The Tsunami Wave

The Tsunami Wave Strategy®
SEARCHING FOR VALUE®

ADAM C. PARRIS
The Promise
A Journey of a thousand miles starts with a single

step.
Chinese Proverb
The promise of this strategy is simple. If you apply the principles and tactics outlined, you
can turn your initial $10,000 dollar investment into $20,000, $50,000 and $100,000, but not
within 6 months, it may take years and the timeframe will depend upon your ability to
execute the strategy.
My aim is to provide you with an extremely practical investment strategy. The order of the
book is loosely in order which will allow you to start at any chapter, without needing to read
the previous chapter. The idea is to allow you to come back at any time to a specific chapter
remember specific parts without reading the whole eBook from the start.
I do not attempt to pass this strategy, the principles or stories, off as my own. I remember
Charlie Munger recommending, in speech a few years ago, to try to catch a wave that is a
find a company like Amazon early, and you only need to catch one or two waves to get
wealthy. So, I created a framework of how this could be done.
I’ve simply applied Isaac Newton’s idea, “If I have seen further than others, it is by standing
upon the shoulders of giants” and then cross pollinating their ideas with new ones. Which is
essentially what Sam Walton, Jeff Bezos and other successful entrepreneurs have done,
which you will read about in the chapter titled Wal-Mart & Amazon: Two Peas in a Pod.
I hope you will take this strategy, apply it, add to it and continually learn more. If you are
just starting out or an experienced investor, I believe this strategy will serve you both well
along your investment journey.
Please Enjoy….
Yours in Investing
Adam C. Parris
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Copyright Searching for Value 2017 - 2018
Chapters
The Promise ............................................................................................................................................ 1
The Tsunami Wave Strategy Explained ................................................................................................... 3
The Founder(s) ........................................................................................................................................ 5
Walmart and Amazon - Two Peas in a Pod. ........................................................................................ 7
“Everybody was singing in the shower and thinking they were great.” Mark Cuban ...................... 38
“The quality of your stock selection will be determined by the quality of your questions” ................ 40
Valuation Techniques............................................................................................................................ 41
Valuation of the Entity ...................................................................................................................... 44
Assessing the Earnings Power Value (EPV) ....................................................................................... 54
Now to the Adjustment of Reported Net Income. ............................................................................... 59
The steps taken to arrive at the distributable cash flow figure. ................................................... 59
Buffett wrote in 1982 the following: ............................................................................................ 62
There is one more step before making a decision to buy. ................................................................... 70
An Extra Founder Story: This quick story stood out to me about Bill Gates from the book Hard Drive:
Bill Gates and the Making of the Microsoft Empire by James Wallace & Jim Erickson. ....................... 72
Sources & Books.................................................................................................................................... 75
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The Tsunami Wave Strategy Explained
Every military strategist worth their weight in gold will tell you that using the same strategy
and tactics to fight different battles will lead to defeat.
Just as the military strategist will use different strategies and tactics to defeat their enemies
based upon the conditions of the battlefield and their enemy capabilities, these same
principles also apply to investing.
A successful investment strategy is executed under specific conditions based upon sound
logic and first principles, and this strategy should complement other investment strategies
in use. Here is a quick overview of the key assumptions of this particular strategy.
The companies that grow fast like Amazon, Google, Wal-Mart, Apple, can be identified early
after listing on a share market. And there are specific external catalysts that help drive share
prices, in addition to the underlying business growth. One of these catalysts is Wall Street
analyst coverage. Wall Street buy-side analysts will generally ignore small capitalization
companies, until they became larger, and as more analysts cover a stock the more attention
the general public give it too.
This and other catalysts can also be used to help identify these early high growth
companies. Another example: before a large hedge-fund (LHF) or Index-Fund (IF) can
purchase shares in a listed company or be added to an index, that company must first
become a specific size in market capitalization (market cap). If the company market cap is
too small the LHFs & IFs cannot purchase them or be added to the index, as LHF & IC have
mandates and size limits on what they can buy or added to the index.
And looking solely at the S&P indexes, there are specific stages and conditions a high growth
company must meet before being added to the S&P 500 index.
For example: Market Cap Size Ranges
1. S&P 600 Small Cap Index: US$ 450 million to US$ 2.1 billion in market cap.
2. S&P 400 Mid Cap index: US$ 1.6 billion to US$ 6.8 billion in market cap.
3. S&P 500 Index: Unadjusted company market capitalization of US$ 6.1 billion or
more.
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There are three tipping points above, to move into the S&P 600 a company must be at a
minimum $450 million in market cap size, and to move up into the S&P 400, the tipping
point is in the range of $1.6 billion - $2.1 billion in market cap. And finally, the tipping point
range to move into the S&P 500 is $6.1 billion.
As a company enters an index, it signals a buy for LHFs, pension funds and so on…creating a
catalyst event, thus driving up the share price as demands increases for its shares.
The reason why LHFs cannot buy small cap stocks is due to their respectable sizes and
mandates set by management. The table below shows the sizes of a single purchase of
shares at different percentage sizes, based upon the industry average.
For example, a small fund with funds of $50 - 100 million under management with a
mandate that no stock shall be no more than 2 percent of total funds under management
(FUM), will spend no more than $1.5 million to purchase a single stocks shares.
Whereas, a large hedge fund with the same mandate will spend $50 million (which is 2
percent of it funds under management to purchase a single stocks shares).
