Lessons from Netflix and Costco on why extracting value from customers is a short-term trap—and how to build (and invest in) businesses on solving friction instead.
Thanks for the write-up, Akshay — really enjoyed it. One contrast that came to mind while reading was TransDigm (glad to see you also referenced it in the comments). For businesses where high margins come from structural lock-in rather than customer value creation, is regulatory change (as you pointed out) the main risk to durability, or are there other factors you focus on? And in your view, are these still attractive long-term investments, or does that dynamic eventually cap returns?
Regulations is definitely an area to look at but you also have to look at the disruptive start-ups in that field. You also have to look at the advancement in technology enabling moat destruction. I'm sure there's more categories of stuff, but it's tough to come up with an exhaustive list because one situation can vary a lot from another. I think it is better to think from first principles in each instance. If you're investing in a user unfriendly business with customer lock in, you have to think very hard about how much longer that is going to last.
People often think it is easier to bet on contractual arrangements. I think it's easier to bet on delighted customers. Putting aside expected returns, I feel more comfortable about Costco's duration than Transdigm's.
Quick questions I thought of: You mentioned lots of case studies for businesses which chose to focus on customer centric problems, which in turn yielded better results in the long term. Have you seen companies who keep this framework in mind, but still don’t see the success they “deserve” (assuming they aren’t early in the stage)?
In terms of shorter term investing compared to value investing, how do you navigate companies who are not making ideal decisions (for the long term), but are still attractive in terms of valuation or shorter term tailwinds?
It's a great question. To follow the framework from The Loyalty Effect, you need 3 groups to be happy: customers, employees, and shareholders. One company that comes to mind is Basic Fit. Seems like a great offer for the customer. The accounting is a mess. Management uses EBITDA for ROIC calculations. I let it slide for a while because the business model and growth were so compelling, but lost patience. I have a hard time attributing it all to macro. People still used Facebook, Google, Amazon, Costco during the financial crisis, COVID, etc. So there must be something broken with BFIT.
Perhaps a better example is WeWork. Think the customers were generally satisfied, but the model simply expanded too fast and the economics blew up so didn't work for shareholders.
If it weren't for super low interest rates, you could argue that businesses like Amazon, Netflix, and Carvana would not have achieved the success they did. EXPI is another example. Think customers and the employees are happy but the share dilution has crushed shareholder returns.
Basically any company where the customers were happy but the business could not make the unit economics work would fit the set of examples you're looking for.
This is a tough one. It is a very different skill set to own businesses playing defense vs offense. You have to really assess the moat and how long it will take for technology or new competition to destroy the business. You would be surprised how long some of these legacy businesses survive. Newspapers survived far longer than anyone expected. Same with Big Tobacco. You have to do the annual returns math and make sure that management is aware the business might not be around in 10 years and is returning capital through dividends or share repurchases. Or you have to find annoying virus like companies like Transdigm that customers hate but will be around for a while due to structural reasons. You really have to watch out for regulatory changes though.
Thanks for the write-up, Akshay — really enjoyed it. One contrast that came to mind while reading was TransDigm (glad to see you also referenced it in the comments). For businesses where high margins come from structural lock-in rather than customer value creation, is regulatory change (as you pointed out) the main risk to durability, or are there other factors you focus on? And in your view, are these still attractive long-term investments, or does that dynamic eventually cap returns?
Hi Jalen, thank you!
Regulations is definitely an area to look at but you also have to look at the disruptive start-ups in that field. You also have to look at the advancement in technology enabling moat destruction. I'm sure there's more categories of stuff, but it's tough to come up with an exhaustive list because one situation can vary a lot from another. I think it is better to think from first principles in each instance. If you're investing in a user unfriendly business with customer lock in, you have to think very hard about how much longer that is going to last.
People often think it is easier to bet on contractual arrangements. I think it's easier to bet on delighted customers. Putting aside expected returns, I feel more comfortable about Costco's duration than Transdigm's.
Brilliant read, thank you so much.
Quick questions I thought of: You mentioned lots of case studies for businesses which chose to focus on customer centric problems, which in turn yielded better results in the long term. Have you seen companies who keep this framework in mind, but still don’t see the success they “deserve” (assuming they aren’t early in the stage)?
In terms of shorter term investing compared to value investing, how do you navigate companies who are not making ideal decisions (for the long term), but are still attractive in terms of valuation or shorter term tailwinds?
My pleasure, Sid! Glad it is helpful :)
It's a great question. To follow the framework from The Loyalty Effect, you need 3 groups to be happy: customers, employees, and shareholders. One company that comes to mind is Basic Fit. Seems like a great offer for the customer. The accounting is a mess. Management uses EBITDA for ROIC calculations. I let it slide for a while because the business model and growth were so compelling, but lost patience. I have a hard time attributing it all to macro. People still used Facebook, Google, Amazon, Costco during the financial crisis, COVID, etc. So there must be something broken with BFIT.
Perhaps a better example is WeWork. Think the customers were generally satisfied, but the model simply expanded too fast and the economics blew up so didn't work for shareholders.
If it weren't for super low interest rates, you could argue that businesses like Amazon, Netflix, and Carvana would not have achieved the success they did. EXPI is another example. Think customers and the employees are happy but the share dilution has crushed shareholder returns.
Basically any company where the customers were happy but the business could not make the unit economics work would fit the set of examples you're looking for.
This is a tough one. It is a very different skill set to own businesses playing defense vs offense. You have to really assess the moat and how long it will take for technology or new competition to destroy the business. You would be surprised how long some of these legacy businesses survive. Newspapers survived far longer than anyone expected. Same with Big Tobacco. You have to do the annual returns math and make sure that management is aware the business might not be around in 10 years and is returning capital through dividends or share repurchases. Or you have to find annoying virus like companies like Transdigm that customers hate but will be around for a while due to structural reasons. You really have to watch out for regulatory changes though.
Wow this is super helpful. Thank you!
This is wonderful. Thank you for sharing this.
:D
my pleasure, thanks for reading!
Yes 100%, a great contrast is Transdigm!