How growth kills economy of scale: A case study

A newspaper article describing the losing sheen of tablets is on ET today. The premise is simple:

“The India tablet story is losing steam. After a 56% surge in 2013, tablet shipment fell nearly 28% sequentially in the first three months of 2014. 

As many as four million units were sold last year, compared with 2.66 million in 2012. But in the January-March quarter of 2014, only 0.78 million tablets were shipped, down more than 17% from a year earlier “

The growth of tablets industry has been phenomenal in the last few years. In 2012, a Hindu BusinessLine article showed a year on year growth of 673%. The growth this year has slowed down to 76%.
A 76% growth in any sector will draw deep cheers but so much has been the historical growth for this sector that a high two digit growth rate is a dampener.

But deep inside this development is a conundrum. The only difference between two manufacturers of electronic hardware is economics of production (or economy of scale). A smaller entity can’t make as much profit as a bigger manufacturer makes purely because the fixed cost per unit is lower.

In absence of any switching costs for the end consumer, price becomes the only difference. For laptops, mobile phones and tablets it is evident. There is just no switching cost for the end consumer. As a result, price or rather features per unit of price become the driving idea behind any transaction.

But with Google’s Android push in the last 5-6 years, almost entire onus of features have moved from hardware to software. There is just no difference between two devices! As a result, there is no differentiation and there is no switching cost for the consumer.

In absence of such demand side advantages, economics of scale becomes harder to protect. But harder still when there is growth involved.

As mentioned elsewhere in this blog, growth expands the pie and everyone becomes a competitor and no one the incumbent. This cocktail effectively makes the least efficient competitors quit the game. ET corroborates this:

“From a peak of 68 players competing in the market in the second quarter of 2013, the number has fallen to 30 now.”

A 50% reduction in the players implies a huge churn. This lack of stability is another indicator that there is no moat really.
However a small silver lining adopted is the new focus adopted by the companies. The manufacturers are going niche rather than going global. Increasingly making their tablets industry centric, they are re focussing on software. As a result they have a chance of creating durable moats, as professionals will (or should be made to ) spend considerable training time to master the different features of a software.
Reminds me of Bloomberg terminals.


Retail is Detail-II

This is the second in series of Retail is Detail. The first post can be found here

If it takes 5 machines 5 minutes to make 5 widgets
How long would it take
100 machines to makes 100 widgets? 100 minutes or 5 minutes

In a lake, there is a patch of lily pads. Every day, the patch doubles in size.
If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake?
24 days or 47 days

A group of 40 Princeton students were given this test. Half of them saw the questions in clear and legible fonts. And the rest half saw it in small fonts, washed out gray print.

90% of the students who saw the questions in clear prints made atleast 1 mistake.
ONLY 37% of the students who saw the questions in faded unreadable fonts made a mistake.

Whats happening here?

Kahnemann explains it by describing how bad ineligible fonts are inducing cognitive strain on our brain. We are taking extra effort to read it. We are furrowing our brows and making intelligent guesses about what a font can really mean. So what it does, is accidentally triggers our System 2- the more rational, intelligent, calculative part of our psyche on.

“accidentally triggers”– note the phrase ladies and gentlemen. Our rational, calculative brain is a slow guy. He doesn’t like to work unnecessarily.It can either be consciously prodded into working or accidentally triggered into it.

When fonts were difficult to understand, our System 2 swung into action and we got better answers.

The answers of the previous two questions are 5 minutes and 47 days respectively. I played a trick on you by bolding out the wrong ones.

What has it got to do with COSTCO?

COSTCO doesn’t give its customers too many choices. While others thrive on offerring 10-15 choices for one particular item, COSTCO limits itself to 5-6.

This lack of choice lowers people’s tendency to judge and think deep. This leads to its customers doing more impulsive shopping. And inflates the individual billing rate.

Costco goes one step ahead and does one better on WALMART. If you have read my thesis report on retailing ,I mentioned at one place:

A retailer is a dispenser of shopping experience. However a retailer can’t charge for that experience. She has to pass on the costs to the products and should reflect in its profit margins

Not WMT,not Target, not JC Penney or anyone else, no one can charge money for that experience. But COSTCO does. And COSTCO does it so well, that people pay to shop at COSTCO. This generates a tremendous amount of float for COSTCO.

