In his recent book, “Zero to One: Notes on Startups, or How to Build the Future,” Peter Thiel draws upon his experience as a serial entrepreneur in defining the key elements needed to create a successful and sustainable startup business. Thiel’s approach is very simple: Avoid competition. This advice appears to be in direct conflict with the precepts of capitalism, where competition amongst private companies operating within free markets determines the clearing price. Competition is generally considered good for business because it shakes off complacency, spurs innovation, expands the scope of the field and gets businesses to focus on their customers. But what Thiel is suggesting is that competing for the sake of competition is a fool’s errand. Instead, when evaluating a business, Thiel searches for two key elements: Does the company provide a unique solution to a problem, contributing to the overall growth or progress of an industry, and is the company focusing on a niche segment of the industry before it expands its reach?
Apple is a legendary startup company with a strong history steeped in entrepreneurship, including the tradition of beginning in a garage. At nearly 40 years old, Apple defies convention by continuing to judge each new and existing opportunity through an entrepreneurial prism. Apple did not create the smartphone or the smartphone market, but its decision to manufacture the iPhone was driven by the belief that the Blackberry (the default smartphone of the time) was ignoring the needs of the consumer market. Before 2007, smartphones were purely a business tool, complete with a keyboard to keep up to date with emails when out of the office. When Apple decided to launch the iPhone, it did so with the primary focus on what would benefit consumers. Additionally, Apple limited the size and scope of its iPhone release. Instead of producing multiple models, Apple began with its “one size fits all.” Instead of releasing the phone to all mobile carriers, AT&T was given the exclusive right to distribute the phone. And instead of blanketing every country, Apple has moved methodically over the years to expand into foreign markets.
In 1994, Jeff Bezos, keenly aware of the hidden potential of the burgeoning internet, began searching for a way to leverage its power. After months of investigation, Bezos determined that the best opportunity available was in retail. He further refined his focus to selling books over the internet and Amazon.com was born. Amazon’s initial purpose was to provide book buyers with 7 times the selection of a brick and mortar store at prices that were 30% cheaper. At first, like most entrepreneurial ventures, the established booksellers disregarded the internet upstart and continued to operate in the same manner it had for over half a century. Soon, the national booksellers could no longer ignore Amazon’s competitive advantages and began their own online operation. But, it was too little too late for businesses like Borders, which could not compete with Amazon’s low overhead costs, robust logistics system, and improving relations with book publishers. After its initial success in online book retailing, Amazon expanded its offerings to include DVD’s, CD’s, video games, electronics, apparel, furniture, food, toys and jewelry. With each new expansion and increase in sales, Amazon has been able to continually exploit its sophisticated and improving logistics system. Cost savings from economies of scale were funneled back to their customer in the form of lower prices in order to build greater market share and customer loyalty. Well aware of the negative impact these choices were having on net profit margins, Amazon addressed its business strategy in a 2009 Letter to Shareholders:
“Our pricing objective is to earn customer trust, not to optimize short-term profit dollars. We take it as an article of faith that pricing in this manner is the best way to grow our aggregate profit dollars over the long term. We may make less per item, but by consistently earning trust we will sell many more items. Therefore, we offer low prices across our entire product range.”
The biggest challenge facing any business is remaining true to its roots while replicating its initial success. Twenty years after its founding, Apple was on the verge of bankruptcy. Instead of focusing on what made the company successful, its creativity and design, Apple allowed itself to become preoccupied with gaining share from the personal computer market. This competition negatively impacted the company as its once cutting-edge products lacked innovation and became commoditized. In 1997, Steve Jobs returned to Apple and revitalized the dormant entrepreneurial culture. He slashed the number of products by 70%, reminding Apple employees that “Deciding what not to do is as important as deciding what to do.” By 1998, Apple regained its creative footing with the release of the iMac and began a streak of innovative products that once again married design with function.
Entrepreneurs are often portrayed as disrupters of industry, the underdog willing to assume great financial risk in order to challenge the conventional wisdom of the time. The truth is just the opposite. Entrepreneurs create businesses because they are able to narrowly focus their scope to address a specific need unmet within the marketplace. The disruption that occurs is the byproduct of their success. Apple began its journey by following an entrepreneurial path, but over time it diverged from the initial route that made it unique and successful. By returning to its entrepreneurial roots, Apple has not only been able to regain its bearings but has developed an uncanny insight and vision into what currently is lacking in the marketplace. Even more remarkable is how Apple was able to ascend from near bankruptcy to a robust market capitalization in excess of $600 billion with over $170 billion in cash/securities in less than 20 years.