Average Position Size
FUM $$$ 1.00% 2.00% 3.00% 4.00% 5.00% 10% 15% 20% 50%
Small 50-100M $0.8m $1.5m $2.3m $3.0m $3.8m $7.5m $11.3m $15m $37.5m
Small -
100-499M $2.5m $5m $7.5m $10.0m $12.5m $25m $37.5m $50m $125m
Medium
Medium
500-999M $7.5m $15m $22.5m $30m $37.5m $75m $112.5m $150m $375m
- Large
Large 1 - 5 B $25m $50m $75m $100m $125m $250m $375m $500m $1,250m
Table 1: Approx. Hedge Fund Sizes and Average Position Sizing.
Determining an approximate tipping point, rather than an exact tipping point, at which the
LHF’s start piling-in buying shares of a specific stock, which creates the upward momentum
of the share price - like a tsunami wave – is much more efficient and effective.
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The Founder(s)
This particular strategy requires us to focus on the Founder or CEO at the helm of the
company, their characteristics and their actions. Our investment returns are determined by
the future actions of the founder and management.
Here are a few insights William N. Thorndike learnt when he wrote his book The Outsiders:
Eight Unconventional CEOs and Their Radically Rational Blueprint for Success:
“In assessing performance, what matters isn’t the absolute rate of return but the return
relative to peers and the market. You really only need to know three things to evaluate a
CEO’s greatness: the compound annual return to shareholders during his or her tenure and
the return over the same period for peer companies and for the broader market (usually
measured by the S&P 500).”
“CEOs need to do two things well to be successful: run their operations efficiently and
deploy the cash generated by those operations”
“All were first-time chief executives (half not yet forty when they took the job), and all but
one were new to their industries. They were not bound by prior experience or industry
convention, and their collective records show the enormous power of fresh eyes. This
freshness of perspective is an age-old catalyst for innovation across many fields. As a group,
they were deeply independent, generally avoiding communication with Wall Street,
disdaining the use of advisers, and preferring decentralized organizational structures that
self-selected for other independent thinkers.”
“[Henry Singleton] Cash return on capital became the key metric within the company and
was always on our minds.”
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“This single decision underscores a key point across the CEOs in this book: as a group, they
were, at their core, rational and pragmatic, agnostic and clear-eyed. They did not have
ideology. When offered the right price, [Bill] Anders might not have sold his mother, but he
didn’t hesitate to sell his favorite business unit.”
“There is an apparent inverse correlation between the construction of elaborate new

headquarters buildings and investor returns. As an example, over the last ten years, three
media companies—The New York Times Company, IAC, and Time Warner—have all
constructed elaborate, Taj Mahal–like headquarters towers in midtown Manhattan at great
expense. Over that period, none of these companies has made significant share repurchases
or had market-beating returns. In contrast, not one of the outsider CEOs built lavish
headquarters.”
William N. Thorndike
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Walmart and Amazon - Two Peas in a Pod.
Look at the Walmart’s Growth in Net Earnings!
"The secret of successful retailing is to give your customers what they want. And really, if you
think about it from your point of view as a customer, you want everything: a wide
assortment of good-quality merchandise; the lowest possible prices; guaranteed satisfaction
with what you buy; friendly, knowledgeable service; convenient hours; free parking; a
pleasant shopping experience."
- Sam Walton
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Sam Walton Jeff Bezos
You would be forgiven for thinking Jeff Bezo’s said the above quote if the words ‘free
parking’ were left out of the quote. Walmart and Amazon are more alike than they are
different, the main difference is the business model used to serve their customers was
dependant on the technology of the day. Both founders, in the beginning, saw a new
business model that served the customer in a more efficient and effective manner than
what was being used at the time.
”The most important single thing is to focus obsessively on the customer. Our goal is to be
earth’s most customer-centric company…with the world’s biggest selection.”
- Jeff Bezos
“If there’s one reason we have done better than of our peers in the Internet space over the
last six years, it is because we have focused like a laser on customer experience, and that
really does matter, I think, in any business. It certainly matters online, where word-of-
mouth is so very, very powerful.”
- Jeff Bezos
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Two founders with new concepts who changed retailing forever.
Starting On a Dime1.
Sam Walton (founder of Wal-Mart) decided while serving his time in the Army, that he
wanted to go into retailing when he time was up, so he studied the Mormon Church
department store ZCMI and read every book in the town’s library about retailing while he
was off duty. Sam did worked in a J.C Penny store as a salesmen before his time in the Army.
Then in 1945, after leaving the Army, Sam weighed up his options, initialling wanting to go
into business partnership with a friend in St. Louis but Sam’s wife Helen put her foot down
and said she was not willing to live in a city with a population over 10,000 people and no
business partnerships – her father was a lawyer who saw a few partnerships go sour – so
they ventured to Newport Arkansas, a cotton and railroad town of about 7,000 people, in
the Mississippi River Delta country of eastern Arkansas, to speak with a guy who wanted to
sell his Ben Franklin store. Sam purchased the Ben Franklin variety store [franchise] for
$25,000 and had no experience running a variety store. [This would turn out to be a blessing
having no experience, as other highly successful entrepreneurs have too proven over
time]And as Sam wrote in his biography “It was a real blessing for me to be so green and
ignorant, because it was from that experience that I learned a lesson which has stuck with
me all through the years: you can learn from everybody. I didn’t just learn from reading
every retail publication I could get my hands on, I probably learned the most from studying
what John Dunham was doing across the street.”
Helen Walton:
“It turned out there was a lot to learn about running a store. And, of course, what really
drove Sam was that competition across the street - John Dunham over at the Sterling Store.
Sam was always over there checking on John. Always. Looking at his prices, looking at his
displays, looking for a way to do a better job. I don’t remember the details, but I remember
some kind of panty price war they got into. Later on, long after we had left Newport, and
John had retired, we would see him and he would laugh about Sam always being in his
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Chapter title of Sam Waltons Book: Sam Walton: Made in America.
