Mad Men MBA - Heinz (HNZ) Case Study in Competitive Advantage

Doug wanted to get me watching the AMC hit series Mad Men and so proposed a series of case studies on companies featured on the show. He had me at case study. Thus was born the Mad Men MBA, a collection of articles exploring the strengths and weaknesses of the businesses being pitched by the admen at fictional Sterling Cooper Draper Pryce.  We conduct our analysis based on a four-part framework, ("for really understanding companies") outlined here. In the end, we try to make this a practical exercise, estimating a reasonable price for buying the business and deciding whether it's a worthy investment today.

Our first case is H.J. Heinz, Inc. (HNZ), the undisputed champ in today's ketchup market and a key account Don Draper and crew were trying desperately to retain in season five of the show (representing the early-1960's).  In episode five, At the Codfish Ball, Jack Heinz is preparing to take his lucrative Heinz Baked Beanz marketing budget to another ad agency. Draper's young wife catches wind of the defection while powdering her nose with Mrs. Heinz at a dinner meeting, relays the tip to her husband, and sets up a dramatic ad-man pitch to keep Baked Beanz with Sterling Cooper Draper Pryce.

Today baked beans is a big business for Heinz in the UK market but has much less importance globally. The big brand is Heinz Ketchup, providing over $5 billion of its $11.6 billion in 2011 sales and with a global market share close to 60 percent. 

Doug sets up the case study in a recent email:

Heinz's big challenge was defining itself after pure domination in the baked beans market. They were friends to the military and the ease of packaging their product for wartime solidified their position. But they also had the vision to know they needed to branch out into new product territory, especially in times of peace. Ketchup became their big push and more than the product their packaging became signature. Pounding of the glass bottle to get it started and even when it pours out, it is all good. You can never use too much ketchup.

That was the 1960's, let's bring it back to the Heinz of today using our four-part framework for understanding businesses.  

Competitive Advantages: The Heinz Ketchup X-Factor

Competitive advantages serve to protect a company's earnings from attack by other businesses eager to steal their customers and their profits. The best companies are protected by advantages that intertwine around each other, creating greater protection in combination than any one of them could individually. Heinz is a clear beneficiary of the intertwining gestalt effect, distancing it from much cheaper catsup alternatives offered by Hunt's, Del Monte, and countless private labels offered by grocery stores. 

We should start out with what we can only describe as an "X"-factor that protects Heinz's ketchup empire. 

In his excellent 2004 The New Yorker article, "The Ketchup Conundrum"*, Malcolm Gladwell sits down with food-tasting specialists who describe how the human palate possesses some intrinsic attraction to flavors with a specific balance among salty, sweet, sour, bitter, and umami. If a particular food or drink strikes the right harmony - the specialists call it "high amplitude" - it keeps drawing consumers back for more. From Gladwell's article:

When something is high in amplitude, all its constituent elements converge into a single gestalt. You can't isolate the elements of an iconic, high-amplitude flavor like Coca-Cola or Pepsi. But you can with one of those private label colas that you get in the supermarket...Some of the cheaper ketchups are the same way. Ketchup aficionados say that there's a disquieting unevenness to the tomato notes in Del Monte ketchup.

Products with high amplitude resonate so much with consumers that they can eat more and more without ever seeming to grow tired of it. So businesses that somehow stumble upon the right formulation for achieving high amplitude - Coke, Pepsi, Heinz - have some sort of built-in advantage rooted deep in the physiology of the human taste buds.  

This creates such consumer demand for Heinz ketchup that they pick it over the alternatives, pay more for it, and even favor restaurants that allow them to slather their burgers and fries with this particular Heinz condiment. The high amplitude has created a strong consumer preference, giving Heinz an opportunity to combine the flavor preference with an emotional attachment by investing heavily in creating a brand. Heinz has wisely exploited this opportunity, and it's effects are undeniable. It has created a preference so powerful that we can recount multiple experiences of sitting in a restaurant and watching as a waitress picks up one of those iconic glass Heinz bottles (surely a Don Draper recommendation) to refill it with a cheaper alternative like Hunt's. Ketchup counterfeits! The restaurant would only bother to do this if they knew customers had a strong preference for Heinz. It doesn't want to pay extra for carrying the premium brand, but it sure loves the benefits of the Heinz halo effect.  

This high amplitude "X"-factor sounds like a pretty compelling competitive advantage. But it doesn't operate in a vacuum. As we explored in a previous article, Scale Advantage and the Great Coke Scandal (where a secretary at the cola company tried to sell Coke's secrets to Pepsi), the success of even the most delectable of food and drink products are not born solely of taste. It creates demand, but the companies must work tirelessly to build additional advantages to fortify this consumer preference and brand. 

Like Coke, Heinz has developed deep relationships with grocery stores and restaurants to get its ketchup on shelves and tables. That's distribution, a component of customer captivity or the network effect. If Heinz can tie up enough shelf-space with its ketchup, it doesn't leave much room for fresh alternatives to establish a toehold to compete. Heinz invests in this distribution network and guards it jealously. Any new entrant that Heinz deems viable that tries to get into the grocery stores will meet a ferocious counterattack to box it out.  It's very, very hard to break through.

Finally, there's the scale advantage that allows Heinz to practice selective low-cost, low-price tactics. While it charges a premium over other ketchups, Heinz produces such an enormous amount of ketchup that it has all sorts of scale benefits. From buying tomatoes in massive volume, to running more throughput in its manufacturing facilities, to spreading its advertising budget over a much wider base of sales...each of these reduce Heinz's cost per unit of ketchup bottle produced. If push comes to shove and a competitive product tapped into its own "X"-factor (thereby threatening Heinz's market dominance), Heinz could - by virtue of its low-cost scale advantages - undercut the emerging threat. It could push them into a price war, and Heinz's scale advantages would provide it the ability to price its products lower for extended periods of time without threatening the survival of the company.

So we see that Heinz has intertwining advantages to protect those earnings from encroachment by competitors.

Information sources:

* Malcolm Gladwell's excellent 2004 article for the New Yorker, The Ketchup Conundrum, is available on his website: www.gladwell.com/2004/2004_09_06_a_ketchup.html.

** Information about Heinz business performance and history is pulled largely from the company websites, www.heinzketchup.com and www.heinz.com/our-company/investor-relations/presentationswebcasts.aspx. We pulled from the company's strategic overview slides from a 5/24/2012 presentation available on the investor relations website.

