Risk is the probability of permanent loss so limiting it as much as possible is incredibly important. Below are 12 risk filters that I run companies through to increase our odds. Most of these are subjective/qualitative and they can change over time as we uncover more information or new information becomes available.
1. Founder or amazing management
At the end of the day, businesses are just groups of people providing value in exchange for dollars. So the people are crucially important, especially earlier in the lifecycle of a business if the moat isn’t impenetrable yet. Buffett is famous for saying that a terrible business will always win against a great manager and that’s true. But pair an amazing management team with a great business, and watch out!
2a. Deep Moat/Hard to Replicate
A company with a flimsy moat will likely get upended at some point, especially if it has a large market opportunity and strong margins. Money-making businesses attract competition and if there is no moat to protect those dollars, they will be competed away. It’s capitalism at its finest. There are various forms of moats like high switching costs, scale economies, process power, network effects, branding, counter positioning, and I believe, at times, culture can be a moat. The fact that you can identify one of these as a potential moat is a good start but it’s more important to understand the depth of the moat. Tesla’s advantage in autonomous miles driven is likely a much deeper moat than Zoom’s brand. The determining factor is replicability. A good question to ask is: if an incredibly well-funded, focused competitor came in, could they replicate the core value prop of this company?
2b. Pricing Power/Consumer Surplus
When thinking about moats, pricing power is often mentioned. It’s a very interesting concept because I think there are two sides to it – demand side and customer acquisition pricing power. Demand side is what you probably think of immediately – an Hermes Birkin bag can go for $10,000 whereas a Michael Kors handbag may go for $100. Hermes has pricing power. If the Birkin bag price was doubled, people would likely pay the price. The roots of demand-side pricing power are usually brand or stickiness. Buying an Hermes bag is a huge signal that you’re super rich and people should be impressed by you. Therefore, people are willing to pay a high price for that. In fact, a lower price would actually be less attractive because, in Clayton Christensen language, the job to be done by a Birkin bag is to show-off. Sure, the quality is extremely high but not multiples higher than something like a Coach bag. So a higher price actually serves the main purpose. Another consistent source of demand-side pricing power is switching costs. If SAP wants to raise prices by 20%, customers will pay it. It’s simply too painful to switch ERP providers. One more, less reliable, source is simply a better product. That gets people in the door, but it’s not necessarily a sustainable source of pricing power. There will also be competition gunning for your customers. However, if you turn your better product into quite a bit of scale, you can lower comparative production costs. Ultimately, all great businesses started out by offering something better than the existing alternatives. But that doesn’t constitute a moat. That’s just the castle. But the protection of the castle is what we are talking about.
This leads us to the other side of pricing power – customer acquisition. This means that a business can raise its customer acquisition cost and still be quite a bit lower than competitors. The main source of this is counter-positioning. A good example here is Nubank in Brazil. Brazilian banks make most of their money fees and high-income customers that prefer physical bank branches. Nubank decided to take away all fees and bank branches. Therefore, the customer acquisition costs are extremely different, by an order of magnitude. But the incumbent banks don’t want to give up their main revenue sources. So Nubank can raise its customer acquisition cost to reach higher-income consumers over time and still outcompete.
Maybe this is just another source of replicability rather than pricing power, but regardless of the framing, it’s helpful to think through different ways of business advantages. At the end of the day, I think pricing power and replicability just expound upon each other in different ways. A company like Costco doesn’t necessarily have demand-side pricing power because its entire value proposition rests on having the lowest prices. But that’s also why they don’t have to invest in marketing. In fact, that’s almost, by definition, the perfect signal that you’ve found a company with customer acquisition pricing power. Think about Tesla, Amazon, Nubank, or Costco. All of these companies spend very little on marketing because they have great products with strong word-of-mouth viral marketing. But they have turned this advantage into hard-to-replicate advantages. So maybe the answer is that moats fall into two dimensions that are self-reinforcing – very hard to replicate and a very strong customer value proposition.
For example, the brand of Hermes couldn’t really be replicated with a $1 billion. The fact that it has been around so long gives it a mystique that would be hard to copy if you just threw around a bunch of money. And the value prop is the brand and the inherent signaling that’s associated. Further, Costco’s low price proposition is a no-brainer for customers and it has built sufficient scale that is very hard to replicate.
But there are instances where a company has a strong value proposition but it’s replicable. I think a lot of software companies might fall into this bucket. Our failed investment in SentinelOne is a perfect example. On the other hand, some companies are hard to replicate but may not have a lot of pricing power. Carvana could fall into this category. If they price cars too highly, someone will just go to CarMax. The value prop is strong but the nature of the transaction is such that there isn’t a ton of price inelasticity.