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store. But I’m sure it aggravated him quite a bit early on. John never had good competition
before Sam.”
The Ben Franklin franchise did teach Sam the operating systems including accounting
practices – profit and loss statement, accounts-payable sheets and so on. “I had no previous
experience in accounting-and I wasn’t all that great at accounting in college - so I just did it
according to their book. In fact I used their accounting system long after I’d started breaking
their rules on everything else. I even used it for the first five or six Wal-Marts.” Sam
The Ben Franklin franchise model operated much the same as many franchises operate
today. Sam who owned the franchise rights to his Ben Franklin store had to purchase
inventory through head office (the Butler Brothers in Sam’s case) who would buy direct
from manufacturers and then marked it up 25% before selling to Sam, Sam would mark it up
again according to the Ben Franklin Franchise program guide. If Sam did it by the book he
would earn 6 or 7% net profit at years end.
“In the beginning, I went along and ran my store by their book because I really didn’t know
any better. But it didn’t take me long to start experimenting – that’s just the way I am and
always have been. Pretty soon I was laying on promotional programs of my own, and then
started buying merchandising directly from manufacturers. Most of the time they didn’t
want to make Butler Brothers mad so they turned me down. That was the start of a lot of
practices and philosophies that still prevail at Wal-Mart today [1992]. I was always looking
for offbeat suppliers or sources.” Sam
Harry Weiner was one of those sources Sam found, Harry acted as a manufacturer’s agent
by collecting the pricing of all manufacturers and only charged a 5% mark-up, which was a
lot better than 25% the Butler Brothers were charging. As you could imagine, Amazon is
effectively an agent between manufacturers and consumers but over the internet.
“I’ll never forget one of Harry’s deals, one the best items I ever had and early lesson in
pricing. It first got me thinking in the direction of what eventually became the foundation of
Wal-Mart’s philosophy. Harry was selling ladies’ panties-two-barred, tricot satin panties
with an elastic waist-for $2.00 a dozen. We’d been buying similar panties from Ben Franklin
for $2.50 a dozen and selling them at three pair for $1.00. Well, at Harry’s price of $2.00, we
could put them out at four for $1.00 and make a great promotion for our store. Here is the
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simple lesson we learned-which others were learning at the same time and which eventually
changed the way retailers sell and customers buy all across America: say I brought an item
for 80 cents. I found by pricing it at $1.00 I could sell three times more of it than pricing it at
$1.20. I might make only half the profit per item, but I was selling three times as many, the
overall profit was much greater. Simple enough. But this is really the essence of discounting:
cutting your price, you can boost your sales to a point where you can earn far more at the
cheaper retails price than you would have by selling the item at the higher price. In retailer
language, you can lower your mark-up but earn more because of the increase volume.
Sam had found out that the department store next to his competitor John’s store was
coming up for lease and that John had planned to expand in there. So Sam tracked down the
landlord and convinced her to lease it out to him. Sam called it Eagle store.
“The Newport store was really the beginning of where Wal-Mart is today [1992]. We did
everything it took to run a store. We kept expenses to a minimum. That is where it started
all those years ago. Our money was made by controlling expenses. That, and Sam always
being ingenious. He never stopped trying to do things different.” Bud Walton (Sam’s
Brother)
By now Sam had spent five years in Newport, the Ben Franklin Store was doing about
$250,000 in sales compared to $72,000 in sales the year before Sam purchased it, and
turning $30,000 to $40,000 in profit. But a legal mistake at the beginning resulted in Sam
having to sell the business to his landlord, because Sam neglected to include a clause in the
lease to give him the option to renew after the first five years. The success he created
attracted of his landlord who decided not to renew the lease-at any price-knowing full well
that Sam had nowhere else in town to move store. So Sam sold the store to the landlord’s
son.
It was 1950 and with $50,000 dollars in Sam’s pocket from the sale of the Ben Franklin’s
store, Sam and Helen left Newport and arrived in Bentonville, northwest Arkansas.
Bentonville contained three variety stores but it didn’t deter Sam, he was up for the
challenge. So Sam opened a Walton’s Five & Dime.
A whole new concept had started in two other Ben Franklin stores Sam read about, it was
the introduction of self-service, it is a strange concept to us now, back then customers went
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to the counter and told the sales person what they wanted and the staff would go off to
collect items for you. But when Sam opened the first Wal-Mart in Bentonville it was the
third variety store in the U.S. to adopt self-service.
By 1952, Sam had opened the second Walton’s Five and Dime in Fayetteville, they had two
dominant competitors Woolworths and a Scott Store, but Sam was undaunted as his new
store modelled on the Bentonville store was open and self-service but this was just the
beginning of operating, and competitors waited a long time before switching.
It wasn’t until 1962 and Sam was 44 years of age when he opened his first Wal-Mart.
“In those days, word was starting to get out that a guy named Sam Walton had some
interesting retailing ideas, so I drove down from Springfield, where I was with Crank Drugs
at the time, to see a Wal-Mart opening. It was the worst retail store I had ever seen. Sam
brought a couple of trucks of watermelons in and stacked them on the sidewalk. He had a
donkey ride out in the parking lot. It was 115 degrees, and the watermelons began to pop,
and the donkey began to do what donkeys do, and it all mixed together and ran all over the
parking lot. And when you went inside the store, the mess just continued, having been
tracked in all over the floor. He was a nice fellow. But I wrote him off. It was just terrible.”
David Glass CEO of Wal-Mart 1988 – 2000.