The Mad Men MBA: A 4-Part Framework for Really Understanding Companies

My friend Doug is on a mission to get my wife and me watching Mad Men. It would seem we're the last denizens of earth still holding out. His latest tactic has won me over. Doug has proposed using the various companies featured in each episode as case studies for the good, the bad, and the ugly of businesses. He had me at case study. 

So what he proposed with such friendly intent, I've expanded with a barrage of verbosity. I've agreed to his proposal (and we'll borrow his box set of seasons 1-4), and countered with this suggestion that we employ a specific framework for our analysis, one that I use for investment valuations and that I believe forces you to truly understand a business. 

For these purposes, I've dubbed it the Mad Men MBA, and below is the framework I proposed via email.

Provided it doesn't send him running for an escape, perhaps we'll feature one or two of the case studies in a Mad Men MBA series here on the Adjacent Progression. 

Ok, Doug, let's up the ante on the Mad Men MBA discussions. When evaluating any business, whether to invest in it or just to understand it a bit better, it helps to have a framework. A framework organizes your thoughts, lets you sift through the information in a systematic way, and gets you pretty close to making valid comparisons between companies. Without a framework you can pick up bits and pieces of what's good or bad about a company, but unless you have some way to organize all the information you're taking in...it tends to float around in disconnected ways. That's how it works for me at least. A framework helps me retain information, shift it around while looking at its different angles, understand it deeply, and ultimately turn it into a base of knowledge I can build on. 

The great hope is that accumulating knowledge can eventually lead to wisdom. Sweet, sweet wisdom. 

So, grasshopper, here is my suggestion for a framework, posed in the form of questions to ask about each company featured on Mad Men...

1. What is the nature of the company's earnings?

This question forces you to go to the heart of a company's prospects, asking hard questions about the demand for its products or services and the potential for growth. It also forces you to consider whether your starting point (the financial results of a given year) are an aberration from the norm or a signal that a new trend is taking effect. 

Some businesses have cyclical earnings demonstrated by high peaks and low troughs of demand. This makes their earnings really high some years and really low others. Auto companies (the Jaguar discussion from Mad Men) tend to have cyclical ties to the economy. When it's good, they kill it. When it's bad, they have a hard time scaling back operations to meet the decline in demand...they hemorrhage money.

Some business depend on blockbuster success. Think movies, music, video games, even toys. They will have huge earnings in a year when they have a blockbuster seller, but then drop off precipitously if they can't produce another blockbuster. For movies, you have a lot of production companies working on the next hit, but a disproportionate amount of the money goes to only a handful of successes. Economist (and fitness guru) Art DeVany did some research that demonstrated that it's virtually impossible to predict what movies will be huge successes and which will be bombs...even for the studios themselves. 

You have businesses whose earnings are declining over time because technology or habits have just passed them by. (Think GameStop...at some point even the most graphic intensive video games will be played via the internet - and probably on iPhones - rather than on consoles.)

You have businesses whose earnings just stay the same. They're neither growing or shrinking. They have their niche, they make a set profit from it, and they just keep plugging along.

And you have businesses whose earnings are growing over time. The growth companies. Either demand is increasing for their products/services, or they're expanding into adjacent markets, or they're raising prices to generate more profits, or they're reducing costs to generate more profits. 

(Also, see here for a discussion of Owner Earnings, an incredibly important concept to understand as part of the framework.)

2. What competitive advantages exist to protect those earnings against foes trying to steal the company's customers?

This is the most important piece of the framework. In a free market, there is vicious competition for profit. And when a business pops up, demonstrating an ability to make tidy profits, it's only a matter of time before bigger, faster, smarter competitors start gunning for them. They will build similar products, they will undercut pricing, they will exclude them from distribution networks...anything to steal their customers and take those profits for themselves.

So, what competitive advantage (or "advantages" plural...the more it has, the better) does the business have that makes it difficult for bigger, faster, smarter competitors to steal customers? The four main categories are these:

a. Low-Cost, Low-Price. Think Southwest Airlines (or Amazon, or Costco). Customers prefer paying less instead of more. (So if you're charging a higher price than your competitor, you better give them a really good reason to pay more.) Companies possessing this competitive advantage usually have some sort of scale benefit from being large. They've passed that tipping point where they can produce more of a product and thereby do it for less on a per unit basis. The best of these are fanatical about keeping costs down and equally fanatical about passing the cost savings on to customers in the form of lowest prices (think Sam Walton).

b. Network Effects/Customer Captivity. It's a matter of making your product or service "sticky" so customers either can't or don't want to leave you. Facebook is the textbook example of this right now, and the case is made when you compare it to what Google is trying to accomplish with Google+. It's arguably a better service, but not enough people use it to get other people using it. Google can't pull people from Facebook because that's where all their friends are. And all their friends are there because all their friends are there. They're stuck! That makes it really hard for Google to make inroads.

My favorite example, however, is online banking with their billpay features. I have stuck it out for way too long with a bank whose other services I can't stand because I didn't want to go through the hassle of switching my bills over. That's a sticky feature.

c. Brand. This is the hardest to define, but you tend to know it when you see it. The hallmark of a great brand is that have such an emotional connection to it that they'll pay a premium to buy the product over a competitor's offering that costs much less. Coke and Apple come to mind for consumer brands. IBM has a powerful brand in corporate IT. A great test of a brand is how well its products do when it gets serious competition from a lower priced competitor. There's a great case study of Richard Branson trying to make Virgin Cola a legitimate contender against Coke and Pepsi. As we know, he failed. It's hard to take on established brands. 

d. Legal Protections. It's always a nice advantage when the government tells your competitors they aren't allowed to go after your customers (legalized monopolies like local cable providers), or you have airtight patent protection for your product (pharma), or you have exclusive rights to an asset like FCC-managed bandwidth (local tv franchises). 

The big debate about competitive advantage is how and whether innovation fits on here. It is, unquestionably, a competitive advantage. Apple is the best example. (See my previous write-ups here, here, and here.) They have a long string of innovation successes that have differentiated their products from the competition, allowed them to charge a premium, and made them amazingly profitable. But how durable is that advantage? Innovation is very, very hard to sustain over long periods of time. Competition will study your success, and they will eventually figure out how to do it. If your earnings depend on constant innovation (as tends to be the case in consumer electronics) - and you don't have other forms of competitive advantage protecting you - I don't call that a durable advantage. You'll stumble at some point. 

