

Just a little reflection on so-called mental models

Much as we have made the following observations to some clients verbally, inside research pieces or on Twitter, we would like to be upfront on what could be described as a little ‘style drift’ at Holland Advisors (but in a good way we hope). As we now have worked our way through the analysis of thousands of companies over decades, we have developed many mental models along the way (Thank you, Mr Munger). As such, we know to look for Brands, Toll Road, Tipping Points and many more attributes that can create future value for investors.

We have also for many years used Buffett’s great shortlist of Dream, Compounders and Gruesome[2] businesses to understand the types of companies we seek and just as importantly those we wish to avoid. That ‘Dream’ businesses (high ROIC + growing) are often statistically the best to seek out we of course can agree with. However, experience has taught us something that the modelling of these businesses does not show. This being that ‘others’ tend to find those companies too and thus they might not be mispriced in equity markets for long. Additionally, that cohort of ‘others’ can include new competitors. That Gillette was a high ROIC, low capital employed, growing business (i.e. a classic Dream model) was likely not lost on the founders of Dollar Shave Club and Harry’s. In short, great branded companies are rarely mispriced.

The road less travelled – ‘Scale Economics Shared (SES)’

What we have noticed along the way is that the shares of some great businesses price-in future growth somewhat efficiently. Efficient markets like the obvious, but that is not always the case in SES businesses. A simple contrast between the average branded company and the average EDLP company might be instructive.

We will not go into EDLP model specifics here, but just say that we think brands and their high ROIC’s are relatively easy for investors to understand and identify. By contrast, companies that chose to invest in say, pricing and infrastructure over long periods to build long-term customer trust and thus future demand can find such a strategy to be costly in terms of short-term profits and thus investor support. In high growth sectors, such as Tech there is a recent seemingly endless belief that blindly building such scale is a good thing. However, we think there are lots of other areas of the economy and investing where the same strategy is employed, but investors often fail to see the moat that is being built or widened.

One might put it this way: the well-worn phrase ‘economies of scale’ is something every lay person understands in life and many companies pursue scale for the obvious benefits. The great companies however go a step further than just seeking scale. As Bezos puts it below, they create more than they consume. Which leads us to the phrase (a Mental Model) ‘Scale Economics Shared’. This is not just an attempt to bamboozle with jargon but is actually a really subtle way of describing a phenomenally powerful business strategy.

As the investor who coined the term, wrote:

“Most companies pursue scale efficiencies, but few share them.”

Hopefully those that will have read our many years of work on JDW/Ryanair/Schwab/Greggs et al will have seen good evidence of this in our own thinking at Holland in recent years. So, you might say, what’s new?

What is new is our increased conviction in this area and as a result the greater amount of time we want to spend seeking out these businesses.

For that we will call out and thank Messrs Nick Sleep and Qais Zakaria who ran the successful Nomad Investment Partnership and coined the above phrase. We have never met either gentlemen, but reading their letters at Christmas was, for us, like looking in a rose-tinted mirror. Rose-tinted of course because they achieved not only great investment performance, but just as importantly they articulated perfectly, the business models of Costco and Amazon presciently many many years before those businesses saw the full fruits of their labour that is today on full display.

Those letters did not change our thinking per se but they clarified it in two ways.

  1. Firstly, we credit the Nomad men for coining the great phrase ‘Scale Economics Shared’ in their beautifully crafted letters. In truth we think the phrase is better than Jim Collins’ ‘Flywheel’ or Walmart’s EDLP language that we had adopted. Nomad’s phrase far better encapsulates what the best EDLP companies do… they share the benefits of their scale.

We might add that it this very sharing of scale is what can make the companies hard for investors to identify early-on/understand which offers opportunity to those that can.

“People who think well, write well” – David Ogilvy (the original “Mad Man”)

  1. Of far greater benefit to us personally however was the conviction and clarity reading these letters gave us in our own approach. As far back as 2012 we had identified Ryanair’s and JDW’s superb lowest-cost models but getting the right language to describe the true value of the model is extremely helpful in solidifying our thinking. Additionally, our EDLP views have been far from universally well received in the past.

