I recently wrote an investor note on some thoughts I have on customer value, and why I think it’s important when analyzing businesses. I thought I’d share that letter here:
In the note, I outline why I think that when you’re evaluating the durability of a company’s moat, it’s critically important to consider the value of a company’s product from the customer’s perspective. It’s a concept I’ve been thinking about for the last year or so, and one that I’ve written about a few times, including in Saber Capital’s 2016 letter as well as in a post containing my main takeaways from Buffett’s annual meeting in May.
In the most recent note I sent to investors last month, I discussed a few brief examples of traditional moats that are losing their strength, but my main point is that customer value is one of the most important things to consider when analyzing companies.
The Widening of Amazon’s Moat
Along these lines, I recently read a TechCrunch article that was very interesting. Talking about Amazon’s moat is very en vogue right now, but I’ve always liked studying and reading about that company. The author of this article goes into discussing his views on why Amazon is so dominant, and is unlikely to be caught.
The author argues that Amazon’s moat has widened because of this extreme focus on customer service and satisfaction to the point that it influences their business model. For example, they allowed third parties to sell their own goods on Amazon’s marketplace (Amazon.com), which puts these sellers in direct competition with Amazon’s own inventory. All of this was obviously done with the goal of profiting, but it started with trying to create a platform that would create the most value for the end customer that shops on Amazon.com (more merchants mean more selection and competitive prices).
This worked out extremely well for customers, and what followed was a growing revenue stream for both the third party sellers and of course for Amazon, which clips off a commission each time it connects a buyer with someone else’s inventory.
Following the success of Marketplace, Amazon also gave competitors access to their cloud computing infrastructure, their call centers, their warehouses, and very soon, competitors will be using excess space on Amazon’s trucks and planes.
Basically, Amazon has turned its largest cost centers into sources of revenue. Computing power, warehousing, and shipping are all large expenses for Amazon. But they are also now sources of revenue.
Difficult Model to Replicate
This is not just a brilliant strategy, it’s one that is extremely difficult for competitors to replicate. The author outlines a few reasons why this is the case:
Competitors will struggle offering third party services because they lack the customer-oriented culture that Amazon has (and this can’t really be “faked”).
The author discusses how Wal-mart should be primed and positioned to offer its distribution capacity to competitors if it wanted to, with its massive footprint of 11,500 stores, 6,000 trucks, and more warehouse space than Amazon. But they have developed a different DNA since the days of Walton. While they’ve always been tough on suppliers, it’s likely they spend more time thinking about suppliers and competitors than they do customers. And this prevents them from maximizing their infrastructure.
For example, Wal-Mart recently made news for blacklisting certain vendors that use Amazon’s servers, regardless of whether or not those vendors might have a product that could result in a better, more valuable experience for customers. This is a decision Amazon would never make, because they have a customer-centric (not competitor-centric) DNA.
It’s also difficult to copy Amazon’s model because others lack experience selling their own excess capacity to competitors (Amazon has been experimenting with handling third party inventory for ten years, making lots of mistakes along the way).
While this is often stated as an advantage, very few companies have the ability to withstand years (and it takes years to perfect these types of businesses) of losses (“investments”) in order to figure out how to run these businesses profitably. Even if they knew that at the end of the road there would be massive profits, the management team isn’t usually incentivized to forego current profits – even if those investments in such businesses will produce huge returns on capital in 5 or 10 years. Also, despite what they say, most investors won’t be able to stomach those interim losses either. So companies don’t typically embark on uncertain capital investments if the payoff is years away, even if these investments will yield huge returns on capital.
Amazon: Its Own Best Customer?
The real genius behind Amazon’s approach is that Amazon is keeping itself lean and mean by marketing their services (Amazon’s expenses) to third parties. This avoids various divisions getting fat, because Amazon now has customers to serve in these areas. Bloated costs and overpriced services won’t sell because some competitor will do it cheaper. So Amazon is forced to stay focused.
Some will argue that this approach was an intentional strategy by Amazon. Ben Thompson wrote a great piece a year ago about how Amazon offers up these services (computing power, warehouse space, logistics, etc…) to third parties because Amazon itself is the number one customer of those very services that it is selling.
Ben makes an interesting argument, and I think he’s correct in analyzing the result of this strategy, but I don’t believe Amazon’s capital investment and third party offerings were done with the intent of Amazon becoming the first and best customer of its own offerings. I think this might have resulted in a massive side benefit for Amazon (keeping Amazon’s cost structure lean and mean), but I think Amazon’s motive was simply to rent out a portion of its unused capacity for profit (why let excess space on the server or in the warehouse go unused when someone else is willing to pay for it?)
It’s a lot like renting out a vacant room in your house on Airbnb. You do it because it makes you a profit on something you own that you’re not using, but in the process it forces you to keep your house neat and clean for your guests.
Buffett Moat vs. Bezos Moat
I’ll wrap up this post by referencing one more article on this topic worth reading. My good friend and fellow investment manager Matt Brice and I share some of our research notes, investment journal posts, and our investment ideas at a members site we started last year. Writing has a way of clarifying your thought process and deepening your understanding of a subject matter. Just like teaching, the person doing the writing is often the one who benefits most from that writing. It was in this spirit that we decided to share some of our thoughts on a separate page. Though we are good capitalists seeking profit, and though we both have a love for teaching, the main reason for the site is to aid our objective of continual self-improvement, which we hope and expect will lead to better results for our investors.
An example of one of these investment journal posts is one that Matt wrote that is related to this topic of moats, and is well worth reading. In the post, Matt describes what he calls “Buffett Moats” vs. “Bezos Moats”. He explains Buffett Moats as companies whose competitive advantage is derived by some structural advantage in the market that is difficult for competitors to attack. Examples of these types of companies in years past might be cable operators, local newspapers, or consumer goods with strong name recognition and abundant shelf space. These are companies that owned some sort of metaphorical toll bridge that its customers had to cross. If you wanted to read the news in Buffalo, you had to go through Buffett (who owned the Buffalo News).
Matt describes the Bezos Moat as a company whose moat stems from its ability to provide value to the customer on a consistent basis. Amazon is obviously the posterchild for this approach, but other industries such as taxi cabs and cable companies have seen their once-dominant market positions encroached by companies that are able to provide more value to the customer.
As he summarizes it:
“A Bezos Moat is premised on the idea that the customer is willingly and is frequently entering into a commercial transaction with the company because the customer is deriving more value from the transaction than he or she is paying for.
“A Buffett Moat attempts to identify companies that will be the only one (or one of a few) available in a commercial landscape, so that the customer is, in effect, forced to transact with these companies (i.e. only bridge, only newspaper, only soft drink option).”
His post references some examples, and also describes his opinion that Buffett is recognizing this shift in business and is likely to evolve his investment tactics accordingly over time, just as he evolved from cigar butts to quality companies.
To Sum It Up
As I laid out in my letter, finding great long-term investments means locating companies with durable earning power and bright future prospects. Now, more than ever, I think evaluating a competitive advantage needs to start with the value that the company’s customer is receiving. A company that produces significant profits at the expense of its customer will likely see its earning power eroded over time. Conversely, companies that are focused first and foremost on customers (even before competitors) have one of the necessary ingredients to a lasting competitive advantage. A strong customer value proposition certainly doesn’t guarantee a durable moat, but without it, I think it guarantees that any edge will be fleeting.
In summary, a business that can provide value to its owners while simultaneously providing value to its customers is the type of business that I’m looking for, because I think both of those factors are required. Without the latter, the former won’t be possible in the long run.
John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.