3. Does the economic model of the business work?

This is where you get more into the finance and accounting stuff. Basically, you want to know if the basic economics of the business make sense. The questions seem almost too elementary, but you have to ask them. If you're considering an investment in the business, you have to go through them like a check-list. They're critical. 

a. Gross Margin Model. Does the company cover the costs of making the goods by the price it charges for them? i.e., Does its business allow it to create a gross profit? Again, elementary, right? Sure, but there are so many things you can learn by watching a company's gross margin. 

For some early-stage and growing companies, sometimes they won't produce a gross margin despite having demand for their products. Their costs for acquiring and transporting materials might be too high, but it will go down as they hit scale and can procure raw materials in high volumes. 

A declining gross margin can show that a business is being attacked by the competition and must therefore reduce prices so it doesn't lose customers. It makes you ask the important questions about competitive advantage.

An increasing gross margin might suggest that the company has some form of pricing power where it can raise prices without losing market share. Maybe its brand is just that good. 

Gross margin is the highest line-item of profit on the income statement, and it's the one that can be least manipulated by accounting tricks. It's the pure one that can tell you a lot about what's happening with a business, so it's worth paying attention to.

b. Operating Margin Model. From the gross profit (above), a company will subtract its operating expenses (overhead, marketing, selling, etc.) to come up with an operating profit. What I'm looking for here is that the business can cover its operating expenses with the amount of gross profit it generates. For a mature business, this is the true sign of control over expenses. Discipline. It also gives you the first hint of what the company might have left over to reinvest in itself or to payout stakeholders (the government, owners of its debt, and then owners of its equity).

c. Net Margin Model. This is the bottom line number. Though it should tell us what the business should have left over the payout to shareholders, accounting standards actually force us to spend time with the statement of cash flows and balance sheet to really figure out that number. Consider it a discussion for another long, boring email. Suffice it to say, the net margin model is really forcing us to look at required debt payments to see if it leaves anything over to pay equity owners. 

d. Return on Invested Capital Model. I've left the most important - and least understood - one for last. It, too, would require its own lengthy discussion. While everyone spends their time frittering away on a-c above, they forget (or just don't know) that the true sign of economic viability is a company's ability to produce earnings in excess of the amount of capital that is invested in the business...and the amount of money that must be reinvested in the business over time so it can maintain its competitive position. 

Back to Mad Men and the Jaguar example...The nature of earnings for automobile companies tends to be cyclical, high in good economies and low in bad. When the economy is especially bad, car companies have a very hard time scaling back their operations (reducing costs) so they don't bleed out all the profits they accumulated in the good times. Scaling back, unfortunately, tends to mean laying off a lot of employees. That's why you have governments stepping in for bail-outs. They're far less interested in whether GM, Chrysler (or Jaguar in the 70s) survive as viable businesses and much more interested that 1. important union constituents aren't out of jobs and 2. that the unemployment of massive workforces won't lead to a ripple effect in the economy, making a vicious downward spiral. Those are important points to understand in terms of the nature of Jaguar's earnings.

For its return on invested capital model, the auto companies engage in high-stakes combat with each other that involves putting obscene amounts of capital to work in building and maintaining production lines in their factories. The constant competition led them to create new models for nearly all their cars every year, and to introduce brand new models every few years. Each time they do that, they must invest capital to change or completely overhaul their production lines. And these are HUGE investments that don't always create the most reliable returns. (Some car lines succeed, others are black holes.)

That additional invested capital they plow back into the business would otherwise go to shareholders in the form of dividends or share buybacks or acquisitions that generate more earnings in the future. Instead, they must put all that money back in the business in a way that doesn't necessarily even create more earnings in the future. It's the worst kind of heavy capital reinvestment...the kind you must make just keep running in place, to stop competitors from taking market share from you.

Even while those car companies might produce a tidy profit in any given year, the brutal truth is that shareholders will probably see very little of it. The car companies must hold onto it (retained earnings) and reinvest it back into the business even though it won't necessarily make for bigger earnings in the future.

That's the nature of a capital intensive business. Over periods of several years, its return on invested capital model will demonstrate that it's not a very good place to invest money. Because you just don't get much of it back... 

If a company can invest capital in itself and produce higher earnings as a result (and I mean higher than you think a reasonable investor could get by putting the cash into a safe investment somewhere else), than you're onto something good. That means it passes this measure of profitability. It can grow and create value in doing so. It will be worth more further down the line than it is now.

If it invests money in itself while the earnings stay the same or shrink, it fails this test. It's probably not worth investing in. Hell, it's likely to be out of business before too long.

4. (For investment purposes)...Does the price make sense?

The three questions above help you establish whether or not the company is a high quality business. This last one tells you whether or not the business is worthy of your investment. Even the highest quality businesses (those with growing earnings, durable competitive advantages, and economic models that make sense) can be priced so high that they don't make sense as an investment. That happens all the time.

The price question forces you to combine elements of what you discovered answering all the questions above. In the end, the value of a company is roughly what cash you can expect to get out of it over the long-term. Once you estimate the value (and since it involves predicting the future using very complex variables, it's NEVER a precise number), you see if the market is offering the company to you at a price that's comfortably below that value.

a. Flat Earnings. If the framework questions demonstrate that the nature of the company's earnings are flat (neither growing nor shrinking), plus protected by some combination of competitive advantages, plus they don't have to reinvest tons of their earnings into keeping the company going (i.e., their economic models make sense)...then you've learned a lot and can probably make a good guess about its value and therefore what you should be willing to pay for it. 

In the above scenario (flat but protected earnings), I would generally pay something around 7x earnings. These tend to be cash cow companies, and since the markets recognize them as steady and true producers of cash, they don't tend to have much fluctuation in the stock price. But because they're so predictable, they tend to fetch premiums above that 7x mark. You have to be patient and prepared to catch them trading for what you want.

b. Shrinking Earnings. If the framework demonstrates shrinking earnings, be very careful. All you know for sure is that the value of the company is in decline, but rarely will you know how quickly the decline happens. Think GameStop again. I'm an investor even though the business will necessarily shrink over time. How can that possibly make sense? Because the price of owning it is low when compared to what the company is paying me while it shrinks. It's market share is currently a bit over $2 billion. As of yesterday, it offers a 5.5% dividend and has committed essentially all the earnings/cash it generates over the next two years to paying dividends and buying back stock. It estimates that amount to be $2 billion, meaning if the stock price stays where it is...GameStop management says it will essentially buy back the whole company using its cash flow.