From the very first Wal-Mart store Sam was determined to deliver real discounting and Sam
said “We want to discount everything we carry.” This was a new store concept at the time,
and even Sam’s close brother Bud was sceptical of the whole new concept and Sam said,
“They thought Wal-Mart was just another one of Sam Walton’s crazy ideas [but] I knew we
were on to something. I knew it in my bones it was going to work.”
Sam was right about his intuition2, because he was simply combining several different ideas
he used very effectively in his Ben Franklin stores – Discounting: buying direct from
2
Intuition: Dr Daniel Kahneman said “Similarly for expertise and intuition, you have to ask not how happy the
individual is with his or her own intuitions, but first of all, you have to ask about the domain. Is the domain one
where there is enough regularity to support intuitions? That's true in some medical domains, it certainly is
true in chess, it is probably not true in stock picking, and so there are domains in which intuition can develop
and others in which it cannot. Dr Herbert A. Simon (Polymath) wrote in detail, in his 1997 book ‘Administrative
Behaviour’ about intuition, that backs up Daniel Kahneman’ s observations. Don’t believe anyone who say’s
they intuitively know how stock prices will move, they are delusional! And that’s technical analysis in a nut
shell.
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manufacturers to pass on the lowest price to consumers. Moving from a semi-niche store to
an ‘everything’ store: creating a one-stop shop of low priced products. And finally the new
self-service concept: Allowing customers to roam the store selecting their own products.
The House of Quants3
“Before it was the self-proclaimed largest bookstore on Earth or the Web’s dominant
superstore, Amazon.com was an idea floating through New York City offices of one of the
most unusual firms on Wall Street: D.E. Shaw & Co.” Brad Stone
Tim, Julie Ray wrote in her book Turning On Bright Minds: A Parent Looks at Gifted
Education in Texas, was “a student of general intellectual excellence, slight of build,
friendly but serious.” He was “not particularly gifted in leadership,” according to his
teachers, but he moved confidently among his peers and articulately extolled the
virtues of the novel he was reading at the time, J. R. R. Tolkien’s The Hobbit.
Tim, twelve, was already competitive. He told Ray he was reading a variety of books
to qualify for a special reader’s certificate but compared himself unfavorably to
another classmate who claimed, improbably, that she was reading a dozen books a
week. Tim also showed Ray a science project he was working on called an infinity
cube, a battery-powered contraption with rotating mirrors that created the optical
illusion of an endless tunnel. Tim modeled the device after one he had seen in a
store. That one cost twenty-two dollars, but “mine was cheaper,” he told Ray.
Teachers said that three of Tim’s projects were being entered in a local science
competition that drew most of its submissions from students in junior and senior
high schools.
The school faculty praised Tim’s ingenuity, but one can imagine they were wary of
his intellect. To practice tabulating statistics for math class, Tim had developed a
survey to evaluate the sixth-grade teachers. The goal, he said, was to assess
instructors on “how they teach, not as a popularity contest.” He administered the
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Chapter title of Brad Stone’s book: ‘The Everything Store’
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survey to classmates and at the time of the tour was in the process of calculating the
results and graphing the relative performance of each teacher.
Tim’s average day, as Ray described it, was packed. He woke early and caught a
seven o’clock bus a block from home. He arrived at school after a twenty-mile ride
and went through a blaze of classes devoted to math, reading, physical education,
science, Spanish, and art. There was time reserved for individual projects and small
group discussions. In one lesson Julie Ray described, seven students, including Tim,
sat in a tight circle in the principal’s office for an exercise called productive thinking.
They were given brief stories to read quietly to themselves and then discuss. The
first story involved archaeologists who returned after an expedition and announced
they had discovered a cache of precious artefacts, a claim that later turned out to be
fraudulent.
Ray recorded snippets of the ensuing dialogue: “They probably wanted to become
famous. They wished away the things they didn’t want to face.” “Some people go
through life thinking like they always have.” “You should be patient. Analyze what
you have to work with.” Tim told Julie Ray that he loved these exercises. “The way
the world is, you know, someone could tell you to press the button. You have to be
able to think what you’re doing for yourself.”
More than thirty years later, I [Brad Stone] found a copy in the Houston Public
Library. I also tracked down Julie Ray, who now lives in Central Texas and works on
planning and communications for environmental and cultural causes. She said she
had watched Tim’s rise to fame and fortune over the past two decades with
admiration and amazement but without much surprise.
“When I met him as a young boy, his ability was obvious, and it was being nurtured
and encouraged by the new program,” she says. “The program also benefited by his
responsiveness and enthusiasm for learning. It was a total validation of the concept.”
She recalls what one teacher said all those years ago when Ray asked her to estimate
the grade level the boy was performing at. “I really can’t say,” the teacher replied.
“Except that there is probably no limit to what he can do, given a little guidance.”
Tim’s real name was Jeff Bezos.
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D.E. Shaw & Co (DESCO) as Stone describes in his book, David E. Shaw, ‘pioneered the use of
computers and sophisticated mathematical formulas to exploit anomalous patterns in global
financial markets. When the price of a stock in Europe was fractionally higher than the price
of the same stock in the United States, for example, the computer jockeys turned Wall
Street warriors at DESCO would write software to quickly execute trades and exploit the
disparity.’