From their 10-K:

Membership Policy
Our membership format is designed to reinforce member loyalty and provide a continuing source of membership fee revenue. Members can utilize their membership at any Costco warehouse location in any country. We have two primary types of members: Business and Gold Star (individual). Our member renewal rate was approximately 89.7% in the U.S. and Canada, and approximately 86.4% on a worldwide basis in 2012, consistent with recent years. The renewal rate is a trailing calculation that captures renewals during the period seven to eighteen months prior to the reporting date. Businesses, including individuals with a business license, retail sales license or other evidence of business existence, may become Business members. Business members generally pay an annual membership fee of approximately $55 for the primary card-holder, with add-on membership cards available for an annual fee of approximately $55 each. Many of our business members also shop at Costco for their personal needs. Gold Star memberships are also available for an annual fee of approximately $55 to individuals who may not qualify for a Business membership. All paid memberships include a free household card.

Can be found here


Effective November 1, 2011, for new members, and January 1, 2012, for renewing members, we increased our annual membership fee by $5 for U.S. Goldstar (individual), Business, Business Add-on and Canada Business members to $55. Our U.S. and Canada Executive Membership annual fee increased from $100 to $110 annually

From here

So how do they recognise it in accounting?

Membership fee revenue represents annual membership fees paid by substantially all of the Company’s members. The Company accounts for membership fee revenue, net of estimated refunds, on a deferred basis, whereby revenue is recognized ratably over the one-year membership period.

From here.

So how does it get reflected in their financials?






So much so that, their liabilities more than make up their inventories, allowing them to operate in a close to zero current account as possible.

This is how they are inverting.
Munger gives another aspect of how Jeremy Siegel James Sinegal went to use inverting the business model of COSTCO. He said Siegel Sinegal started by asking what kind of customers he wouldn’t want. The answer was easy. Those who park their vehicles for hours at end in the store’s parking lot, spend hours in the store and yet buy nothing. He wouldn’t want the penny pinching folks from whom he cant charge anything extra.

So he targets exclusively the upwardly mobile $100,000+ annual income population.

And boy, is he minting money!

WMT and COSTCO are different giants. They eat different food (read customers) and hence they are not straight away direct head to head customers. But their similarities are hard to ignore.

1. Both have fanatical management
2. Both have thrived by bringing people onto their “platform”- WMT by opening stores in a radius of 2 kms for an average JOE. COSTCO by bringing in membership cards to shop there.
3. Both have grown by laser sharp targeting. WMT grew on rural America, COSTCO growing on upwardly mobile America. WMT whenever it tried to move out of its base has paid. I am not aware of COSTCO making such mistakes. (Think: Sam’s Club)






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Retail is Detail

Watch the following video and try to spot the following ideas:

1. How Costco prevents the triggering of System 2 (remember Daniel Kahnemann’s idea) ?  Costco uses Munger’s (and original Jacobi’s idea) – “Invert, Always Invert”- can you give an example?

Also read this piece of understand Walmart’s success to contrast this with Costco’s strategy.

Are they head to head competitors? Can you think of their differences? Perhaps they are having lots of similarities. Can you spot them?


Then read this piece by Tren Griffin (A Dozen things I learned from James Sinegel) and understand more about Costco.

As Griffin said

If you are the big picture guy, then you are out of picture. Retail is Detail

Banking on Trust-III

This is the third and final post on the Banking on Trust series. While the previous post winded down to an extraordinary length I recognise it lacked the practical treatment. I hope to set it out right this time. For the first part see here and the second part take a peek here

The last post, Banking on Trust-2 can be summarised in four words- “Management maketh, Management breaketh.”

Due to the highly discretionary job of risk management and a fragile business model (need plenty of other people’s money to even work) a good management can be the invisible asset for a bank.

And I argued, though admittedly without much proof, that Wells Fargo Corp’s management has been extraordinary in its handling of the business.

Let us attack the issues one by one.