Except in situations like these, I shy away from shrinking earnings. Unless you REALLY know the company and its market, it's like trying to catch a falling knife...chances are good you'll cut yourself up when you grab it.

c. Cyclicals and Blockbusters. I tend to shy away from these unless I really understand the business, the industry, and the cycles in which they operate. The trick here is to have the discipline to only buy at a low point in the cycle or in a non-blockbuster year (but you anticipate - with good reason - that the company will produce more block busters in the future). Never, ever, ever buy at the high point of earnings. You'll overpay and get burned when the earnings drop.

d. Growing Earnings. A business with growing earnings, protected by durable competitive advantages, and with profitable economic models (especially when it comes to returns on invested capital) is the holy grail. These are the compounding machines that take capital in, apply the eighth wonder of the world, and make that capital really grow. Most investors, naturally, want their money with these companies, and so they tend to be overpriced. Sometimes to ridiculous levels.

Take Amazon.com for a moment. Today the market values it at 240 per share. That's about 300 times its reported earnings over the previous 12 months. Ludicrous, right? Probably. I mean, you know I'm fascinated by this business. Its earnings will undoubtedly grow over time. (They're currently depressed because of all of Amazon's investments in growth.) It has low-cost, low-price, network, and brand competitive advantages protecting its earnings. It's hard to see someone being able to take those away. And its economic model is profitable, especially for returns on invested capital (despite the depressed earnings, it invests very little capital to create higher earnings). 

But to pay 300 times earnings is a tough pill to swallow. It requires that you assume the current earnings will grow at a rate (and for an extended period of time) that very few large companies have ever accomplished. Not an impossible feat, mind you. But tough. 

So here's my investing prime directive, a sub-heading of the "price question" in this framework... 

Never, EVER buy anything when the market is optimistic about its future prospects. Only buy in pessimism, and preferably in dark pessimism. 

(See the Buffett quote at the end of this article.) 

I still want high quality companies, but I want to buy them when the price is depressed. This creates a margin of safety for your investment. For Amazon, people are very heady on that business right now. They understand its dominant position in web retailing, and they see how it's expanding its competitive advantages. But Amazon's earnings are bumpy. Not in a bad way, but in a way that's just natural for a fast-growth business. The market HATES bumpy earnings, and if it sees a couple of quarters of falling earnings it may decide that a downward trend is in play and quickly change from optimism from dark pessimism about its fortunes. When that happens, the stock tanks. 

I'm on the sidelines of Amazon, knowing that it will likely show a loss in next quarter's earnings report, just waiting for the optimism to turn dark. When/if that happens, that current 300x earnings valuation will likely drop in breath-taking fashion. Which will create an buying opportunity for anyone that has studied the business and understands it according to the framework above...anyone who recognizes that its earnings will grow substantially over time, be protected from competitors, and show a nice return on invested capital. 

But it takes a strong stomach to buy even the highest quality companies when the market says they're junk.

The best way to use the framework questions is to lay it on top of any company that you want to understand better, practice using it, and make sure to consider the questions in an intertwining (as opposed to "siloed") way. In other words, the answers to one question will help you better understand the answers to another question. 

So, what's the next Mad Men case study?

What Would You Buy If Price Didn't Matter? (Take Two)

Somehow, inexplicably to me, this blog has generated a modest (and believe me, my humility in using the term "modest" is well-deserved humility) readership. And here I thought it was an echo chambers for my ears only. Go figure.

A theme you might notice in the blog is that I want to challenge the limited way of thinking inherent to the acolytes of value investing. Before the torches and pitchforks come out, let me say defensively...I'm one of you!  Well, mostly. Probably 90 percent. But the absolute fixation on price to the neglect of those other traits of a good business and a good investment...well, that just keeps me spinning in my own circles, flirting with the (gasp!) growth-story stocks.

I'm using price more as my last box to check off in my investment checklist. I'm interested first in the qualities of the business itself. Does it have a profitable economic model? (i.e., returns on invested capital, cash producing...even if we have to look into the future to see it) Does it possess real competitive advantages? (i.e., scale-price advantage, brand, network effect or other means of making captive demand, or legal protections) And does it have a big market to grow into to compound its earnings?

And then, within the context of those questions, is Mr. Market offering it at a price that's either reasonable or discounted?

Margin of safety is not strictly a function of price. It's provided by the interconnectedness of competitive advantages, economic profitability, and ability to grow.

Perhaps I get burned and the strict-value minds feel vindicated. If that's the case, I will probably never admit it publicly because I'll be too busy panhandling the streets of my small town. 

So, for anyone new or interested, I wanted to re-issue my thought challenge. 

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?


The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...


1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)



What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

***

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

- Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

Understanding Amazon...A Spin Off

First, a housekeeping note. I've been experimenting with the mysterious world of twitter. I'll confess it baffles me, but it also intrigues. If you're interested in my occasional twitter musings, feel free to connect with me at this handle: @pauldryden. 

I've also put a box of tweet updates on the blog. 

This is a brave new world for me, folks. Be patient!

Now, as many of you have noticed, my interest in the business of Amazon.com has turned into an obsession. But it's a healthy one. I think. 

I don't want that to suck all the oxygen out of my other ideas and research exercises here on Adjacent Progression. Amazon-related posts now account for about a quarter of the content of this blog, and - for better or worse - there's a lot more coming. 

So it's time for a spin off. New musings about Amazon will appear at this site, www.understandingamazon.com. I've also put a link to it at the top right hand corner of the side navigation bar. 

My goal is to continue posting at Adjacent Progression two or three times a week on average. There remains plenty of material to wrap my brain around. And while the cardinal purpose of the blog continues to be about helping me develop my own thoughts (especially around investments), I hope the readers who have stumbled upon it will still find it useful, entertaining, frustrating, confounding...whatever those reasons are that keep you reading.

