Monday, April 7, 2014

Strategic Planning Analogy #527: Wedding Ring Blues

I got married right out of college. Since I was just a poor college student, I didn’t have a lot of money to spend on a wedding ring.

The man at the jewelry store could tell that I was a bit nervous about the big purchase and tried to ease my mind. He told me that they had a lifetime buyback guarantee. If, at any time, I wanted to return the wedding ring, I could do so—no questions asked—and get my money back.

That sounded too good to be true, so I asked a few questions. As it turns out, there was a loophole in his guarantee. I was buying the wedding ring from him at the retail price. I would be selling it back to him at the wholesale price.  That sounded like a bad deal to me.

The salesman reassured me that it was not such a bad deal. After all, wedding rings have been going up in value for centuries. If, years later, I decided to sell the ring back to him, it may have appreciated enough in value to have a wholesale price higher than the retail price I paid for it.

Maybe so, but it still sounded like this was a much better deal for the jeweler than it was for me.

Buying that wedding ring was my first real experience dealing with the spread between retail prices and wholesale prices. As an average consumer, that spread did not seem to be in my favor. If I’m always buying at retail and selling at wholesaling, it is extremely difficult to get ahead.

There has to be quite a bit of appreciation in value to compensate me for that spread. And even then, the broker of the deal benefits more from the appreciation than I do. It doesn’t sound like a good business plan for me. And it probably doesn’t sound like a good business plan to you.

Yet business strategies often fall into the same trap. We end up with strategies which “buy at retail” and “sell at wholesale”.

Take manufacturing…you buy your raw materials at retail prices and sell your finished product to a distributor at wholesale prices.

What if you’re a web site whose profits are based on advertising? The ones advertising on your site may be paying retail advertising prices, but all you get to pocket are the wholesale prices because the advertising broker gets the markup.

What about M&A activity…you pay a hefty acquisition premium over current value to buy the asset (sort of like a retail markup), but when you get it, all you have is the core business (as is) which was valued well below your premium (sort of like the wholesale price). It’s going to take a whole lot of asset appreciation to cover that spread.

And if you want to dump a troubled asset that doesn’t work for you, others will know you are dumping and it becomes a “fire sale”, where people pay you less than you think it is worth (like selling a wholesale price).

And even if you have a desirable asset you can sell at a premium, it seems like the investment bankers and lawyers are the ones who rake in all the cash. The brokers of the deal get a much better return on the sale than you do.

So maybe business strategies aren’t all that different from my early experience with that jeweler after all.

The principle here is that the wholesale-retail spread is a reality. Depending on how you build your strategy, you have that spread either work for you or against you. We’ll look at three strategic angles to minimize the negative or accentuate the positive aspects of the spread.

1) Creating Value Vs. Waiting for Value
There are two ways to attempt to profit from assets. The first way is by trading the assets (buying and selling). This method only works if you are successful at buying low and selling high. But as we’ve seen, trading assets often works in reverse (buying high at retail and selling low at wholesale). And usually there is some kind of broker or middleman in the transactions who gets a cut of the money when you buy and when you sell. Therefore, your only hope is that prices for the asset will greatly appreciate to cover these spreads.

The second way to profit from assets is to hold them and use them to create value. In this second way, the primary value comes not from selling the asset, but by selling what the asset produces, year after year after year.

Over the decades, Warren Buffett has been telling the world that the second method (hold and create) is a far superior path to profits than the first (buy and trade).  Hold and create is what had made Warren Buffet so wealthy. He regularly earns money from these companies by what they do, rather than what he can trade them for. By avoiding the churn of trading, he avoids dealing with the wholesale-retail spread found in trades and avoids paying out all the money to the brokers who facilitate all the trades. He explains it well beginning on page 18 of his 2005Berkshire Hathaway shareholder letter.

So building a strategy like Berkshire Hathaway (Buy-Hold-Create) is one way to avoid the mess of the wholesale-retail spread.

2) Own the Supply Chain
As I mentioned earlier, the supply chain creates an adverse wholesale-retail spread. You buy things upstream in the supply chain at retail and sell things downstream in the supply chain at wholesale. This can be disadvantageous. One way to get around this is by owning a larger share of the supply chain.

Take the fashion world, for example. Nearly every fashion brand owns a portion of its downstream retail channel, with company-owned stores. Why? It helps them better control pricing at retail and wholesale, which helps keep the brand value from deteriorating. It also helps the fashion brand capture a higher portion of the value of the brand whether it occurs at the brand level or the store level. When the brand sells to its own stores, it doesn’t get cheated by the wholesale-retail spread because it owns the whole transaction.

Similarly, most fashion retailers have gone upstream and own a meaningful proportion of the brands sold in their stores (called controlled brands, or private label). Retailers like Macy’s and Kohl’s own more than 40% of the fashion brands they sell. Why? By going upstream they can capture more of the value of the product without it getting lost in the transaction between brand owner and retailer. They get everything across the spread because they own both ends.

This is not to say that vertical integration is without risk. I talk about those risks here. But at least if you vertically integrate, you have greater control over pricing and are less likely to be on the losing side of the spread.

3) Be the Broker
One of my favorite movies is Trading Places, a comedy about commodity brokers. Here is a quote from the movie:

Randolph Duke: We are 'commodities brokers', William. Now, what are commodities? Commodities are agricultural products... like coffee that you had for breakfast... wheat, which is used to make bread... pork bellies, which is used to make bacon, which you might find in a 'bacon and lettuce and tomato' sandwich. And then there are other commodities, like frozen orange juice... and GOLD. Though, of course, gold doesn't grow on trees like oranges.
Randolph Duke: Clear so far?
Billy Ray: [nodding, smiling] Yeah.
Randolph Duke: Good, William! Now, some of our clients are speculating that the price of gold will rise in the future. And we have other clients who are speculating that the price of gold will fall. They place their orders with us, and we buy or sell their gold for them.
Mortimer Duke: Tell him the good part.
Randolph Duke: The good part, William, is that, no matter whether our clients make money or lose money, Duke & Duke get the commissions.
Mortimer Duke: Well? What do you think, Valentine?
Billy Ray: Sounds to me like you guys a couple of bookies.
Randolph Duke: [chuckling, patting Billy Ray on the back] I told you he'd understand.

Brokers get their money regardless of the fortunes of those around them. They take their cut from the spread which is there for both good deals and bad. Therefore, if you want to get the spread to work for you, then you have to become more like the broker.

Look at Google. The company appears to make a lot of money from doing a lot of things. But when you boil it down, Google is basically an advertising broker. Pretty much everything else they do is vertical integration into the places where they can control the brokering of ads. Google search is a place for brokering of search ads. Android is a place for brokering of smartphone ads. Driverless cars are a place where the former driver can now look at ads rather than look at the road.

Google avoids a lot of the wholesale-retail spread by owning the company that brokers the ads. The spread goes into the broker’s pocket. Then, by also owning the place where a lot of those ads appear, they cut out the spread between them as well. Google profits from the spread rather than losing to it.

Although we like the idea of buying low and selling high, we are often forced to buy high and sell low due to the wholesale-retail price spread and the use of brokers. There are three strategies you can use minimize these disadvantages. First, you can use a buy-hold-create approach rather than a buy-trade approach to your assets. Second, you can vertically integrate. Third you can become the broker in the transactions.

I did a buy and hold on that wedding ring. My wife and I are still married after more than 35 years.