Competitive Advantage 101

What separates a big 4 bank (Wells Fargo, JP Morgan Chase, Citigroup and Bank of America) from community banks?

Short Answer: Scale
Long Answer: Economies of Scale.

Being larger in size Wells Fargo and Company (WFC) is able to keep  its fixed costs per unit of loan disbursed far lower than its local competitors.

With lower fixed costs, it is able to charge lesser interest on loans disbursed thus winning the first battle in a commodity business.

Another question.

What prevents the community banks from growing into a big 4 bank?

Short Answerr & Long Answer: Search costs for customers

 The incumbent banks have been able to offer full services at a lower cost (due to scale) than community banks. As a result for a customer it is difficult to find a substitute of such a bank which offers all those services at lowest prices. And hence community banks stay ever small.

The management of WFC understands these ideas very well. Yet they have taken their execution to a completely different level. By being one of the first banks to repeatedly  innovate its financial offering (keeping in view changing regulations as well as customer needs) it has performed extremely well.

Peruse this:

A history of success of WFC

1967: WFC introduces a Mastercharge card as a new form of credit card.

1968: Under high inflation, FED restricts overseas spending. But outbound customers and expats need a solution to this new regulatory development. WFC recently opened London subsidiary WESTERN AMERICAN BANK swings into action- servicing the clients and turning in better than expected performance.

Converts to a federal bank charter (Community Banks- 0, WFC-1)

Mastercharge credit cards which turn out to be a success. Adopted in 37 States and used by 13million cardholders. These numbers generate substantial benefits for WFC. Accepted by virtually every major oil company.

1970: WFC organised as a bank holding company to broaden their services. New branches opened in Sydney, Hong Kong, Luxembourg, Mexico City, Managua etc.

1975:  Its market share of the retail savings trade increased more than two points, a substantial increase in California’s competitive banking climate. With its increased deposits, Wells Fargo was able to reduce its borrowings from the Federal Reserve, and the 0.5% premium it paid for deposits was more than made up for by the savings in interest payments.[from wiki]

1978: Fed allowed banks and thrifts to offer savings intruments with interest rate linked to T bills (savings rate deregulation). Wells Fargo quickly              deregulates its own savings rate. Launches two new plans in response to this. Automatically allows savings account interests to be moved into checking accounts.

1978-80: Wells Fargo’s investment services becomes a leader. More accounts garnered than any other money manager. Wells Fargo’s early success, particularly with indexing—weighting investments to match the weightings of the S&P500—brought many new clients aboard.

In short,with a rise in offerrings WFC is constantly increasing the search costs for customer. But the management of WFC has one more ace up its sleeve.

A mental model to analyse Mastercharge

But wait a second here!

Are we missing something?

Yes surely we are! We missed an important development.

In 1967, WFC launched a system of transaction where customers can take credit from their banks for purchasing items. It was named Mastercharge.

Lets first explore, the success (if any) of Mastercharge as of 1969.

37 states out of 51 adopted it.
13mn customers use it.
Almost every major oil company supports it.

Can we make a reasonable guess on the future of Mastercharge? Its benefit to WFC?

Surely we can. Mastercharge is nothing but the first credit card offering in the world. It is essentially making its customers dependent on itself!

Thats the classic case of moat. Think about it! Marlboro, Coke, See’s Candies. All are businesses which will be sorely missed by its customers.

Lets attack it from another perspective. Lets check if it can be lodged off from its perch (13mn cardholders, acceptance by major oil co.) by a new competitor.

Have you heard of Replicator Dynamics? It is an interesting mental model.

Its in essence a system which says- folks adopt those behaviours more readily which has the more payoff (the material aspects) AND is copied by more number of people. So we can see- people switching and adopting new behaviours. Something like people coming from different cultures quickly adopt the cultures of their new country.

I will be talking about this mental model in another post (Stay tuned!)

Lets apply it here.

Assume that Mastercharge gets a new competitor called Surcharge. It is the new kid on the block. Zero people use this and no states have adopted it, yet.

Now Alex wants to enroll in one of the two credit card companies- Mastercharge or Surcharge. 