As purveyors of our own investment research, we get lots of questions and feedback from other great investors. We are genuinely lucky and proud to have such talented investors as clients and have learnt a great deal from them. However, the danger perhaps in this is that we are encouraged to look for too many different types of value in too many places of the market. Indeed c.10 years ago we were proud to say that we did just that (i.e. we then sought-out ‘deep value’, ‘work-outs’, ‘franchises’ etc…).

There is of course nothing wrong with such a broad approach but there is a point when you have to establish what you are best at/where your niche is. Ours, we think, has always been as contrarian value buyers. More specifically, it lies with buying owner-managed businesses that have shown past compounding potential but today for some reason are priced to fail/no longer compound. But could we focus-in a little more?

Although the publication of Nomad’s letters has developed a cult following in the last few months, we can honestly and proudly say our style drift was well under way before their publication. Never-the-less we thank the authors for helping solidify our thinking.

You either ‘get’ deferred gratification or you don’t.

“Waiting helps you as an investor and a lot of people just can’t stand to wait,” Munger once said. “If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.” – Charlie Munger

We have almost always found value in EDLP businesses as rarely do we observe are they all priced for success (some are, some are not). In addition, we have almost always been surprised with the strength and reliance of their future growth (i.e. lack of ‘fade’ rate). This being a by-product of the unrecognised customer trust that today’s low prices and great service builds over time. Investor reluctance we think comes from the difficulty in understanding the outsized reward of deferred gratification, low margins or long required investment cycles. Importantly it also comes we think from industry and sector-specific framing. By that we mean there might be only one true EDLP/’Scale Economics Shared’ company in that region or sector thus making the understanding of the company hard both for local analysts and global franchise investors alike. JD Wetherspoons and AirAsia we think are both excellent examples of this.

Investors noting Amazon or Costco as examples of this model should note that they have become in some ways exceptions to our rule, i.e. they are now widely recognised for the scale and power of business model that they have built. We admire them both greatly, and realise that as early proponents of the power of this business model, that not buying Amazon shares was a huge error of omission on our part. However, at today’s starting prices we can now often find better value in similar but less well understood SES companies elsewhere in the world.

Our experience has shown us how powerful these scale economics shared models are. It has also shown us that for some extended periods they can be mispriced. That is an opportunity we should not pass by. Recent pieces have already seen us spend more time in their area (JDW/AirAsia/Schwab). Followers of our work should expect more of the same.

Fig.1 below shows the excerpt from Bezos’ letter where he articulates how Amazon ‘shares the spoils’ of its scale with each constituent stakeholders.

Fig.2 is a reminder that we had done this exact same analysis ourselves when assessing JD Weatherspoon’s moat earlier this year.

Fig.1a: Amazon 2020 letter extract 1

Machine generated alternative text: (reate lore luau \ou (‘on%ume If you want to be successful in business (in life, actually), you have to create more than you consume. Your goal should be to create value for everyone you interact with. Any business that doesn’t create value for those it touches, even if it appears successful on the surface, isn’t long for this world. It’s on the way out. Remember that stock prices are not about the past. They are a prediction of ,thrur’ cash flows discounted back to the present. The stock market anticipates. I’m going to switch gears for a moment and talk about the past. How much value did we create for shareowners in 2020? This is a relatively easy question to answer because accounting systems are set up to answer it. Our net income in 2020 was $21.3 billion. If, instead of being a publicly traded company with thousands of owners, Amazon were a sole proprietorship with a single owner, that’s how much the owner would have earned in 2020. How about employees? This is also a reasonably easy value creation question to answer because we can look at compensation expense. What is an expense for a company is income for employees. In 2020, employees earned $80 billion, plus another $1 1 billion to include benefits and various payroll taxes, for a total of $91 billion. How about third-party sellers? We have an internal team (the Selling Partner Services team) that works to answer that question. They estimate that, in 2020, third-party seller profits from selling on Amazon were between $25 billion and $39 billion, and to be conservative here I’ll go with $25 billion. For customers, we have to break it down into consumer customers and AWS customers. We’ll do consumers first. We offer low prices, vast selection, and fast delivery, but imagine we ignore all of that for the purpose of this estimate and value only one thing: we save customers time. 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 2l century. So that we can get a dollar figure, let’s value the time savings at $10 per hour, which is conservative. Seventy- five hours multiplied by $10 an hour and subtracting the cost of Prime gives you value creation for each Prime member of about $630. We have 200 million Prime members, for a total in 2020 of $126 billion of value creation. AWS is challenging to estimate because each customer’s workload is so different, but we’ll do it anyway, acknowledging up front that the error bars are high. Direct cost improvements from operating in the cloud versus on premises vary, but a reasonable estimate is 30%. Across AWS’s entire 2020 revenue of $45 billion, that 30% would imply customer value creation of $19 billion (what would have cost them $64 billion on their own cost $45 billion from AWS). The difficult part of this estimation exercise is that the direct cost reduction is the smallest portion of the customer benefit of moving to the cloud. The bigger benefit is the increased speed of software development — something that can significantly improve the customer’s competitiveness and top line. We have no reasonable way of estimating that portion of customer value except to say that it’s almost certainly larger than the direct cost savings. To be conservative here (and remembering we’re really only trying to get ballpark estimates), I’ll say it’s the same and call AWS customer value creation $38 billion in 2020. Adding AWS and consumer together gives us total customer value creation in 2020 of $164 billion.

