Seeking Unpredictable Value Creation

18 September 2018 | by Todd Wenning, CFA

Reading old articles about Amazon’s 1997 IPO is predictably amusing. The most common critique of the time was that Amazon’s valuation was absurdly expensive. It was just an online bookstore, the thinking went. Traditional competitors were going to eventually crush it once they figured out how to sell online.

The thing is, these arguments were totally valid at the time. There were decent odds that Amazon would struggle to branch out beyond books. Indeed, Amazon may have been saved by a well-timed convertible bond issuance in early 2000, just before the dotcom bust accelerated.

So what happened?

As Steven Johnson notes in his new book, Farsighted: How We Make the Decisions That Matter the Most, there are three types of “unknowns” we should consider before making any long-term decision:

  • Knowable unknowns: Uncertainties we should be able to identify with available information or experience.
  • Inaccessible unknowns: The information is available, but, for whatever reason, we don’t have access to it.
  • Unknowable unknowns: Uncertainties that result from the inherent unpredictability of the system being analyzed.

When researching a new company, an investor should be able to map out the knowable and inaccessible unknowns. Because they can be mapped, these risks are already priced into the stock in some manner.

However, it’s the third factor – the “unknowable unknowns” – which cannot be fully considered from the outset, that have an enormous impact on the company’s value, both positively and negatively.

Sure, financial commentators in 1997 could have read Bezos’s now-famous 1997 shareholder letter for a sense of where he wanted to take the company. But this was years before Amazon Prime or Amazon Web Services were even on the table. Prime and AWS were two major unknown unknowns that had a positive impact on Amazon’s current valuation. In 1997, neither investors nor perhaps even Bezos could have predicted them.

Unknown unknowns are particularly critical in driving value in intangible asset-dependent businesses. There’s far less “option value” with a tangible factory than there is with a brand, for instance. Consider the following passage from Capitalism Without Capital by Jonathan Haskel and Stian Westlake:

“Intangible investments tend to have synergies…(which) are often unpredictable. The microwave oven was the result of a marriage between a defense contractor, which had accidentally discovered that microwaves from radar equipment could heat food, and a white goods manufacturer, which brought appliance design skills.”

Naturally, luck has a lot to do with it. As with most situations where luck is a factor in outcomes, however, the more skilled operators often find more luck. To illustrate, Joe DiMaggio had a lot of luck during his famous 56-game hitting streak, but the streak sprang from the fact he was one of the best hitters in history. Another way to say this is that good things tend to happen to good companies.

If we went back to 1997 and re-rolled the dice on Amazon, the ultimate outcomes would likely be different. In reading Bezos’s 1997 shareholder letter, however, we can see there were signs that it was creating fertile ground for unpredictable value creation. Namely, the letter showed that Amazon was long-term focused, mission-driven, and had a large market opportunity. These factors alone don’t always lead to unpredictable value creation, but they improve the odds.

Amazon is admittedly a cherry-picked example, but we’ve also seen these factors lead to unpredictable value creation at companies like Google, Apple, and Charles Schwab. These companies were lucky, but they also provided fertile ground for innovation.

By focusing our research on what we consider to be wonderful companies – those that have or are building a moat, are long-term focused, are great places to work, etc. – we think we can increase our odds of benefiting from unpredictable value creation.

 

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Alphabet (GOOGL), Apple (AAPL), and Schwab (SCHW). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

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