Even though Amazon has been able to create one of the strongest and best known retail brands, its future remains uncertain. By providing exceptional customer service and competitive pricing, the company has left a growing sea of bankrupt and failed businesses in its disruptive wake. But to what end? Unlike Apple, whose near death experience has shaped its view on competition, Amazon is committed to gaining market share solely on service and price. But do these two fundamentals create customer loyalty? Recently, Alibaba, a Chinese online retailer and a business to business portal, went public on the New York Stock Exchange. In an interview with its chairman, Jack Ma repeatedly talked about his priority: To build a world class online commerce company that is focused on its customers first. With companies like Alibaba, it is hard to imagine a time when Amazon will not be forced to compete on price. I love using Amazon; it is so easy. It is the first place I go when shopping both on and off line. But I am sure, over time, I could learn to love Alibaba, as well. The question is what problem is Amazon currently solving? Although I do not see the company’s competitive behavior leading to its ultimate demise, I also do not see the company able to leverage its growing sales into greater profitability.
Thiel’s book can be distilled down to a singular idea: Success comes from solving unaddressed needs while avoiding competition. The roadmap to become a successful entrepreneur is easy to follow but remains a challenging journey. Just like investing, an entrepreneur must be courageous enough to swim against the conventional tide while he waits for his idea to gain acceptance, which can be lonely at first and overtime appear to be madness. Of course, the difference between madness and genius is timing. In 2004, Peter Thiel invested $500,000 in Facebook for 10% of the company. He was the first outside investor, but not the first potential investor as many individual and venture capital firms passed on the idea. With less than 1 million users, Thiel believed that Facebook would be “the social platform” for users of all ages which, up to this point, did not exist. In May of 2012, Facebook went public and currently has a market capitalization over $200 billion. Today, with over 1.2 billion users, Thiel’s prophecy has come true. But the question is: Would you have been courageous enough in 2004 to have made the investment when the rest of “the market” was sidestepping the deal? The prevailing maxim: If it is such a great idea, why isn’t anyone else doing it? should be rephrased to say: If it were so easy, everyone would be doing it.
This article has been excerpted from the Hazelton Capital Partners 3rd Quarter 2014 Letter to Investors.
Like millions of people, I ride an elevator up to our office each day. It’s a daily routine for me and millions of others in the global game of commerce. We take certain things for granted, such as an elevator, or who might be riding with us in the elevator.
Nearly every business is comprised of a mixture of tangible assets–factories, production equipment, inventory and vehicles–along with intangible assets including brands, patents, trademarks, reputation, business methodologies, or expertise. We’re going to discuss the really soft stuff: reputation, business methods and expertise. These intangible assets have enormous value, until Google figures out how to build learning robots and renders us all obsolete.
Yes, some of the most important economic assets a company possesses are not listed on the financial statements. But accounting is only an approximation of economic reality. One of my favorite quotes is from Albert Einstein: “Not everything that counts can be counted, and not everything that can be counted counts.” Hey, he just described the accounting profession!
Certain businesses derive their economic value not from buildings, equipment and the like but from intangibles, including reputation, methodologies and expertise. The real assets are the people who manage and operate the business. In these businesses the valuable assets go up and down the elevator every night.
Businesses such as financial services–we can relate to this–are highly dependent upon the people who manage the business. We’ve seen numerous examples of well-run and poorly-run financial businesses, and the primary distinction between the well-managed survivors and the road-kill is the quality of the people, the strength of the culture, risk-management, etc. Soft concepts but hard realities. It’s all about the people running things.
For every well-run Wells Fargo there are too many Lehman Brothers, Washington Mutual, Bear Stearns, Fannie Mae, Freddie Mac, Wachovia or Countrywide Financial. Financial crisis road-kill. What they shared in common was a willingness to own poor quality assets combined with a further willingness to borrow excessively–leverage–that created a situation where a bit of trouble with asset quality magnified the damage due to their leveraged balance sheets.
Large institutions undone by managers who mismanaged these firms. It’s a Darwininan process–the better-run firms managed through the crisis and survived. The weaker players have joined the Dodo bird, the Saber-toothed Tiger and Tyrannosaurus Rex-in extinction.
Since we can’t see inside a manager’s head–again Google may eventually solve this problem–we pay lots of attention to the “track record” of managers in certain businesses where people can either create success or make a mess.
The above commentary is taken from The Misbehaving Investor, provided by Triad Investment Management.
WellPoint is one of the largest nationwide managed-care organizations (MCO) in the United States operating primarily under the Blue Cross/Blue Shield brand. In 2003, $1.4 trillion was spent in the United States on healthcare. By 2009, that number rose to $2.0 trillion and by 2018, healthcare spending is expected to breach $3.2 trillion. The MCO industry is a mature industry, dominated by a handful of companies, organically growing between 6 and 9%, and whose operations are highly scalable – the greater the membership, the lower the costs per member. Achieving market share is crucial for WellPoint, as it gives them a competitive cost advantage. Operating in 14 states, WLP averages about a 34% market share. In late 2008 and well into 2009, WellPoint’s stock price came under pressure due to the uncertainty surrounding the impact of the Affordable Care Act (Obamacare). Even though the size of the healthcare membership pie would be growing, it was not clear how the introduction of new members would impact profitability.