In the fall of 1991, Jeff Bezos who one of the youngest vice presidents at the firm had just
turned 29, was five foot eight inches tall, already balding and with the pasty, rumpled
appearance of a committed workaholic. He had spent seven years on Wall Street and
impressed seemingly everyone he encountered with his keen intellect and boundless
determination. Upon graduating from Princeton in 1986, Bezos worked for a pair of
Columbia professors at a company called Fitel that was developing a private transatlantic
computer network for stock traders. Graciela Chichilnisky, one of the cofounders and
Bezos’s boss, remembers him as a capable and upbeat employee who worked tirelessly and
at different times managed the firm’s operations in London and Tokyo. “He was not
concerned about what other people were thinking,” Chichilnisky says. “When you gave him
a good solid intellectual issue, he would just chew on it and get it done.” Stone
Stone recounts an observation by Halsey Minor, who went on to create the online news
network CNET, remembering that Bezos had closely studied several wealthy businessmen
and that he particularly admired a man named Frank Meeks, a Virginia entrepreneur who
had made a fortune owning Domino’s Pizza franchises. Bezos also revered pioneering
computer scientist Alan Kay and often quoted his observation that “point of view is worth
80 IQ points”—a reminder that looking at things in new ways can enhance one’s
understanding. “He went to school on everybody,” Minor says. “I don’t think there was
anybody Jeff knew that he didn’t walk away from with whatever lessons he could.”
Other Bezos unique characteristics were; At DESCO, Bezos displayed many of the
idiosyncratic qualities his employees would later observe at Amazon. He was disciplined and
precise, constantly recording ideas in a notebook he carried with him, as if they might float
out of his mind if he didn’t jot them down. He quickly abandoned old notions and embraced
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new ones when better options presented themselves. Bezos thought analytically about
everything, including social situations.
Single at the time, he started taking ballroom-dance classes, calculating that it would
increase his exposure to what he called n+ women. He later famously admitted to thinking
about how to increase his “women flow,” a Wall Street corollary to deal flow, the number of
new opportunities a banker can access. Jeff Holden, who worked for Bezos first at D. E.
Shaw & Co. and later at Amazon, says he was “the most introspective guy I ever met. He was
very methodical about everything in his life.”
While the rest of Wall Street saw D. E. Shaw as a highly secretive hedge fund, the firm
viewed itself somewhat differently. In David Shaw’s estimation, the company wasn’t really a
hedge fund but a versatile technology laboratory full of innovators and talented engineers
who could apply computer science to a variety of different problems.
In early 1994, several prescient business plans emerged from the discussions between Bezos
and Shaw and others at D. E. Shaw. One was the concept of a free, advertising-supported e-
mail service for consumers—the idea behind Gmail and Yahoo Mail. DESCO would develop
that idea into a company called Juno, which went public in 1999 and soon after merged with
NetZero, a rival.
Another idea was to create a new kind of financial service that allowed Internet users to
trade stocks and bonds online. In 1995 Shaw turned that into a subsidiary called FarSight
Financial Services, a precursor to companies like E-Trade. He later sold it to Merrill Lynch.
Shaw and Bezos discussed another idea as well. They called it “the everything store.”
Several executives who worked at DESCO at that time say the idea of “the everything store”
was simple: an Internet company that served as the intermediary between customers and
manufacturers and sold nearly every type of product, all over the world (Just like Harry
Weiner, who was one of those manufacturer’s agent Sam Walton used to source cheaper
merchandise from). One important element in the early vision was that customers could
leave written evaluations of any product, a more egalitarian and credible version of the old
Montgomery Ward catalog reviews of its own suppliers. Shaw himself confirmed the
Internet-store concept when he told the New York Times Magazine in 1999, “The idea was
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always that someone would be allowed to make a profit as an intermediary. The key
question is: Who will get to be that middleman?”
Bezos intrigued by Shaw’s conviction about the internet, he started researching its growth
and in one particular monthly newsletter, by John Quarterman called Matrix News, he
outlined the growth numbers at the time.
And Stone wrote: “In one chart, he showed that the number of bytes—a set of binary
digits—transmitted over the Web had increased by a factor of 2,057 between January 1993
and January 1994. Another graphic showed the number of packets—a single unit of data—
sent over the Web had jumped by 2,560 in the same span. Bezos interpolated from this that
Web activity overall had gone up that year by a factor of roughly 2,300—a 230,000 percent
increase. “Things just don’t grow that fast,” Bezos later said. “It’s highly unusual, and that
started me thinking, what kind of business plan might make sense in the context of that
growth?”
Bezos concluded that a true everything store would be impractical—at least at the
beginning. He made a list of twenty possible product categories, including computer
software, office supplies, apparel, and music. The category that eventually jumped out at
him as the best option was books.
They were pure commodities; a copy of a book in one store was identical to the same book
carried in another, so buyers always knew what they were getting. There were two primary
distributors of books at that time, Ingram and Baker and Taylor, so a new retailer wouldn’t
have to approach each of the thousands of book publishers individually. And, most
important, there were three million books in print worldwide, far more than a Barnes &
Noble or a Borders superstore could ever stock. If he couldn’t build a true everything store
right away, he could capture its essence—unlimited selection—in at least one important
product category. “With that huge diversity of products you could build a store online that
simply could not exist in any other way,” Bezos said. “You could build a true superstore with
exhaustive selection, and customers value selection.”
In his offices on the fortieth floor of 120 West Forty-Fifth Street, Bezos could hardly contain
his enthusiasm. With DESCO’s recruiting chief, Charles Ardai, he investigated some of the
earliest online bookstore websites, such as Book Stacks Unlimited, located in Cleveland,
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Ohio, and WordsWorth, in Cambridge, Massachusetts. Ardai still has the record from one
purchase they made while testing these early sites. He bought a copy of Isaac Asimov’s
Cyberdreams from the website of the Future Fantasy bookstore in Palo Alto, California. The
price was $6.04. When the book appeared, two weeks later, Ardai ripped open the
cardboard package and showed it to Bezos. It had become badly tattered in transit. No one
had yet figured out how to do a good job selling books over the Internet. As Bezos saw it,
this was a huge, untapped opportunity.