Why all the thinking about Amazon? In brief, it's a remarkable business (which I mean less in the adoring fan sense and more from the perspective of a - somewhat - neutral researcher willing to be impressed by the performance of his specimen). It's poised to do some transformational things in its various spheres of influence. I see it taking those models refined in its web retailing ventures, and applying them to a long string of new initiatives. And I think its likelihood of success in the new businesses is unusually high. I'll explore those concepts more on the new blog.

From an investment perspective, I remain on the sidelines. The price is not right. Though I suspect it will be in the not so distant future. What is the right price? I have no idea the amount. The opportunity to buy will come less from a precise price and more from Mr. Market's attitude about the company. Today he is optimistic and excited. But because Amazon is investing so heavily in its growth opportunities - to a point where it could very well post a loss at some point in the next few quarters - and because those growth opportunities are hard to understand, I anticipate the current attitude will give way to overreaction on the downside. The sort of pessimism that, when attached to an outstanding business, gets my heart pumping.

I'll revert back to this Warren Buffett quote previously posted under No Extra Credit for Being a Contrarian:

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

I hold out great hope for calamity. My optimism in the market's eventual pessimism knows no bounds! And in the meantime I wait.

I hope you'll continue indulging my obsession by following the series at Understanding Amazon.

Re: Google vs. Your Boys (but really about amazon)

We had a very pleasant lunch, as we always do. He is an old and good friend. He was amused by my unhealthy fixation with Amazon. And so he sends me this gentle barb a few days later:  Google is coming! [Links to WSJ article.] 

Uh-oh, a threat to Amazon's AWS cloud computing service. I get these challenges with some frequency from people that have learned of my obsession. I love them. Not so much because it offers a chance for debate and I consider myself the superior debater. I'm not. It's more because the challenges keeps me honest. 

It reminds me of the verse from Rudyard Kipling's "If": 

...If you can trust yourself when all men doubt you,

But make allowance for their doubting, too...

It's the only way to keep a kernel of intellectual integrity in his game of investing...look for challenges to your theses. Not to fight back and counterpoint the opposing argument, but for the strength and the wisdom the challenge could bring, giving you the opportunity to improve your models, test your reasoning. It's possible to find something nearing sublime in approaching the debate with philosophical detachment, shunning dogma as best as our bloated egos allow.

Unfortunately, our tendency is to seek out those of like-minded opinions, forming echo chambers for our views and doubling down on the risk of our wrongness being compounded in a confirmation marketplace.

Below is my reply to my good lunch friend:

Thanks for passing this on, T. I'm fascinated by this impending convergence of the major tech giants. They're all sitting on these enormous and valuable assets, mainly large customer bases and some combination of tech gear, tech infrastructure, and customer captivity. As a sort of manifest destiny, they are all compelled to extend and expand the use of their infrastructure...those assets. It's inevitable, as if the combination of management ego and economic drive for higher profits, creates a siren's song for the businesses to expand. I've started calling it the growth imperative, a set of behaviors I've noted in other industries, too.

So it becomes interesting with Amazon, Apple, Facebook, and Google. [See The Great Tech War of 2012 by Farhad Manjoo in Fast Company back in October 2012.] Their markets, as they expand, are overlapping more and more. They must compete, not only to grow, but also to make sure one of the competitors doesn't gain some advantage that allows them to attack their core markets....sort of like offense is the best defense.

A theory I've considering works something like this: cloud computing is a huge market that Amazon entered early and has pretty much controlled. Amazon is taking great pains to commoditize the industry - making the services non-branded - so it will be defined by who can offer computing at the cheapest price to customers. Amazon has demonstrated its willingness to make AWS (its cloud computing) cheaper and cheaper, having lowered prices 20 times since launching. Jeff Bezos has thrown down a gauntlet and dared others - IBM, Microsoft, a slew of tiny players, and now Google - to follow. Amazon has said it will make it all about price.

That creates a fascinating dynamic, and this is where the theory part kicks in. What company can afford to offer cloud computing the cheapest? Both Amazon and Google have deep cash reserves, so they can duke it out on low price there while subsidizing any losses with their own cash. That could be a painful war, and we must ask who would win.

My bet would be with Amazon, and for a simple reason...Amazon has demonstrated both an indifference to how the stock market perceives it as it pursues long-term dominance of an industry, and it has demonstrated a capacity to suffer while its stock price is getting killed because it is losing money in pursuit of dominance. Jeff Bezos frequently says he's comfortable being misunderstood for long periods of time.

So let's consider this like a game theory scenario...you have two giants pressing on the gas, hurling their dragsters at each other in a business that one of them (amazon) is willing to define by price. They will both take losses. The more they fight, the deeper those losses will be, and the more likely their stocks will tank as long as the war persists.

Jeff Bezos is fond of saying something to the effect of ..we want to sell the same thing as everyone else, but because we run more efficiently than they do, we can sell it cheaper. So if they want to have a price war, they'll go broke 5 percent before we do.

He's signaled to the world his intentions and his willingness to be a fanatic in pursuit of them. Now, how crazy is google willing to be as it enters the cloud computing market? How deep is its capacity to suffer? And remember, there's a lot of catching up to do since Amazon has been in the market since 2006.

In this game theory game of chicken, my vote is with crazy Jeff Bezos. That dude's a fanatic!

Solon's Warning...More Thoughts On Success and Failure

I'm re-reading Nassim Taleb's Fooled By Randomness. There are a handful of books I think worth revisiting every year or two to see how your refined understanding of the world - those things you've learned since reading it the last time - influence how you interpret it. It can become a measure of how you've matured in your learning quest. Taleb's book(s) belongs in that rarefied air.

I'm not sure what it means about my own intelligence or reading comprehension level, but it just seems fresh with each new pass. Like I'm reading it for the first time though this is my third time flipping through its well-worn pages.

This will not be a book report. I wanted to highlight a quote that appears before the first chapter and relate it back to a previous post here.

Solon's Warning

Taleb retells an apocryphal story from ancient Greece in which King Croesus (the richest man) is making a futile attempt to get Solon (the wisest man) to agree that the former's wealth and success mean he must be the happiest.

Solon responded:

The observation of the numerous misfortunes that attend all conditions forbids us to grow insolent upon our present enjoyments, or to admire a man's happiness that may yet, in the course of time, suffer change. For the uncertain future has yet to come, with all variety of future; and him only to whom the divinity has [guaranteed] continued happiness until the end we may call happy.