Fig.1b: Amazon 2020 letter extract 2

Machine generated alternative text: Summarizing: Shareholders $21 B Employees $918 3P Sellers $25B Customers $1 MB Total $301 B If each group had an income statement representing their interactions with Amazon, the numbers above would be the “bottom lines” from those income statements. These numbers are part of the reason why people work for us, why sellers sell through us, and why customers buy from us. We create value for them. And this value creation is not a zero-sum game. It is not just moving money from one pocket to another. Draw the box big around all of society, and you’ll find that invention is the root of all real value creation. And value created is best thought of as a metric for innovation.Source: Jeff Bezos, Amazon CEO 2020 letter to Shareholders

Fig.2: An assessment of JDW’s moat. Great minds think alike?

Source: Holland Advisors JDW, Walton on Thames, March 2021 Pg10

NB. The Nomad letters were distributed online without their authors permission or knowledge. Graciously however they have put an edited copy onto their own foundation’s website. We encourage those interested to only look at this link and also read the touching preamble and post-amble that accompanies them. #ClassPersonified.

https://igyfoundation.org.uk/

Andrew Hollingworth & Mark Power

Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as managers to.

 

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This document does not consist of investment research as it has not been prepared in accordance with UK legal requirements designed to promote the independence of investment research. Therefore even if it contains a research recommendation it should be treated as a marketing communication and as such will be fair, clear and not misleading in line with Financial Conduct Authority rules. Holland Advisors is authorised and regulated by the Financial Conduct Authority. This presentation is intended for institutional investors and high net worth experienced investors who understand the risks involved with the investment being promoted within this document. This communication should not be distributed to anyone other than the intended recipients and should not be relied upon by retail clients (as defined by Financial Conduct Authority). This communication is being supplied to you solely for your information and may not be reproduced, re-distributed or passed to any other person or published in whole or in part for any purpose. This communication is provided for information purposes only and should not be regarded as an offer or solicitation to buy or sell any security or other financial instrument. Any opinions cited in this communication are subject to change without notice. This communication is not a personal recommendation to you. Holland Advisors takes all reasonable care to ensure that the information is accurate and complete; however no warranty, representation, or undertaking is given that it is free from inaccuracies or omissions. This communication is based on and contains current public information, data, opinions, estimates and projections obtained from sources we believe to be reliable. Past performance is not necessarily a guide to future performance. The content of this communication may have been disclosed to the issuer(s) prior to dissemination in order to verify its factual accuracy. Investments in general involve some degree of risk therefore Prospective Investors should be aware that the value of any investment may rise and fall and you may get back less than you invested. Value and income may be adversely affected by exchange rates, interest rates and other factors. The investment discussed in this communication may not be eligible for sale in some states or countries and may not be suitable for all investors. If you are unsure about the suitability of this investment given your financial objectives, resources and risk appetite, please contact your financial advisor before taking any further action. This document is for informational purposes only and should not be regarded as an offer or solicitation to buy the securities or other instruments mentioned in it. Holland Advisors and/or its officers, directors and employees may have or take positions in securities or derivatives mentioned in this document (or in any related investment) and may from time to time dispose of any such securities (or instrument). Holland Advisors manage conflicts of interest in regard to this communication internally via their compliance procedures.