In October of 2009, Hazelton Capital Partners began accumulating shares of WellPoint at a cost basis of $46.36/share. Well aware of the ambiguity surrounding the company, the Fund felt comfortable that WLP’s downside was limited while providing a significant upside opportunity. In 2010, Hazelton Capital Partners added to the position as management proved themselves not only to be good operators but good stewards of its capital through share repurchases and a newly issued dividend yielding 3%. Between 2009 and 2013, WellPoint was able to repurchase 40% of its float at an average price of $59.25. By late July 2014, Hazelton Capital Partners decided that much of WLP’s diligent work was now fairly reflected in its $115/share stock price and exited the position.
This article has been excerpted from the Hazelton Capital Partners 3rd Quarter 2014 Letter to Investors.
Even though Apple recently became a Hazelton Capital Partners’ top five holding, it is not a new position. The Fund began acquiring shares of Apple starting in March of 2013 and continued to add to the position over the next few months. Apple garners a tremendous amount of attention from Wall Street analysts, tech gurus, and consumers, all who have a fervent connection with the company and its devices. If one wants to set the “Twittersphere” ablaze, then comment on Apple or one of its products, sit back and observe the firestorm that erupts. But it is this same passionate connection with the company and its products that make Apple so unique. Just shy of 40 years old, Apple is the patriarch of the tech industry. For a company to survive 40 years is an accomplishment unto itself, especially given the tumultuous economy. But for a tech company to endure for 40 years is the equivalent of immortality. Even more remarkable, Apple has done more than just survive. Instead of sitting back in a beach chair, sipping an umbrella drink and reminiscing about yesteryear, Apple remains not only on the cutting edge of technology, but sets the tone for the consumer market.
Over the last 10 years, Apple has grown its revenues from $8.2 billion to $180 billion which equates to a 36% compounded annual growth rate. During that same period, gross margins have improved from the low 20’s to nearly 40%, total operating expenses declined from the mid 20’s down to just shy of 10%, and net profit margins have risen from the single digits into the low 20%. All of this was achieved while the company accumulated more than $170 billion in cash/securities on its balance sheet. By any metric, Apple’s recent growth has been extraordinary. With the introduction of the iPhone, representing $95 billion in sales and 70% gross margins, in addition to products like the iPad, Apple has transitioned from a computer manufacture into a consumer technology brand. It is unusual for a technology company, or any company for that matter, to be able to maintain such high gross margins for an extended period of time, especially in the highly competitive smartphone market. But Apple’s unique ability to fuse design and function into its products has created a powerful ecosystem, differentiating itself from its competitors, and allowing the company to charge a premium for its products. In October, it took just 3 days for Apple to presale over 10 million iPhone units. Factoring in the current 2-3 week backorder for its iPhone 6 & 6 Plus, it appears that the Apple brand is not only intact but growing in both size and scope.
It is very unlikely that Apple will be able to maintain its breakneck growth witnessed over the last number of years. However, with only 18% of the global mobile market, there is still room to expand. Even though the price of Apple’s stock has had a strong appreciation year-to-date, there still remains a meaningful gap between price and value.
This article has been excerpted from the Hazelton Capital Partners 3rd Quarter 2014 Letter to Investors.
OSI designs and manufactures specialized electronic systems. Most people would recognize its Rapiscan systems at airport checkpoints, and the company also has a healthcare device and an electronics manufacturing segment. The company has well-entrenched businesses in growing end markets and earns a good return on capital.
Late last year the price of OSIS plunged by approximately a third when the TSA cancelled an order for new Rapiscan systems. OSIS had upgraded a component of the system – an X-ray machine’s light bulb that was made in China – without realizing that the component was not on the approved contractors list. OSIS self-reported the problem to the TSA, but given the uproar in Washington about Chinese corporate espionage the TSA decided to cancel the order. (How China could spy on the TSA through a light bulb is another question.) And while the cancelled order was very small as a share of OSIS’s backlog, the fear was that OSIS might be barred from all future government work.
A Notice of Debarment seemed possible if not likely, but a settlement and a fine were far more likely than an actual debarment. Historically, debarment was reserved for companies that had committed far more serious transgressions. The more likely explanation for the stock’s reaction was investor fatigue and concerns about future growth, both of which were understandable but seemed more than discounted in the price. We initiated our investment in January as the uncertainty swirled but I became comfortable that the actual risk was quite low.
Unfortunately the opportunity didn’t last long. The price recovered in short order as the dust began to settle, and we did not accumulate a large investment. We began adding to our investment in April as the price briefly weakened, but by July and August the price had increased significantly. The debarment fears largely abated, no Notice of Debarment was ever issued and OSIS recently received a new, unrelated government contract at Rapiscan and a large order from the Department of Defense. The Healthcare segment, meanwhile, has been struggling a bit, and the improved valuation left less room to be wrong about the company’s growth prospects. Accordingly, we sold our investment in August for a reasonable gain.
The above commentary is excerpted from the 3Q14 quarterly letter of Anabatic Fund, L.P., dated October 14, 2014. The fund’s portfolio manager is Philip C. Ordway, a principal of Chicago Fundamental Investment Partners, LLC. Please note that the complete text of the disclaimer included with the fund’s quarterly letter is also reproduced below.
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