These are the thoughts it inspires (mostly self-plagiarized from a previous post):

Thoughts on Success and Failure

What is success? Is it really an outcome? Too often we think of it as a destination as if it were a platform we land on and upon which we reside forever more. I think we would find that most people we consider successful don't think of it as such a static thing. It's very dynamic. And it's not accurate to use the term in such a general way. I would argue it's just not a precise use of the term.

Perhaps you accomplished a specific thing successfully. You employed strong thinking in an investment decision process that produced an outcome with high returns. That was an example of being successful, but does it define you as a "success." Or say you produced a string of these good outcomes with high returns. Again, those are multiple instances of success, but are you now a "success?" 

You can have a thousand such "successes" followed by a single "failure." How are you then labeled? Or you have a thousand failures followed by a single success. 

Such labels are meaningless. I'm reminded of Malcolm Gladwell's New Yorker profile of Nassim Taleb  [ah, this is why these thoughts reconnect for me a few months later...neural synapses, funny things] several years ago. (Click here to read Blowing Up: How Nassim Taleb Turned the Inevitability of Disaster Into an Investment Strategy.) Taleb revered Victor Niederhoffer as one of the world's best traders and a brilliant thinker. Niederhoffer had a respected fund with investors desperate to include their capital in his investments. He had more wealth than most people could hope for. 

Niederhoffer had it all. Until he didn't. He "blew up", as traders put it, when the strategy he had used with such success for a decade suddenly didn't work. He lost everything. One day he was a "success" and the next he was a "failure." Well, that would be the description if you chose to think of it in such "destination" terms. 

It all brings to mind the story of the Taoist farmer. I had a vague recollection of the tale, and googling it produced this version (from this source):

This farmer had only one horse, and one day the horse ran away. The neighbors came to condole over his terrible loss. The farmer said, "What makes you think it is so terrible?"

A month later, the horse came home--this time bringing with her two beautiful wild horses. The neighbors became excited at the farmer's good fortune. Such lovely strong horses! The farmer said, "What makes you think this is good fortune?"

The farmer's son was thrown from one of the wild horses and broke his leg. All the neighbors were very distressed. Such bad luck! The farmer said, "What makes you think it is bad?"

A war came, and every able-bodied man was conscripted and sent into battle. Only the farmer's son, because he had a broken leg, remained. The neighbors congratulated the farmer. "What makes you think this is good?" said the farmer.

Luck is fleeting. It is a point-in-time result. What we perceive as luck today, we may view as the root of great misfortune tomorrow. The same reasons we might have used to consider a person lucky today we might use to pity him tomorrow.

So goes success, and so the path is circuitous and the arrow points forever further.

Henry Blodget

I'm hesitant to admit such a fascination with him, but after several posts quoting or featuring him, I must now confess a bit of an obsession with Henry Blodget. To refresh on his story, you may turn to Wikipedia here. 

It helps to know the back story to understand the context of why he posted this image on his business news aggregator Business Insider back in April:

The grit required to stage a comeback (it's in process) after being laid so low is a much better story - a Greek tragedy reversed - than a straight line success story. 

Scale Advantage and The Great Coke Scandal

Profits are good. And our profitability bias - that preference to own, to cover, to work for, to partner with companies that turn a profit - is a pretty good filter to apply when evaluating a business for whatever reason. But the best companies sometimes forego profit in the short-term, investing capital more heavily than perhaps is absolutely required or plowing back what might have been profit to increase their expenses in certain areas that provide advantages over the competition. 

It's not as if they don't recognize that everyone prefers they were profitable. It's that they understand that delaying the gratification of immediate profits, when those dollars are spent wisely on honing the defenses of the business, can lead to much greater profits down the road. And, more importantly, it can lead to profits that are protected against the encroachment of bigger-smarter-richer competitors that want nothing more than to steal away its customers.

Profits can be very nice, but they do not necessarily make for the best businesses.  The best businesses couple profitability with sustainable competitive advantages that protect future profits. And when a dilemma requires companies to sacrifice either profits or competitive advantages, the best ones watch out for their long-term interests. They sacrifice profits and keep investing in their defenses.

Of the major categories of competitive advantage - strong brand, legal protection, captive demand, and scale - the one with the longest lasting benefits is scale. This is where the size and efficiency of your operations allow you to produce an offering for less than your competitors, so much so that no rational actor would dare attack your position. 

When combined with other forms of competitive advantage, scale makes for the deepest defenses of all.

The Curious Case of the Coca-Cola Secretary

In late-2006 a secretary at Coca-Cola headquarters conjured up a lurid plot. Working with two ex-convicts, she contacted arch-rival Pepsi and offered Coke's most sensitive trade secrets in exchange for large sums of cash. The cabal believed Pepsi would be eager to steal a glance of secret Coke recipes, that such information would somehow help the competitor in its never ending battle with Coca-Cola to win the cola wars. 

Pepsi wasn't so keen on the scam. In fact they called up the FBI immediately and were glad participants in an exciting sting to catch the crew in the act and send them away on federal charges. Besides questions of basic human decency, why would the Pepsi executives not be eager for the patented trade information offered up by the secretary?

At best, the secret Coke recipe is one part honest-to-god competitive advantage based on a particular mixture of ingredients to produce a specific taste. And it's nine parts marketing ploy, a wink at its audience to suggest Coke is so delicious that the company must keep the secret recipe behind locked doors (lest a competitor produce a beverage with the same flavors and thereby steal away all its customers, of course). The public loves the mystery that comes of a secret formula!

Coca-Cola's competitive advantages are far less grounded in the legal protection of patents and formulas defended as trade secrets than they are a potent combination of brand and economies of scale. The company has spent billions over the years on savvy marketing, creating a Pavlovian tie between the sound of fizz escaping from an opened bottle and a person salivating in anticipation of her refreshing drink. But more importantly, they have made the product omnipresent. You are probably never more than a few steps away from the opportunity to buy a cheap Coke the moment the urge hits you, whether that urge is induced from a commercial or your own thirst. 

This is an example of scale applied to distribution. Its products are everywhere, and making that happen is a far more impressive business feat than inventing a tasty carbonated beverage in the basement of an apothecary's shop. 