Stone goes on to explain that Bezos wanted to have complete control over the company and
its financial rewards, which would not occur if the company was started in DESCO, he knew
he had to leave his lucrative and comfortable job on Wall Street.
What happened next became one of the founding legends of the Internet. That spring,
Bezos spoke to David Shaw and told him he planned to leave the company to create an
online bookstore. Shaw suggested they take a walk. They wandered in Central Park for two
hours, discussing the venture and the entrepreneurial drive. Shaw said he understood
Bezos’s impulse and sympathized with it—he had done the same thing when he’d left
Morgan Stanley. He also noted that D. E. Shaw was growing quickly and that Bezos already
had a great job. He told Bezos that the firm might end up competing with his new venture.
The two agreed that Bezos would spend a few days thinking about it.
During the few days of thinking, Bezos had just finished reading the novel Remains of the
Day, by Kazuo Ishiguro, about a butler who wistfully recalls his personal and professional
choices during a career in service in wartime Great Britain. “Looking back on life’s junctures
was on Bezo’s mind when he came up with what he called “the regret-minimization
framework”
“When you are in the thick of things, you can get confused by small stuff,” Bezos said a few
years later. “I knew when I was eighty that I would never, for example, think about why I
walked away from my 1994 Wall Street bonus right in the middle of the year at the worst
possible time. That kind of thing just isn’t something you worry about when you’re eighty
years old. At the same time, I knew that I might sincerely regret not having participated in
this thing called the Internet that I thought was going to be a revolutionizing event. When I
thought about it that way … it was incredibly easy to make the decision.”
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Later it was revealed that Bezos seemed to keep his ambitions and plans very close to the
vest, not revealing much even to Kaphan. When his goals did slip out, they were improbably
grandiose. Though the startup’s focus was clearly on books, Davis recalls Bezos saying he
wanted to build “the next Sears,” a lasting company that was a major force in retail.
Once Bezos made the decision to go, he and his wife headed for Seattle. Bezo originally
wanted to call Amazon – Cadabra Inc. But as Todd Tarbert, Bezos’s first lawyer, pointed out
before they registered that name with Washington State in July of 1994, it was too obscure,
and over the phone, people tended to hear the name as Cadaver.
Stone points out that: “Bezos chose to start his company in Seattle because of the city’s
reputation as a technology hub and because the state of Washington had a relatively small
population (compared to California, New York, and Texas), which meant that Amazon would
have to collect state sales tax from only a minor percentage of customers. While the area
was still a remote urban outpost known more for its grunge rock than its business
community, Microsoft was hitting its stride in nearby Redmond, and the University of
Washington produced a steady stream of computer science graduates. Seattle was also
close to one of the two big book distributors: Ingram had a warehouse a six-hour drive
away, in Roseburg, Oregon. And local businessman Nick Hanauer, whom Bezos had recently
met through a friend, lived there and urged Bezos to give Seattle a try. He would later be
pivotal in introducing Bezos to potential investors.”
They set up shop in the converted garage of Bezos’s house, an enclosed space without
insulation and with a large, black potbellied stove at its center. Bezos built the first two
desks out of sixty-dollar blond-wood doors from Home Depot, an endeavor that later carried
almost biblical significance at Amazon, like Noah building the ark. In late September, Bezos
drove down to Portland, Oregon, to take a four-day course on bookselling sponsored by the
American Booksellers Association, a trade organization for independent bookstores. The
seminar covered such topics as “Selecting Opening Inventory” and “Inventory
Management.” At the same time, Shel Kaphan (founding employee) started looking for
computers and databases and learning how to code a website—in those days, everything on
the Internet had to be custom built. It was all done on a threadbare budget. At first Bezos
backed the company himself with $10,000 in cash, and over the next sixteen months, he
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would finance the startup with an additional $84,000 in interest-free loans, according to
public documents.
“The whole thing seemed pretty iffy at that stage,” says Kaphan, who some consider an
Amazon cofounder. “There wasn’t really anything except for a guy with a barking laugh
building desks out of doors in his converted garage, just like he’d seen in my Santa Cruz
home office. I was taking a big risk by moving and accepting a low salary and so even though
I had some savings, I didn’t feel comfortable committing more than I did.”
In early 1995, Bezos’s parents, Jackie and Mike Bezos, invested $100,000 in Amazon. “We
saw the business plan, but all of that went over our heads to a large extent,” says Mike
Bezos. “As corny as it sounds, we were betting on Jeff.” Bezos told his parents there was a
70 percent chance they could lose it all. “I want you to know what the risks are, because I
still want to come home for Thanksgiving if this doesn’t work,” he said.
One of their driving goals was to create something superior to the existing online
bookstores, including Books.com, the website of the Cleveland-based bookstore Book Stacks
Unlimited. “As crazy as it might sound, it did appear that the first challenge was to do
something better than these other guys,” Davis says (Paul Davis, a British-born programmer
who had been on staff at the University of Washington’s computer science and engineering
department). “There was competition already. It wasn’t as if Jeff was coming up with
something completely new.” (As Discussed about Wal-Mart, Bezos wasn’t creating new
concepts, he like Sam Walton, were cross-pollinating new concepts with current proven
ideas).
But in late October of 1994, Bezos pored through the A section of the dictionary and had an
epiphany when he reached the word Amazon. Earth’s largest river; Earth’s largest
bookstore. He walked into the garage one morning and informed his colleagues of the
company’s new name. He gave the impression that he didn’t care to hear anyone’s opinion
on it, and he registered the new URL on November 1, 1994. “This is not only the largest river
in the world, it’s many times larger than the next biggest river. It blows all other rivers
away,” Bezos said.