  1. https://s2.q4cdn.com/299287126/files/doc_financials/2021/ar/Amazon-2020-Shareholder-Letter-and-1997-Shareholder-Letter.pdf ↑
  2. See Berkshire Hathaway 2007+ 2007 annual letters ↑

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This does not exclude or restrict any duty or liability that Holland Advisors has to its customers under the regulatory system in the United Kingdom. Indemnity You agree to indemnify and defend Holland Advisors, its affiliates and licensors, and the officers, directors, employees, and agents of Holland Advisors and its affiliates and licensors, from and against any and all claims, liabilities, damages, losses, or expenses, including legal fees and costs, arising out of or in any way connected with your access to or use of this website and the Information. Use of Cookies If you agree to these terms and conditions a “cookie” might be placed on your computer. A cookie is a packet of information that does not identify individual users of a website, but allows the collection of website activity (such as the number of users who visit our website, the date and time of visits, the number of pages viewed, navigation patterns, what country and what systems users have used to access the site). We can use this information for statistical purposes, which allows us to analyse and improve our website. The cookie will expire automatically after 6 months or you can manually remove cookies in your browser settings. Copyright, Trademarks and Other Rights Copyright, trademarks, database rights, patents and all similar rights in this site and the information contained in it are owned by Holland Advisors or relevant third party providers. You may use the Information and reproduce it in hard copy for your personal reference only. The information contained herein and any supplemental documentation provided is confidential and should not be copied, reproduced or redistributed without the prior consent of Holland Advisors. Governing Law You agree that your use of this site and any dispute arising from this use is subject to English law and you submit to the jurisdiction of the Courts of England & Wales.
Privacy Notice
This is the privacy notice of Holland Advisors London Ltd our company number is 07431314. Our registered office is at The Halt, Smugglers Way, The Sands, Farnham, Surrey, GU10 1NB.
Introduction
This notice describes how we collect, store, transfer and use personal data. It tells you about your privacy rights and how the law protects you. In the context of the law and this notice, ‘personal data’ is information that clearly identifies you as an individual or which could be used to identify you if combined with other information. Acting in any way on personal data is referred to as ‘processing’. This notice applies to personal data collected through our website www.hollandadvisors.co.uk. Except as set out below, we do not share, or sell, or disclose to a third party, any information collected through our website.
Data Protection Officer
We have appointed a data protection officer (‘DPO’) who is responsible for ensuring that our privacy policy is followed. If you have any questions about how we process your personal data, including any requests to exercise your legal rights, please contact our DPO, Claire Brunt at  claire@hollandadvisors.co.uk.
Personal data we process
1. How we obtain personal data The information we process about you includes information:
  • you have directly provided to us
  • that we gather from third party databases and service providers
  • as a result of monitoring how you use our website or our services
2. Types of personal data we collect directly When you use our website, you may provide personal data by submission of data by our Sign Up or Contact Us forms. This can be categorised into the following groups:
  • personal identifiers, such as your first and last names
  • contact information, such as your email address and your telephone number for communication
  • records of communication between us including messages sent through our website, email messages and telephone conversations
  • marketing preferences that tell us what types of marketing you would like to receive
3. Types of personal data we collect from your use of our services By using our website and our services, we process:
  • technical information about the hardware and the software you use to access our website and use our services, including your Internet Protocol (IP) address, your browser type and version and your device’s operating system
  • usage information, including the frequency you use our services, the pages of our website that you visit, whether you receive messages from us and whether you reply to those messages
  • your preferences to receive marketing from us; how you wish to communicate with us; and responses and actions in relation to your use of our services.
4. Our use of aggregated information We may aggregate anonymous information such as statistical or demographic data for any purpose. Anonymous information is that which does not identify you as an individual. Aggregated information may be derived from your personal data but is not considered as such in law because it does not reveal your identity. For example, we may aggregate usage information to assess whether a feature of our website is useful. However, if we combine or connect aggregated information with your personal data so that it can identify you in any way, we treat the combined information as personal data, and it will be used in accordance with this privacy notice. 