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An Exercise on Thinking Differently and a Great Business

I came across an excellent presentation that I wanted to share because it sparked some thoughts. It is not about a current—or even prospective—investment, but one that exemplifies the art of thinking differently.

I spend a fair amount of time reading annual reports about businesses that I have no intention of owning. Typically, these businesses are high quality companies that—although maybe too expensive to offer attractive investor returns—are great entities to study and learn about. Studying businesses that have a history of compounding their value (and their owner’s equity) over time can help you develop a blueprint of sorts—things to look for in an effort to find such businesses when they are more attractively priced, smaller, or otherwise more unknown.

Quality Business Characteristics

A friend and I were discussing some of the ideal things we like in businesses. Valuations aside, we all like high ROIC, ample reinvestment opportunities, great management, etc… When thinking about what I like in a business, I always start with simple business models. I like toll bridges. I like parking garages in attractive downtown locations. I just was reading about a business I like that is the largest provider of ATM machines and other point-of-sale products (and the recurring revenue associated with many of these products) for restaurants, retailers, and convenient stores. I like simple models. It’s easy to understand why these businesses are profitable, sustainable, and predictable.

Those are nice businesses to own. The owner of a strategically located parking garage will do quite well over time. One thing I want to mention in more detail—maybe the next post—is pricing power, something Buffett called “the single most important” aspect of a business. Even though the parking garage owner might have limited reinvestment options for his sizable cash flow, he does possess pricing power.

At the top of the post, I mentioned I like to read about great businesses and great business models—even if they are stocks that I really have no intention of owning. Amazon is one of these businesses. (Don’t leave, keep reading).

Much to Learn from AMZN’s Model

It is now 13-f time, and I always enjoy reading through what other respected value investors are doing. About this time last quarter when I was reading through my 13-f list, I was quite surprised to see Amazon listed as one of Tom Gayner’s stocks that he was buying. He actually began buying it about a year ago, and has purchased very small amounts each quarter since. It’s a tiny position, but regardless of the size, I was surprised to see AMZN enter his portfolio. So I casually began thinking about it here and there, perusing through annual reports. I actually really enjoy reading the AMZN reports, and would encourage investors to check them out.

The stock isn’t cheap, but the business model can teach us a lot about the importance of scale, efficiency, pricing power, capital allocation, and great management with ownership mentalities and long term horizons.

Of course, it is with great trepidation that I reference Amazon on these pages here at BHI, as it perennially trades at ungodly prices when using traditional value metrics that most of us look at. But fear not, I don’t own Amazon, and I don’t necessarily intend to—although I’m always aware of one of Ben Graham’s famous quotes which I’ll paraphrase: “For almost every business, there is a price at which it could be purchased, and a completely different price at which it should be sold.”

Good, if Not Cheap

So certainly at some price, I’d love to own Amazon, as it is—in my opinion—one of the greatest companies in existence. But the purpose today is to share some brief thoughts on a specific aspect of Amazon’s quality that is important—namely an owner operator that thinks and acts for the long term benefit of owners. My thoughts on AMZN today were sparked by an excellent presentation I came across over the weekend by Josh Tarasoff of Greenlea Lane, a value investor who happens to own this forbidden fruit.

My reaction to seeing a recommendation for AMZN at a value investing conference is similar to when I noticed it in Gayner’s portfolio. I was surprised. But nevertheless, it rekindled my energy to begin paging through some of the old AMZN annual reports again.

Every value investor knows Amazon’s P/E is in the stratosphere. Some investors have made the case that their high P/E is actually inflated due to the massive amounts of expenses they incur–all in the name of “future revenue”. My very general interpretation is that Amazon is basically advancing expenses—paid for with current cash flow—that would normally be reserved for next year, or 2016, or beyond. They are incurring these “future” expenses today in an effort to expedite their already incredible revenue growth, building out massive infrastructure that will support even greater sales volumes.

At some point, this will stop and the expenses will slow down to match revenues, and the real (i.e. normal) cash flow will rear its pleasant head, and the multiples will come crashing down (or maybe the stock will continue rising). I really have no idea when this occurs, but reading through the 10-K’s, and studying this business, I do believe this is part of what’s happening there. Amazon is actually understating their true earning power—which is the opposite of what often occurs in the more common situation among the more GAAP-conscious, Wall Street pleasing managers.

The Importance of Long Term Oriented Managers

As I said, I really enjoy reading the reports. Bezos makes it clear that he is an owner minded manager with a long term horizon. He has no interest in what Wall Street says or thinks, and he is completely focused on generating long term shareholder value. To borrow a quote from the presenation, which can also be found in Bezos’ 1997 shareholder letter,

“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.”

This is one of my favorite new quotes, and it would behoove shareholders of every company if their managers would post this quote on their office wall, internalize it, and implement the corresponding behavior. It’s kind of the anti-activist style of “profit now, ask questions later”.

By the way, despite the fact that many of these noisy activist investors are successful in driving stock prices higher in the short term through massive cost cuts and buybacks, I’m very unconvinced of how much true value they are adding for long term owners.

Bezos runs AMZN like it’s his family business that he intends to own for generations, without a care toward what outside judges think of his short term performance.

Regardless of whether AMZN is ridiculously expensive or not, I think studying the business and reading the annual reports really help create a blueprint for what kind of manager we’d ideally like to partner with as shareholders.