In the spring of 1995, Bezos and Kaphan sent links to the beta website to a few dozen
friends, family members, and former colleagues. The site was bare, crammed with text and
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tuned to the rudimentary browsers and slowpoke Internet connections of the time. “One
million titles, consistently low prices,” that first home page announced in blue underlined
text. Next to that was the amateurishly illustrated logo: a giant A set against a marbled blue
background with the image of a river snaking through the letter. The site seemed uninviting
to literate people who had spent their lives happily browsing the shelves of bookstores and
libraries. “I remember thinking that it was very improbable that people would ever want to
do this,” says Susan Benson, whose husband, Eric, was a former colleague of Kaphan’s. Both
would become early employees at Amazon. Kaphan invited a former coworker, John
Wainwright, to try the service, and Wainwright is credited with making the very first
purchase: Fluid Concepts and Creative Analogies, a science book by Douglas Hofstadter. His
Amazon account history records the date of that inaugural order as April 3, 1995. Today, a
building on Amazon’s Seattle’s campus is named Wainwright.
While the site wasn’t much to look at, Kaphan and Davis had accomplished a lot on it in just
a few months. There was a virtual shopping basket, a safe way to enter credit card numbers
into a Web browser, and a rudimentary search engine that scoured a catalog drawn from
the Books in Print CD-ROMs, a reference source published by R. R. Bowker, the provider of
the standard identifying ISBN numbers for books in the United States. Kaphan and Davis also
developed a system that allowed users of early online services like Prodigy and AOL to get
information on books and place orders via e-mail alone—though that was never rolled out.
These were all state-of-the-art developments during the gritty initial days of the Web, a
time when tools were primitive and techniques were constantly evolving. The HTML
standard itself, the lingua franca of the Web, was barely half a decade old, and modern
languages like JavaScript and AJAX were years away. Amazon’s first engineers coded in a
computer language called C and decided to store the website in an off-the-shelf database
called Berkeley DB that had never seen the levels of traffic to which it would soon be
exposed. Each order during those early months brought a thrill to Amazon’s employees.
When someone made a purchase, a bell would ring on Amazon’s computers, and everyone
in the office would gather around to see if anyone knew the customer. (It was only a few
weeks before it started ringing so often that they had to turn it off.) Amazon would then
order the book from one of the two major book distributors, paying the standard wholesale
rate of 50 percent off the list price (the advertised price printed on the book jacket). There
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was little science to Amazon’s earliest distribution methods. The company held no inventory
itself at first. When a customer bought a book, Amazon ordered it, the book would arrive
within a few days, and Amazon would store it in the basement and then ship it off to the
customer. It took Amazon a week to deliver most items to customers, and it could take
several weeks or more than a month for scarcer titles.
Even back then, Amazon was making only a slender profit on most sales. It offered up to 40
percent off the list price on bestsellers and books that were included in Spotlight, an early
feature on the website that highlighted new titles each day. The company offered 10
percent off the list price on other books; it also charged shipping fees starting at $3.95 for
single-book orders. One early challenge was that the book distributors required retailers to
order ten books at a time. Amazon didn’t yet have that kind of sales volume, and Bezos later
enjoyed telling the story of how he got around it. “We found a loophole,” he said. “Their
systems were programmed in such a way that you didn’t have to receive ten books, you only
had to order ten books. So we found an obscure book about lichens that they had in their
system but was out of stock. We began ordering the one book we wanted and nine copies of
the lichen book. They would ship out the book we needed and a note that said, ‘Sorry, but
we’re out of the lichen book.’ ”
Bezos believed that if Amazon.com had more user-generated book reviews than any other
site, it would give the company a huge advantage; customers would be less inclined to go to
other online bookstores. They had discussed whether such unfiltered user-generated
content could get the company in trouble. Bezos decided to watch reviews closely for
offensive material rather than read everything before it was published.
Naturally, some of the reviews were negative. In speeches, Bezos later recalled getting an
angry letter from an executive at a book publisher implying that Bezos didn’t understand
that his business was to sell books, not trash them. “We saw it very differently,” Bezos said.
“When I read that letter, I thought, we don’t make money when we sell things. We make
money when we help customers make purchase decisions.”
The site went live on July 16, 1995, and became visible to all Web users. And as word
spread, the small Amazon team saw almost immediately that they had opened a strange
window onto human behavior. The Internet’s early adopters ordered computer manuals,
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Dilbert comic collections, books on repairing antique musical instruments—and sex guides.
(The bestseller on Amazon.com from that first year: How to Set Up and Maintain a World
Wide Web Site: The Guide for Information Providers, by Lincoln D. Stein.) There were orders
from U.S. troops overseas and from an individual in Ohio who wrote to say he lived fifty
miles away from the nearest bookstore and that Amazon.com was a godsend. Someone
from the European Southern Observatory in Chile ordered a Carl Sagan book—apparently as
a test—and after the order was successful, the customer placed a second order for several
dozen copies of the same book. Amazon was getting one of the first glimpses of the “long
tail”—the large number of esoteric items that appeal to relatively few people.
No one had been hired yet to pack books, so when volumes rose and the company fell
behind on shipping, Bezos, Kaphan, and the others would descend to the basement at night
to assemble customer orders. The next day, Bezos, MacKenzie, or an employee would drive
the boxes to UPS or the post office.
Bezos tapped Nicholas Lovejoy, a former D. E. Shaw employee who had left the hedge fund
to teach high-school math in Seattle, to assist with recruiting and told him to go hire the
smartest people he knew—just like David Shaw, Bezos wanted all of his employees to be
high-IQ brainiacs.