5. The bases on which we process information about you The law requires us to determine under which of six defined bases we process different categories of your personal data, and to notify you of the basis for each category. If a basis on which we process your personal data is no longer relevant then we shall immediately stop processing your data. If the basis changes then if required by law we shall notify you of the change and of any new basis under which we have determined that we can continue to process your information. 6. Information we process with your consent Through certain actions when there is no contractual relationship between us, such as when you browse our website or ask us to provide you more information about our business, you provide your consent to us to process information that may be personal data. Wherever possible, we aim to obtain your explicit consent to process this information, for example, we ask you to agree to our use of non-essential cookies when you access our website. We continue to process your information on this basis until you withdraw your consent or it can be reasonably assumed that your consent no longer exists. You may withdraw your consent at any time by instructing us  claire@hollandadvisors.co.uk. 7. Information we process for the purposes of legitimate interests We may process information on the basis there is a legitimate interest, either to you or to us, of doing so. Where we process your information on this basis, we do after having given careful consideration to:
  • whether the same objective could be achieved through other means
  • whether processing (or not processing) might cause you harm
  • whether you would expect us to process your data, and whether you would, in the round, consider it reasonable to do so
For example, we may process your data on this basis for the purposes of:
  • improving our services
  • record-keeping for the proper and necessary administration of our business
  • responding to unsolicited communication from you to which we believe you would expect a response
  • preventing fraudulent use of our services
  • exercising our legal rights, including to detect and prevent fraud and to protect our intellectual property
  • insuring against or obtaining professional advice that is required to manage business risk
  • protecting your interests where we believe we have a duty to do so
How and when we process your personal data
8. Your personal data is not shared We do not share or disclose to a third party, any information collected through our website.
Use of information we collect through automated systems
9. Cookies Cookies are small text files that are placed on your computer’s hard drive by your web browser when you visit a website that uses them. They allow information gathered on one web page to be stored until it is needed for use at a later date. They are commonly used to provide you with a personalised experience while you browse a website, for example, allowing your preferences to be remembered. They can also provide core functionality such as security, network management, and accessibility; record how you interact with the website so that the owner can understand how to improve the experience of other visitors. Some cookies may last for a defined period of time, such as one visit (known as a session), one day or until you close your browser. Others last indefinitely until you delete them. Your web browser should allow you to delete any cookie you choose. It should also allow you to prevent or limit their use. Your web browser may support a plug-in or add-on that helps you manage which cookies you wish to allow to operate. The law requires you to give explicit consent for use of any cookies that are not strictly necessary for the operation of a website. 10. Personal identifiers from your browsing activity Requests by your web browser to our servers for web pages and other content on our website are recorded. We record information such as your geographical location, your Internet service provider and your IP address. We also record information about the software you are using to browse our website, such as the type of computer or device and the screen resolution. We use this information in aggregate to assess the popularity of the webpages on our website and how we perform in providing content to you.
Other matters
11. Your rights The law requires us to tell you about your rights and our obligations to you in regard to the processing and control of your personal data. We do this now, by requesting that you read the information provided at  http://www.knowyourprivacyrights.org 12. Communicating with us When you contact us, whether by telephone, through our website or by email, we collect the data you have given to us in order to reply with the information you need. We record your request and our reply in order to increase the efficiency of our business. We may keep personally identifiable information associated with your message, such as your name and email address so as to be able to track our communications with you to provide a high quality service. 13. Complaining If you are not happy with our privacy policy, or if you have any complaint, then you should tell us. When we receive a complaint, we record the information you have given to us on the basis of consent. We use that information to resolve your complaint. 14. Retention period Except as otherwise mentioned in this privacy notice, we keep your personal data only for as long as required by us to provide you with the services you have requested. 15. Compliance with the law Our privacy policy complies with the law in the United Kingdom, specifically with the Data Protection Act 2018 (the ‘Act’) accordingly incorporating the EU General Data Protection Regulation (‘GDPR’) and the Privacy and Electronic Communications Regulations (‘PECR’). 16. Review of this privacy policy We shall update this privacy notice from time to time as necessary.

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