Long Term Orientation Plus Favorable Economics Means Growing Owner’s Value

Of course, long term thinking on its own means nothing if not combined with advantageous economics. And Amazon also has plenty of those. They basically beat every other retailer because they can afford to operate with the lowest markups and the slimmest of margins. Basically, their incredible economies of scale means they can spread their costs across an ever growing number of customers, which translates into lower prices, which begets more customers, creating even greater scale, and the cycle continues, etc…

Their business model is interesting, and I might write another post or two on some things I’ve picked up from reading through the old reports. I was recently inspired this weekend after reading Josh’s presentation, which was excellent. Josh also has some absolutely brilliant things to say regarding pricing power, which got me thinking, and might make a nice summary post on its own.

Beware of Your Biases 

As an aside: Consider your internal reaction when you first saw that I was talking about Amazon. Maybe you had no reaction… but lots of value investors have an immediate negative reaction because of the high valuation. I used to have this same reaction whenever I came across something on Amazon. But seeing Gayner buying it made me open up my mind and begin to approach it with curiosity, which is a much better mindset for learning. The closed-mindedness that many exhibit with AMZN prevents the brain from being able to consider facts in an unbiased way, and thus stunts the development that can take place by studying a model as successful as Amazon’s.

Again, I really have no opinion on the stock, and like many value investors, I also find that even after adjusting expenses to try and estimate normal earning power, it still seems that a lot of future growth is built into the current price. I am unsure if this future has been properly discounted or not, but regardless of AMZN’s value or lack thereof, I’ve enjoyed occasionally reading about the company and I thought Josh’s presentation did a great job at succinctly summarizing most of AMZN’s strengths.

I may or may not ever own the stock, but I’m happy to continue reading the reports as they come out each year if nothing else.

Here’s some relevant links:

15 thoughts on “An Exercise on Thinking Differently and a Great Business

  1. Great write up!

    “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.” – 1997 Bezos Letter

    Bezos is also one of my favourites to read and I look forward to his 2013 letter. The everything store was also a great read. Amazon is no doubt one of the best businesses on the planet but at what price would it be justified to buy? I can see the value provided “A,B,C,D,E,F and G future outcomes all materialize. I have asked myself this on numerous occasions and have felt it was overpriced in recent years only to watch it continue to climb. Sometimes it is easier to disregard valuation you do not understand and move on, I for one am not comfortable paying a premium for growth but like to have it as a kicker.

    I look forward to your writing on pricing power as I believe it to be a very important factor when it comes to future valuation and expected cash flows. Eager to here what you think.



    1. Thanks Tannor. Yeah the price seems too high at AMZN, but I never really considered it as an investment idea-more just to study the model, which is one of my favorite models: low prices, economies of scale, leads to even greater unit volume, etc… it’s really tough to beat. Basically WMT’s model, only AMZN has much lower markups over cost than even WMT.

  2. John, I agree with you it’s always interesting to read annual reports of high quality businesses, even if they are priced outside of a buying range. I often find myself doing the same thing.

    In such situations, I think it’s helpful to create a very simple “quick and dirty” valuation spreadsheet based on ROIC and growth so I can see what the company must do to justify the current price.

    Thanks for the links at the end of the post, I will definitely check them out.

    1. Thanks for the comment Pedro. Hope you find them useful. I enjoyed the Bezos interviews, and the annual letters are excellent.

  3. Great post John. The Amazon example was a bit surprizing but it made sense when you look at how the stock’s value has compounded over the years. It was definitely a value stock, few years ago. And Bezos is a great leader. One of the rare ones these days. I’ve read the Everything Store and his way of conducting business is extra-ordinary.

    Thanks for the link to the presentation.

    I think you should write more about the blueprint of successful business models. How can such companies be identified in the early stages.

    1. Thanks Milan. Yeah, I thought AMZN would be a good model to study, and I thought some might misinterpret my comments… but what I really want to do is study the business with complete disregard for the stock, as the business can provide some clues for what to look for in other investment ideas. Specifically, the economies of scale, small markups, higher volume, etc… Not a cheap stock, but a great business to read about.

  4. Nice article John! My favorite businesses so far in the Charlottesville area are the Water St downtown mall parking garage and Bold Rock Hard Cider. The parking garage because the area is a historic pedestrian mall which has no free parking around it — makes some compelling barriers to entry, and it often has around 100 cars parked in it for $2 an hour (I guess there are economies of scale when constructing such buildings). The hard cider because it’s a niche business, in between wine makers (terrible economics), which have all this competition with rich guys in Napa Valley, France, or Oregon (where I am originally from) who just want to make wine at a loss, and soda which is ever popular. I think it has the popularity of soda without too much competition which creates the loss making economics of wine. Also the label is iconic and memorable, and it’s $10 for a 6 pack. It should be pretty scalable. I’m a fan of niche businesses in general actually, by the same analogy as evolution, where niche species typically are ecologically protected and suffer less resource contention than those who are duking it out in the commons.

  5. Did you notice that Markel sold out of their Amazon position as of their May 13F filing? Any thoughts on what that implies?

    1. Hi Ted, Yeah, it was a very small position. I found it curious that Gayner initiated the position in the first place. But, I’m glad he did because it prompted me to take a closer look at the business model of Amazon. As to what that implies, I’m not sure. I don’t really try to hard to figure out other investor’s investment ideas. Occasionally I try to reverse engineer their ideas, but I primarily use the 13-F’s as just an idea generating source to provide me with things to research and come to my own conclusions. I have no idea what Gayner was thinking about with his AMZN position–but it was very, very small, a virtually meaningless position relative to his whole portfolio.

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