What does Alex see? Alex sees around him 13mn customers already using Mastercharge. 

13mn cardholders of Mastercharge! 

It effectively means wherever Alex looks, he sees every card holder as a Mastercharge holder. He is surely going to adopt that behaviour which is being followed by others [Replicator Dynamics].

But when 37 States and all the major oil companies have adopted Mastercharge, what does it imply?

A large number of vendors are already using it. So for Alex, Mastercharge has clearly become significantly beneficial.Its the classic Network Effect at play. 
Each new vendor when joins the network makes the network more valuable to its individuals (Think Facebook in 2006 and 2014).

So for Alex, not only does it make more sense for him to adopt Mastercharge than Surcharge, it also makes it more profitable to him (i.e. gives him disproportionately large material benefits than Surcharge).

Thus we see, Mastercharge owning the market, like a boss!

Mastercharge finally became -> this

The ace up Wells Fargo’s sleeve

The management perhaps thought, if I am indeed locking away the community banks in services why not go the entire way!

Lets lock them out of physical proximity to customers as well!

Take a look:

Dotting the California: New Branches opened or pending in 1968

Its opening new branches so close to each other that it is effectively crowding out community branches.
In the same year it merged with Bank of Pasadena (a 10mn $ deposit bank), Azusa Valley Savings Bank and First National Bank of Azusa (combined 11mn$ deposits).

It acquired Sonoma Mortgage Corp.
In 1969, Wells Fargo has 19 offices in Southern California, the deposits exceeded 165mn$ and loans topped $230mn.

Offices in South California

In 1970, the conquest of Los Angeles and Orange counties(right) is shown. And also take a look at the San Jose metropolitan area expansion

The Conquest of South-West America aka LA and California

The Conquest of South-West America aka LA and California

So we see an all out attack to disproportionately increase the search costs in every way possible.
The qualitative aspects are done, let us train our guns on perspectives.

Is the management really running a tight ship?
Is it keeping its costs down?

In contrast BofA had an overhead margin of 47% in 1998 inspite of 100 years+ of experience

The management- does it go bonkers in good times?

With the qualitative aspects out of the way, let us consider the quantitative aspects of management i.e. its ability to make conservative loans, predict their vulnerability and make the right amount of provisions so that, I repeat, so that the net operating profit after tax is smoothened.

Take a look at this:

The NOPAT barely nudged even in a downcycle

What I did was simple.
I took the Net Interest Income subtracted only the charged off loans so that I get the true picture of ‘damage’ in the current year and added back the loan provisions.

Remember loan provisions exist to smoothen out bad loan losses. So ideally management should have anticipated the loan provisioning properly so that charged off loans are fully accounted for.
But probability of loan going bad is a combination of expected and unexpected developments.

Hence how good a management is, can be checked by how good its predictions are.
In turn, how succesful it had been in making its NOPAT smooth.

Since provisioning is tax free, I adjusted the tax accordingly. Taxes paid in real is the second row, and the last but second row are the taxes applicable on our adjustments, given the same tax rate.

Take a look at NOPAT levels again.
Remember in the period from 1970-72 US entered a recession.
With each economic downturn banks are the first to suffer losses.
And yet, Wells Fargo’s NOPAT has barely nudged.

What do we conclude?

We do conclude that Wells Fargo’s management has been extraordinary capable of cushioning the bank’s fortunes from macro economic shocks. WFC- 1 , Competitors – 0

So now it comes down to valuations. Lets take a look!

Valuations- Valuing the Wells Fargo!

It went public in 1972, and its average market cap for that year was around $1.5bn.
What growth expectations are we attaching to Wells Fargo?
Lets first try to establish a way to value this company.

We adopt the Economic Value Added (EVA) methodology to analyse this bank.

EVA = NOPAT – Shareholder Equity * Cost of Capital

Market Value of Enterprise = Shareholder Equity + Future Value of all EVAs

Using this framework, lets try to find out the EVA from 1967-1971. The cost of capital for a shareholder is merely the opportunity cost.The second best idea is investing in index, assuming a blank portfolio.Consider it to be the historical growth in index DJIA from 1940-1970. Thus the cost of capital equals 8%.

