A friend of mine works at one of those big mutual fund companies that advertises all the time on CNBC. Every investment firm has its own cautionary tales, little urban legends passed down to new employees to instill certain values. At my friend’s firm, the main cautionary tale is about the day in late 1995 when Jeff Bezos visited their office seeking to raise pre-IPO capital for Amazon.com—and the fund declined to invest after only 20 minutes. A five-billion-dollar-and-rising mistake at last count.
It’s a good story, and it has its desired effect among the troops, but the truth is that most investors can tell an only slightly less dramatic version of it about themselves. We all had the chance to invest in Amazon “before it was Amazon”—that is, when most books were still bought in bookstores and Barnes & Noble was the dominant bookstore—and nearly all of us passed too. There are many reasons why, several of them legitimate, and even if we didn’t invest, we still grasped some of the important elements of the Amazon story, such as the advantages of having a much wider selection of books online than it’s possible to have in any one physical bookstore.
I wouldn’t say that anyone who declined to invest in Amazon back then made a mistake. But in the spirit of self-improvement, I’d like to suggest that there is one thing we could have done better, something that might have tilted the odds a little more in favor of seeing 1995-vintage Amazon’s investment proposition clearly. What we could have done better is conceptualize Amazon as a generator of economic efficiency. That is, as a means to produce a given quality of a given product using significantly fewer economic resources—with “economic resources” properly understood to include capital. It’s in the nature of things that this original failure, the failure to conceptualize Amazon in terms of economics efficiency, led straight to other failures—the failure to see that economic efficiency is the root cause of lower prices for consumers; the failure to estimate in a disciplined, systematic way how much economic efficiency Amazon could generate; and finally the failure to estimate how much of that economic efficiency might be captured by Amazon itself in the form of higher profits.
I did not invent the idea of thinking in terms of efficiency or the basic framework for doing so. It’s basic microeconomics, and I’m sure cost accountants and capital allocators inside of companies use it all the time. The framework is summarized towards the beginning of this Economist article about attempts to compare different types of renewable energy power plants:
“But whereas the cost of a solar panel is easy to calculate, the cost of electricity [i.e. the price to consumers of the output of the power plant] is harder to assess. It depends not only on the fuel used, but also on the cost of capital (power plants take years to build and last for decades), how much of the time a plant operates, and whether it generates power at times of peak demand. To take account of all this, economists use ‘levelised costs’—the net present value of all costs (capital and operating) of a generating unit over its life cycle, divided by the number of megawatt-hours of electricity it is expected to supply.”
I didn’t understand this paragraph when I first read it, but something about it seemed familiar. Eventually it hit me: these economists are doing the same thing we fundamental investors do, only they’re doing it sort of backwards and they’re switching around the knowns and unknowns. In other words, investors try to solve for an enterprise’s return on capital, having made some assumption about the price it can charge for its product. These economists, on the other hand, try to solve for the price a company will ultimately charge for its product after the the hidden hand of market competition has done its work, having assumed it will earn a “competitive” return on capital (I usually use 12 percent as my competitive return on equity capital).
Whether you’re doing it the economists’ way or the investors’ way, in both cases the you will use the same sequence of surprisingly simple algebraic equations that combine to form an identity. I did not invent this sequence either, but I did invent my own name for it. Since I like writing and I like business I call it the Play in Five Acts, after the greatest “great writer who was also a great businessman” who ever lived. In its basic form, the Play in Five Acts goes like this:
In Act One, you assemble all of the assets you’ll need to conduct a given business. In my opinion, it’s surprisingly difficult to define exactly what we mean by an “asset.” Basic accounting textbooks define it as “what the enterprise owns,” but I think that’s too simplistic. One day I’ll favor you with a little treatise that goes into this further, but for now we can just rely on our intuitive understanding of what an asset is: it’s fixed assets like land and buildings and plant, and its working capital assets like inventory. It’s basically all the things you need to “buy up front” in order to conduct your business.
In Act Two, you think about how those assets are to be financed. The rules of accounting say that all assets must be financed somehow, whether by payables, or debt, or some other liability, or equity. For our purposes, the important thing to note is how much of the assets can be financed by someone other than the equity owner of the enterprise. Note that by the end of our second act, we’ve built the balance sheet of the enterprise. We can also calculate our first important ratio, that of assets to equity, also known as “leverage.” The higher the leverage ratio, the greater the assets at the disposal of the enterprise that are not financed by its equity holders.
In Act Three you figure out how much sales are generated by the assets you’ve just assembled. Here the play starts to build up excitement, because we’re now arriving at the fundamental essence of capitalism, which is the interaction between two basic “dimensions”: the stock of capital invested to form a given enterprise, and the flow of business conducted by that enterprise over a given period of time. The unit of measure is the same, usually dollars for me, but conceptually we’re talking about two different things. The resulting ratio, sales to assets, is called the “asset turnover” ratio, and every time I calculate it I feel the ghost of that prehistoric person who first picked up a seed and thought, “We can either eat this seed like we usually do, or we can put it in the ground and wait for it to produce more seeds in the future.”
In Act Four, we consider the expenses associated with the sales we’ve just generated during the period in question, and the resulting profits after all expenses—including the explicit cost of debt capital—are paid. This gives us two more ratios: the ratio of net income to sales, or net margin; and the ratio of net income to equity capital invested, or return on equity. Note that the product of the leverage ratio, the asset turnover ratio, and the net margin ratio equals the return on equity.
In Act Five, we decide what to do with the income we’ve just earned, which is now part of our assets. We can keep it as is, we can turn it into another kind of asset, we can distribute it to shareholders, etc. The cash flow statement tells us this.
When you’re done with Act Five, you just turn around and start again with Act One.
The Play in Five Acts framework seems trivially easy, even obvious, and I’m pretty sure it does not enjoy high status among professors of finance or on Wall Street. But I find it very useful when thinking about equity investing. Literally every equity investment proposition can be conceptualized using it. And when you combine the Play in Five Act framework with the economic efficiency framework discussed above, you can see that an improvement in any one of the Acts can lead to a lower price to consumers if you hold ROE constant. So if you’re evaluating an investment prospectively for a product where efficiency is a factor, you can just go Act by Act looking for sources of efficiency, in both the obvious and non-obvious places.
Which brings us back to Amazon, circa 1995. Then as now, to the extent people focused on Amazon’s ability to generate efficiency at all, they tended to focus on its ability to lower the operating expenses associated with retailing books, most notably the “bricks and mortar” expenses like rent. But if an investor had gone through all five acts, he/she would have discovered other sources of efficiency relative to Barnes & Noble. For instance, while both B&N and Amazon carried inventory, Amazon turned its inventory over much more because it never sat there waiting for a buyer. This meant that while B&N had to finance some of its inventory with working capital (which most people think of as just “current assets minus current liabilities,” but which I prefer to think of as “that portion of your current assets that you’re forced to finance with equity capital”), while Amazon did not. This led to more leverage for Amazon, as well as to greater asset turnover. Smushing these two things together a little, I’d say that Amazon’s ability to generate greater sales per dollar of working capital invested was its single greatest efficiency advantage over Barnes & Noble. And yet in my 15 years of following Amazon, I’ve never heard anyone cite this metric. Keep going through the play and you’ll find more sources of efficiency.
Again, I’m not saying that this framework would have led you to invest in Amazon, just that it’s a good arrow to have in your quiver when thinking about it or any company that promises to generate economic efficiency, especially in the “software is eating the world” world we live in. Use it well, and perhaps one day you’ll start in someone else’s cautionary tale.