Coca-Cola has the benefit of scale in production costs, advertising, and distribution. They can produce a mind-bending amount of product for mere pennies per unit, with all the fixed costs being spread across  enormous production volumes. They can then buy national and international ads, reaching consumers all over the globe, inculcating them on the idea that Coke is it. And their distributors move tons upon tons of cases each day, spreading the cost of stocking shelves over all those bottles.

The benefit of investing to create all this scale means Coke can charge a pittance for each bottle of product, a dollar or two that most consumers will never miss, while still turning a very tidy profit. What would it take for a competitor to make a reasonable return at a comparable price point? Richard Branson tried in the mid-1990's with Virgin Cola, even pricing below both Coke and Pepsi in hopes of stealing only a sliver of their customers. The cola incumbents ramped up their advertising budgets in every market they thought Branson might have a reasonable chance of establishing a toe hold, and they leaned hard on their customers to keep shelf space off-limits to the upstart. Branson couldn't even get most grocery stores in his native UK to give his drinks a shot. When you can't gain entry through basic distribution channels, you must know your future is grim. Price doesn't even matter.    

Any other competitor would run into the same challenges trying to surmount the advantages provided by Coke's scale. As a last resort of scale, Coke could always fall back to its balance sheet - it has plenty of cash - and fight a price war to makes its products much cheaper than any alternative, gladly exchanging short-term profits to ensure it maintained long-term advantages. The profits will come back if the defenses remain strong.

And so we get a good chuckle out of the misguided secretary, hoping to make a buck selling Coca-Cola's most valuable secrets. In reality, Coke's competitive advantages are hidden in plain sight.  A big piece resides with its brand...but the bulk sits with its scale, the end-product of years of foregoing billions in additional profits in return for high volume production capabilities, wide reaching advertising, and a scaled distribution infrastructure.

Competitive Advantages - The Umbrella Categories

Sometimes it makes sense to deny the profitability bias, the investor's case of the Marshmallow Test, deferring the instant gratification of today to invest in defenses that promise even greater profits in the future.

Building those defenses is making investments in your competitive advantages, the bulwarks protecting your customers, your revenues, and your profits (current and future) against bigger-smarter-richer companies that want access to your market. 

For the sake of simplicity, let's say all competitive advantages fit under one of four umbrella categories: brand, legal protection, captive demand, and economies of scale. 

For brand, just think Coke or Apple. These are the icons of their industry that have somehow (through tremendous investment in quality, consumer experience, and marketing over long periods of time) endeared themselves to their end-users in ways that I can only describe with the term "gestalt." The whole is much greater than the sum of its parts. 

The connection with customers transcends emotional. It seems almost spiritual. Or cultish, take your pick. For true Apple believers, you would have to pry their cold, dead fingers off a Mac keyboard before getting them to type a document on a PC.  Steve Jobs' crew delayed profits for years and years as Apple invested heavily in engineering, design, elegant software, and lots of advertising. The totality of those investments contributes to the end-user's experience of buying and using Apple products in ways bigger than any of those  investments considered individually.

Bigger-smarter-richer companies could not replicate Apple's connection with customers. 

For legal protection, think about pharmaceutical companies having patent protection over the molecular formulation of their drugs. For example, patents gave Pfizer years of exclusive rights to sell Lipitor to help American baby boomers reduce the amount of cholesterol floating in their arteries. It brought Pfizer as much as $13 billion of annual revenue at its peak, and plenty of profits to boot. 

But let's remind ourselves, those profits were the result of investments that lowered Pfizer's overall profits for years before they peaked. The pharma giant invested hundreds of millions to develop the drug, patent it, win FDA approval to sell it, and then fight like crazy to defend and extend those patents. 

We see the full impact of legal protection as a competitive advantage by watching what happened to Lipitor when its patents finally expired in November 2011. In about a month's time, its market share was cut in half by generic competitors marching gladly past its now defunct bulwarks, selling their much cheaper alternatives to Lipitor patients eager for a lower pharmacy bill. 

For captive demand, "sticky" has become the popular descriptive term to explain a service whose customers have a hard time putting it down once they start using it. Cigarettes come to mind, what with they being addictive and all. But my preferred example is the way banks have used online bill pay as a sticky feature that makes it an enormous pain to ever ditch your existing account for a competitor's offer. Do you really want to trudge through the process of entering all your biller information, due dates, and payment schedules on another bank's website? And for what? A free toaster with your new checking account? No thanks. 

Finally, we have economies of scale, or just "scale" for short. The businesses best protected from bigger-smarter-richer companies have some combination of all four of the umbrella categories of competitive advantages. But the strongest have a healthy dose of scale, a trait that allows you to produce something for so much less than your competitors that the rational ones would see that it's foolhardy to even attempt to compete with you and the fanatical ones - those that make an irrational decision to compete anyway - would run out of money before you.  

We'll dig more later on the benefits of scale...

Profits As Marshmallows

Let's continue the thought from our last post regarding the profitability bias... 

Over the longer term a business must be profitable. Of course. But if it has the chance to be wildly profitable in the future with little chance of the bigger-smarter-richer company being able to steal its customers, perhaps those profits could be deferred for a time.

This is the business version of the marshmallow test, that Stanford University experiment from the 1960s popularized by Jonah Lehrer's 2009 article Don't from The New Yorker.  By way of brief recap, forty years ago Professor Walter Mischel brought four-year-old kids into a room for observation, offering each a simple choice: you could have one marshmallow now, a tasty-looking morsel set in tempting reach of your chubby fingers, or you could wait a few minutes and have two. 

This was the ultimate test of the ability to delay gratification, foregoing the instant benefit to get an even better benefit in the future. If you've spent much time around young children, you'll know that putting off pleasure does not come naturally to the vast, vast majority of them. This was Professor Mischel's experience, too. Most kids gobbled down the tempting treat within seconds of the proposition being made. For those who held out, not only did they double their marshmallow bounty, but Mischel discovered their ability to delay gratification correlated even more closely with high achievement later in life than other more obvious factors like, say, raw intelligence. 

Sometimes profits are marshmallows. We want that instant gratification of stuffing them in our mouths - getting that immediate surge of sugar energy - even though they could lead to even more profits in the future, profits that would be protected from bigger-smarter-richer companies trying to compete with us. If only we delayed our profitability bias for a time. If only we invested those profits into building and maintaining defenses for our business.

Next, let's talk about what those competitive advantages are...

