A Dozen Things I have Learned from Jeff Bezos

 

1. “Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that.  So if you could take the free cash flow, that’s something that investors can spend. Investors can’t spend percentage margins.”  “What matters always is dollar margins: the actual dollar amount. Companies are valued not on their percentage margins, but on how many dollars they actually make, and a multiple of that.” “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.” Jeff Bezos is very focused on this “absolute dollar free cash flow metric.” You will see many people talk about Amazon’s focus on “growth” vs. margins, but the right focus is instead absolute dollar fee cash flow. Jeff Bezos spelled out his focus on absolute dollar free cash flow in his 2004 letter to shareholders. He is not about to run his company based on a ratio much beloved by someone outside the company, such as a Wall Street analyst. Next weekend I will write about Howard Schultz who similarly ignores metrics beloved by analysts (the ignored metric is “same store sales” in the case of Starbucks).  If you want to see Amazon’s approach to absolute dollar free cash flow generation taken even further, go to China and see Xiaomi and Alibaba up close.

 

2. “Your margin is my opportunity.” Jeff Bezos sees a competitor’s love of margins and other financial “ratios” as an opportunity for Amazon since the competitor will cling to them while he focuses on absolute dollar free cash flow and slices through them like a hot knife through butter.

 

3. “Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.” Jeff Bezos knows when to use economies of scope and scale to his advantage. He also knows that in maximizing absolute dollar free cash flow, velocity of capital and inventory turns matter in a huge way. When Jeff Bezos lacks scale or scope advantages in a given business, Amazon’s attack on competitors will be asymmetric in nature.  At this point readers might expect that I would give my opinion of the value of a share of AMZN stock. I will give readers a methodology but not a number. If you can’t calculate your own number, like 97% of all investors you should be buying a diversified portfolio of index funds/ETFs anyway.  If you want simple numerical stock “tips,” there are lot of other bloggers and writers who will to give them to you. If you invest based on these third party stock tips, your performance will fall somewhere between lousy and dreadful. Me giving readers of this blog a valuation number for a stock just encourages the wrong investing behavior. I will say that to generate the return on invested capital necessary to support the existing stock price you must believe that AMZN’s cash flow will at some point in the future rise significantly faster than AMZN’s need for new capital expenditures. Under this thesis as capital expenditures fall, depreciation’s slower growth will mean it will have less negative impact on GAAP results. This thesis requires that you believe that AMZN will create a more significant moat for itself via brand, intellectual property, supply side economies scale, economies of scope and demand side economies of scale (network effects).  How much any company’s moat will increase or decrease in strength over time is a qualitative and not quantitative determination. The definitive essay on moats has been written by Michael Mauboussin and I am on record as saying that you are a damn fool if you do not read it.  https://t.co/7Vl7urkCkB If you do not understand this essay you should be buying a diversified portfolio of index funds/ETFs.

 

4. “On the Internet, companies are scale businesses, characterized by high fixed costs and relatively low variable costs. You can be two sizes: You can be big, or you can be small. It’s very hard to be medium. A lot of medium-sized companies had the financing rug pulled out from under them before they could get big.” Jeff Bezos is talking about what Michael Porter calls being “stuck in the middle.” A company stuck in the middle lacks the scale and scope economies as well as the greater access to capital of a big company, but is too big to effectively pursue a differentiation strategy.

 

5. “If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn.”   “We’ve had three big ideas at Amazon that we’ve stuck with for 18 years, and they’re the reason we’re successful: Put the customer first. Invent. And be patient.” By investing on a seven year time frame Jeff Bezos generates a behavior-based moat since other companies who invest for the short term flee Amazon’s approach to preserve their financial “ratios.”

 

6. “The balance of power is shifting toward consumers and away from companies…the individual is empowered… The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it. If I build a great product or service, my customers will tell each other….In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts.”   “Your brand is formed primarily, not by what your company says about itself, but what the company does.”  The essence of business is the ability to cost effectively acquire customers. The very best businesses acquire customers “organically” without advertising. Great products and word of mouth drives sales at these companies. By contrast, companies which must sell their wares with huge advertising budgets are losing their edge in the Internet era.  Television advertising enabled the creation of mass market advertising driven brands, but the Internet is undoing this in many cases.