Hence plugging it in and assuming a 20% growth rate for the next 30 year, we arrive at its 1972 valuations of $1.5bn.

20% growth rate in EVA, discounted at 8% for the next 30 years.

Is it too costly?
Well it is if you see the time duration involved. Growing at the rate of 20% for the next thirty years is not a mean feat!

However if you consider that this is a good business, with  a responsible management at helm, with very interesting offerings like Mastercard and a deepening moat, then you might like to reconsider your position.

But I will be fair. Had I been in 1972, I wouldnt have dared to buy it. But given the mental model working in my head now, I would have surely stalked this company very closely.

Three Years ahead- August 1974

Let us consider three years ahead.

Has the position worsened?
Lets see.

In 1974, Wells Fargo NOPAT was $66mn.
Equity stood at approx 450mn$.
At a cost of capital at the same 8%, we have EVA of Wells Fargo in 1974 at $30mn.

If we assume the growth rate in EVA to be about 8% for the next 30 years, the future value of all EVAs come to $0.9bn. With the shareholder equity standing at $450mn, the market value of the enterprise comes to $1.35bn.

In 1974 for about 4-5 months (from August-December) it traded at a marketcap of $860mn.

Fours more years ahead-  1978

Let us go four more years ahead. How well would we have fared in our assumptions?

Constantly increasing Earnings and Dividend per share

It clocked an average of 18% growth in the last 5 years. Topline growth has clocked an average of 17%.

And has the moat deepened?

Everincreasing return on shareholder equity! What else is it other than deepening moat. And this has come at the cost of dumb competition.

Remember Walmart? Walmart did the same with mom and pop shops.

But ladies and genetlemen, I will completely understand if you are hungry for some more.

Take a look at this:

Increasing return on assets for WFC. Almost a vertical line!

And take a look at its effect on leverage:

Falling leverage implies better asset utilisation and deepening moat.

It just shows one thing- Wells Fargo and Company will continue to make a heck lot of a money for its shareholders. In fact, from 1974, if you would have bought and held WFC it would have returned 29400% ; compounded yearly at the rate of 15% for the next 40 years.

Think about it.

Recommended Reading:

1. John Hubers excellent posts on Wells Fargo which has served as an inspiration to conduct this study. here, here and here

2. Annual reports of Wells Fargo from 1968-71,1978,1988,1998

3. The featured image is taken from John Huber’s wonderful blog Base Hit investing


Sustainable Value Creation- Truths and Myths

Michael Mauboussin and Dan Callahan came together sometime in 2013 under the aegis of Credit Suisse to bring out a research report named – “Measuring the Moat”. It is an excellent 70 pages report and I recommend any serious value investor (worth his salt) to read it.

Sustainable Value Creation contrary to what many people believe is not a managerial miracle. Its a near about 50-50 split between the industry dynamics and the managerial prowess. Industry dynamics, internal competition and the extent of fragmentation influence managerial decisions. The phase through which the industry is going (i.e is it consolidating or is it getting disrupted) influence a manager in favour of competition or cooperation.

Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance.

Mauboussin highlights that Industry is not destiny, there are outliers of outperformance in every industry but the base rate of success differs. As a result it takes varying amounts of managerial skills to create value.

Value Creation across Industries

Value Creation across Industries

Interestingly out of this picture, two things jump out:

1. As one selects an industry closer to the origin i.e higher rates of internal return (CFROI-WACC), the number of companies which succeed in creating value is always higher. I.e in communication equipment industry, very few companies destroy value, while its the opposite in paper and forest products industry- very few companies create value.

2. As one selects industries with varying rates of internal return, the best company with the maximum IRR cannot be “far better” than its own peers/industry averages. i.e the best company in paper and forest products have an IRR of mere 10% whereas the best company in communication equipment industry has an IRR of 40%.

Industry might not be destiny, but surely deserves a scrutiny.

I carry with me after reading this report two major lessons- how important is an industry map and how fruitful is creating a profit pool of a sector across a time period.

Do give the report a read. Its worth its weight in gold.