The Profitability Bias

When thinking about business, we immediately let our minds wander to profits. Great businesses generate tons of profit. Of course, but we have a profitability bias in that we use it as an early measure of judging how good a business is. Does it bring in substantially more money than it must spend to buy its raw materials, build its products and convince you to buy them? If there's money left over, it's a profitable company. And the bigger the profits, the better the company.

And why would anyone argue with that? We like profits, and the profitability bias is not necessarily a bad one to have. When you're using a framework to understand and assess businesses, it's fair that you would want your checklist to include profitability. But like so many frames we use to understand complex and fluid systems, we do ourselves a disservice using just one, in isolation, without considering other important concepts as we scratch through the qualities the best companies must possess.

Profits are good. They are best when they can be sustained, and they are misleading when they cannot be sustained. Unsustainable profits can trick you into believing a company is more valuable than it actually is when you assume those profits will continue coming in or that they will compound over time. 

But what happens if the profits go away? A bigger-smarter-richer competitor comes sniffing around, attracted by those tasty profits your business is showing, and decides it might like to get in the game. It decides to build the same product, but to build it better and sell it for less. And the bigger-smarter-richer competitor has the ability to do this.

Now those tasty profits are beginning to slip away as your company is forced to defend its market, spending more to earn each new customer, and pricing products lower to keep existing customers from deserting for the bigger-smarter-richer competitor.  Your business suddenly looks less valuable as the profits from yesterday don't translate into profits tomorrow. 

We need to check our profitability bias with another important concept that comes in handy when trying to gauge the quality of a business. 

Enter the competitive advantage. That post is next...

The Most Significant Battle in Amazon History (Why Bezos Celebrated the Bubble Popping)

On June 27, 2001 Jeff Bezos sat down for an interview with Charlie Rose. His comments over the course of 30 minutes provide much of what you need to understand the retail business of Amazon.com. We featured it originally in a post here. (And you can watch the full broadcast of the video here.) 

To remind you of the context, the interview corresponds with the steepest part of the dot-com collapse. Amazon's stock price had been in free-fall for 18 months, declining from $106 in December 1999 to $14 when he sat down with Charlie. And its drop wouldn't end until shortly after 9/11 when it hit a $6 bottom. Bezos own net worth dropped by half a billion dollars (reference here).  

And yet Jeff Bezos was doing all he could to hide his ebullience. 

Bezos welcomed the end of the internet-telecom bubble of 1998-99 for the simple reason that Amazon had reached scale and achieved a level of capital self-sufficiency that meant the company no longer depended on the goodwill of Wall Street for cash to grow operations. It was sitting on plenty of it and could generate more from operations.

The same was not true for other web retailers in the process of scaling up. They needed more funding to sustain themselves and grow. They had received a steady flow of it from venture capital firms willing and able to invest large sums in unproven businesses, confident they would recoup by bringing their seedling companies public in short time. But with the bubble popping, that all went away. It took down pets.com, wine.com, toys.com and countless other companies with which Amazon competed and (more interestingly) in which Amazon had made investments. 

Bezos had this to say about it with Charlie Rose:

So all these companies could get funded. And that's what created one of the imperatives for moving so quickly. Because there were so many start-up companies getting $60 million or more in venture capital. And those companies with that much capital, if that financing environment had continued for any extended period of time...many of those companies might have been able to build the scale to be successful.

Losing its investments in online competitors hurt Amazon, but only in the most superficial and temporary sense. Amazon invested in these businesses as a hedge. Bezos was already working toward the lofty goal of being the ubiquitous force in online retail...the only place people would shop. That meant he would expand Amazon into every conceivable product category, offering universal selection. Of course he couldn't get there immediately. He had to prioritize where the company invested its money and time. So he adopted the land rush mentality, investing in a broad swath of developing web retailers in early stages of growth. 

If the competitors could reach any sort of scale - with their software, merchandising expertise, and distribution capabilities - they could begin expanding into adjacencies. It didn't matter what product niche they specialized in to launch themselves, they could use the infrastructure to expand. They could threaten Amazon's objective to be ubiquitous. So Bezos bought the competition or invested in them, holding his enemies closer than his friends. 

One of the things we were very convinced of, and indeed was definitely true in the earlier days, is that there was a land rush phase to the internet. And so, when we saw product categories that we thought were important to our future at some point, but they weren't the ones we were going to do first...Pets.com, wine.com, etc....there were a bunch of things that we were invested in that didn't work out. We knew we weren't going to do those things anytime soon, but we wanted placeholders  in those industries so that later, perhaps, we could fold these industries back into Amazon.com. So that was driven by...a land rush mentality...It's hard to put a precise date on it, but I believe that for the first four years of our existence, that land rush mentality was correct. And the only reason we exist today is because we...behaved that way.

Then the crash came. The talking heads wanted to focus on Amazon's foolish investments in all these dot-com bombs, the value of which evaporated in a slew of bankruptcies. No doubt it hurt Bezos, but he had confidence in the bigger picture of what was happening. Why weep over these investments gone bad? They were hedges. The bigger bet was paying off. Your competition was gone, you didn't need Wall Street for more money, and you had scale.

Bezos was ebullient because he recognized, despite the stock price going down in flames, that he had just won the most significant battle in Amazon history. He was the last man standing. 

And so we can understand the confidence behind his statements in the closing minutes of the interview with Rose (emphasis is mine):

In the early days, that's when the company's destiny is really not in its own control. At this point in time, with the brand name that we have...we have so many assets now, now it really is under our control. We don't worry about externalities now. What we worry about now is that we don't do our job. And I'll tell you one of the things in this period that I kind of like is that it's a lot easier in the year 2001 for Amazon.com as a company to be humble, working our butts off, than it was in 1999 when the world believed we couldn't lose.

And this conclusion:

Charlie Rose: [Paraphrased] There are two schools of thought. One is that Amazon will become the most spectacular retailer of all time. The other is that Amazon may become the most spectacular failure of the internet era. What's the odds of the first being true versus the second?

Jeff Bezos: Let's put it this way: we get to decide, nobody outside the company can decide that. 

Jeff Bezos was history's happiest man for losing $500 million in personal fortune in 2001. He had long ago separated the concepts of the value the stock market places on his business versus the value contained within the actual operating business...the intrinsic value. Bezos knew how temporary that loss would be and the great path it set for Amazon's future.