 

7. “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.” Jeff Bezos seeks to harvest optionality (relatively small potential downside, massive potential upside) Harvesting optionality *requires* failure. It can’t be avoided since failure provides information that enable success. This is via negativa. On this and items 8 and 9 see my posts on optionality at:  http://25iq.com/2013/10/13/a-dozen-things-ive-learned-from-nassim-taleb-about-optionalityinvesting/  and  http://25iq.com/2014/04/05/the-best-venture-capitalists-harvest-optionality-dealing-with-risk-uncertainty-and-ignorance/

 

8. “There’ll always be serendipity involved in discovery.” “If you double the number of experiments you do per year you’re going to double your inventiveness.”  This is why Nassim Taleb recommends tinkering when engaging in the innovation/harvesting optionality. Another related Jeff Bezos quote: “Even well-meaning gatekeepers slow innovation. When a platform is self service, even the improbable ideas can get tried because there’s no expert gatekeeper ready to say ‘that will never work!’”

 

9. “I believe you have to be willing to be misunderstood if you’re going to innovate.” You can’t outperform the market if you are the market.  Similarly, you must adopt a non-consensus view and be right about that view to beat competitors. The way Jeff Bezos runs Amazon when it comes to a willingness to be misunderstood is exactly how Howard Marks invests. See: http://25iq.com/2013/07/30/a-dozen-things-ive-learned-about-investing-from-howard-marks/

 

10. “I think frugality drives innovation, just like other constraints do. One of the only ways to get out of a tight box is to invent your way out.” More money often equals more problems. Companies with too much money are often less rather than more innovative. A quote much used by venture capitalists and entrepreneurs comes to mind here:  “We have no money, so we must think!”

 

11. “If you decide that you’re going to do only the things you know are going to work, you’re going to leave a lot of opportunity on the table. Companies are rarely criticized for the things that they failed to try. But they are, many times, criticized for things they tried and failed at.” This is what Warren Buffett calls “mistakes omission” and they can be the biggest mistakes of all. Warren Buffett puts it this way: “Typically, our most egregious mistakes fall in the omission, rather than the commission, category. That may spare Charlie [Munger] and me some embarrassment, since you don’t see these errors; but their invisibility does not reduce their cost.”

 

12. “The great thing about fact-based decisions is that they overrule the hierarchy.”  It is wise to be rational, objective and dispassionate in making decisions. It’s just that simple

 

P.s., As for the 10% drop in the share price yesterday, Jeff Bezos takes the same “ignore it” approach to daily price gyrations as Warren Buffett.  Running a company to please a bi-polar Mr. Market is a fool’s errand and he won’t do it.  Jeff Bezos: “I care very much about our share owners, and so I care very much about our long term share price. I do not follow the stock on a daily basis, and I don’t think there’s any information in it. Benjamin Graham said, “In the short term, the stock market is a voting machine. In the long term, it’s a weighing machine.” And we try to build a company that wants to be weighed and not voted upon.”

 

 

21 thoughts on “A Dozen Things I have Learned from Jeff Bezos

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  3. Thank you for your thoughts. I’d like to add a bit more. I hope you don’t mind.

    Just because a company generates economic value (significant return on invested capital relative to its cost of capital) doesn’t mean it is a good investment. Price will always be the most important consideration. A company can generate gobs of economic value and have explosive free cash flow and still be overvalued. It is the classic ‘good company, bad stock’ paradigm. Though evaluating competitive advantages is certainly important, a focus on long-term free cash flow (Step I in above) is the determinant of intrinsic value — a firm’s value will advance at the annual pace of its discount rate less the dividend yield, regardless of any qualitative moat assessment (as the value-creation aspect is already captured in future free cash flows). I believe that investors place too much emphasis on the qualitative aspects of research and may not give enough weight to actual cash flow. This is where it hits home: Only when stocks are priced in ‘number of moats’ instead of ‘number of currency’ will a discounted free cash flow assessment become subordinate to a moat assessment. Cash flow will always be the most important determinant of an investment opportunity — not its moat.

    In any case, thank you for your insightful piece.

    Kind regards,

    Brian Nelson, CFA
    President, Equity Research
    Valuentum Securities, Inc.

    http://www.valuentum.com

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  5. How often have I argued that you don’t take gross margin percent to the bank! And though big business execs can understand this point on an intellectual basis, they are driven in the opposite direction by a warped rewards structure that they benefit from. And that’s one reason Amazon will never be undone by the likes of a Walmart. Another reason: an operating model free from reliance on brick and mortar stores. As the world becomes more comfortable with online ordering and Amazon learns how to reduce delivery times and cost, the company will have widened its moat while B & M players will have cemented their own ill fate with excessive real estate.

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