Nicholas Sleep is a very successful investor who had a decent amount of his portfolio invested in Costco and Amazon in the mid-2000’s while he was managing his investment partnership. As you can guess, it worked out very well for him and his partners. Nick said that he would sift through hundreds of annual reports and discard almost every company he read about as potential investment candidates.
So what was it about Costco and Amazon that he liked so much? The answer was economies of scale shared. You may be familiar with economies of scale where a company gets larger, therefore, they’re able to spread their costs over a larger production capacity which decreases their per unit costs.
To get a better idea of this in more simpler terms, think about when you go to buy water at your local grocery store.
One bottle of water may cost around $1 or $1.25, but when you buy a 12 pack or a 24 pack you may pay around $5-$6 for a 12 pack or $9-$10 for the 24 pack.
The bigger the pack you buy, the lower it cost for each bottle of water.
1 bottle = $1.25
$6/12 pack = $0.50 per bottle
$10/24 pack = $.42 per bottle
Now think about if you were running a business and your business got bigger to the point where it was buying more of their products in much larger bulk.
This will result in cost savings to you as the business owner.
Now here is the interesting question, what would you do with those savings? Would you keep them for yourself resulting in higher profits?
Would you use the savings on other parts of your business like advertising? Would you pass them on to the customer, possibly lowering the price of your product? Or would you do a combination of these? Well Amazon and Costco would pass 100% of the savings from economies of scale back to the customer. Here is a great story told from Nicolas Sleep in one of his investment letters on what Costco did one time after they got a huge savings from a bulk order of jeans: “To understand how important [Everyday Low Prices] is to Jim Sinegal, the firm’s founder, consider the following story which was recounted to us by a company director. Costco bought 2m designer jeans from an exporter and shipped them into international waters and re- imported the jeans for an all-in price of U$22 or so per pair. This was U$10 less than the firm had sold the jeans for in the past (offering the potential for a 50% mark-up) and half the cost of most other retailers. One buyer recommended taking a higher gross margin than was usual (i.e., more than the usual 14% mark-up) as no one would know. Apparently Sinegal insisted on the standard mark up, arguing that if ‘I let you do it this time, you will do it again’. The contract with the customer (very low prices) must not be broken.” This is a perfect example of a mental model that Nicolas Sleep applied when he was evaluating companies to add to his fund’s portfolio — economies of scale SHARED. Every once in a while, I think about what other models are out there so I’m glad that Todd Henning of Ensemble Capital wrote this article.
The article is titled “15 of our Favorite Investment Patterns” and it’s so similar in a way to what Nick was doing — look for models (or patterns) that work and then find companies that they apply to. Todd starts this article off nicely by mentioning that the most popular guitar chord progression, C-G-AM-F, is used by these very popular songs: Let It Be by The Beatles, With Or Without You by U2 and No Woman No Cry by Bob Marley. It’s a perfect metaphor for what Todd’s article is about.
It’s also interesting to note that there are certain recurring patterns that work in almost all activities, whether it’s playing Texas Hold’em, drawing, or drafting players for professional sports teams but this is a whole different discussion. Sticking to just investing, here are some of Todd’s favorite investment patterns below: Idiosyncratic Businesses — business that have uncommon characteristics or are in two or more different industries, though it may be hard to realize.
Example: Ferrari — it’s both an auto company and a luxury brand. Predator and Prey Cultural Advantage — a business that has a great culture in an industry where all their competitors have lousy cultures.
Example: First Republic Bank — they are a customer-service-first business and a bank second, meanwhile, their competitors have awful customer service ratings and are too big to change their culture. Passionate Fans Base — a business that has such a passionate group of followers that these cult-like followers give you free marketing.
The example Todd gives here is Costco since their customers quickly share the bargains they found with their friends or their social media networks but you could probably put Tesla in this group as well. No-Brainer Products — when the utility from a company’s product is very obvious.
Example: Masimo’s pulse oximetry sensors based on clinical data. Products You Can’t Live Without — businesses that are exactly what the name says.
Example: Google’s search business and their YouTube products.
Surviving A Moat Attack — businesses that have survived an attack on their moat in the past are more likely to retain their resilience and continue to earn high returns on capital.
Example: Chipotle who survived the bad press they received from their food illness outbreaks in 2016. Mission Critical Businesses — businesses that supply some type of software or service that are so entrenched in the business of their customer that they are hard to switch away from.
Examples: Broadridge and Service Now for their software and Fastenal for their supply process. Sacrificing the Present for The Future — this applies to companies that don’t focus on this quarter’s or next quarter’s earnings but instead are focused on increasing long-term intrinsic value.
Example: Old Dominion Freight Lines who, according to Todd, invests aggressively in their less-than-truckload (LTL) network capacity rather than spending less money in the short-term to increase quarterly earnings.
Self-Disruptors — these are companies who aren’t afraid to disrupt themselves.
Example: Netflix who developed a video streaming platform despite having a short-term successful DVD-by-mail business. Some of these investment patterns may seem cliché, and of course this article doesn’t take valuation into effect, but I do think the idea of finding out which models work and which ones don’t, and then finding companies that these investment patterns apply to is a viable strategy.
And finding the models that work isn’t always that difficult. Just pay attention to the more successful companies out there and narrow in on what they’re doing that’s working.
The hard part though is trying to find a new company that is applying one of these patterns, especially since it might involve having a contrarian point of view during the early stages.