Bezos felt that hiring only the best and brightest was key to Amazon’s success. For years he
interviewed all potential hires himself and asked them for their SAT scores. “Every time we
hire someone, he or she should raise the bar for the next hire, so that the overall talent pool
is always improving,” he said, a recurring Jeffism. That approach caused plenty of friction. As
Amazon grew, it badly needed additional manpower, and early employees eagerly
recommended their friends, many of whom were as accomplished as they were. Bezos
interrogated the applicants, lobbing the kind of improbable questions that were once asked
at D. E. Shaw, like “How many gas stations are in the United States?” It was a test to
measure the quality of a candidate’s thinking; Bezos wasn’t looking for the correct answer,
only for the individual to demonstrate creativity by coming up with a sound way to derive a
possible solution. And if the potential employees made the mistake of talking about wanting
a harmonious balance between work and home life, Bezos rejected them.
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Taking a sip from the fire hose
The first week after the official launch, they took $12,000 in orders and shipped $846 worth
of books, according to Eric Dillon, one of Amazon’s original investors. The next week they
took $14,000 in orders and shipped $7,000 worth of books. So they were behind from the
get-go and scrambling to catch up.
A week after the launch, Jerry Yang and David Filo, Stanford graduate students, wrote them
an e-mail and asked if they would like to be featured on a site called Yahoo that listed cool
things on the Web. At that time, Yahoo was one of the most highly trafficked sites on the
Web and the default home page for many of the Internet’s earliest users. Bezos and his
employees had of course heard of Yahoo and they sat around eating Chinese food that night
and discussing whether they were ready for a wave of new business when they were
already drowning in orders. Kaphan thought that it might be like “taking a sip through a fire
hose.”7 But they decided to do it, and within the first month of their launch they had sold
books to people in all fifty states and in forty-five countries. Every day the number of orders
increased, and the tendrils of chaos—the company’s constant antagonist over the next
several years—began to tighten around the young startup. Bezos insisted that Amazon had
to have a customer-friendly thirty-day-return policy, but it had no processes in place to
handle returns; it had a line of credit but would regularly max out its account, and
MacKenzie would then have to walk down the street to the bank and write a check to
reopen it.
Capital Injection & Expansion
On August 9, 1995, Netscape Communications, the corporate descendant of the pioneering

Mosaic Web browser, went public. On the first day, its stock jumped from an initial price of
$28 per share to $75, and the eyes of the world opened to the gathering phenomenon that
was the World Wide Web. While he and his employees worked exceedingly long days, Bezos
was always thinking about raising money. That summer the Bezos family, using the Gise
family trust (Gise was Jackie’s maiden name), invested another $145,000 in Amazon.9 But
the company couldn’t continue hiring and growing on the Bezos family savings alone. That
summer, Nick Hanauer, a garrulous fixture of the Seattle business community whose father
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had started a successful pillow manufacturing company, helped to line up pitch meetings for
Bezos. He canvassed sixty potential investors, seeking to raise $1 million from individual
contributions of $50,000 each.
In the meetings, Bezos presented what was, at best, an ambiguous picture of Amazon’s
future. At the time, it had about $139,000 in assets, $69,000 of which was in cash. The
company had lost $52,000 in 1994 and was on track to lose another $300,000 that year.
Against that meagre start, Bezos would tell investors he projected $74 million in sales by
2000 if things went moderately well, and $114 million in sales if they went much better than
expected. (Actual net sales in 2000: $1.64 billion.) Bezos also predicted the company would
be moderately profitable by that time (net loss in 2000: $1.4 billion). He wanted to value the
fledgling firm at $6 million—an aggressive valuation that he had seemingly picked out of
thin air. And he told investors the same thing he told his parents: the company had a 70
percent chance of failing. Though they could not have known it, investors were looking at
the opportunity of a lifetime. This highly driven, articulate young man talked with conviction
about the Internet’s potential to deliver a more convenient shopping experience than
crowded big-box stores where the staff routinely ignored customers. He predicted the
company’s eventual ability to personalize a version of the website for each shopper based
on his or her previous purchases. And he prophesied what must have seemed like a radical
future: that everyone would one day use the Internet at high speeds, not over screeching
dial-up modems, and that the infinite shelf space of the Web would enable the fulfillment of
the merchandiser’s dream of the everything store—a store with infinite selection.
After speaking with dozens of investors trying to raise money for Amazon, Bezos would later
remark to the online journal of the Wharton School, “We got the normal comments from
well-meaning people who basically didn’t believe the business plan; they just didn’t think it
would work.” Among the concerns was this prediction: “If you’re successful, you’re going to
need a warehouse the size of the Library of Congress,” one investor told him.
By the first weeks of 1996, revenues were growing 30 to 40 percent a month, a frenzied rate
that undermined attempts at planning and required such a dizzying pace that employees
later found gaps in their memory when they tried to recall this formative time. No one had
any idea how to deal with that kind of growth, so they all made it up as they went along.
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In 1996, the company launched what could be considered its first big innovation: allowing
other websites to collect a fee when they sent customers directly to Amazon to buy a book.
Amazon gave these approved sites an 8 percent commission for the referral. The Associates
program wasn’t exactly the first of its kind, but it was the most prominent and it helped
spawn a multibillion-dollar-a-year industry called affiliate marketing. It also allowed
Amazon, very early on, to extend its reach across the Web to other sites, entrenching it in
advance of the looming competition.
John Doerr, a prominent partner at the storied Silicon Valley venture-capital firm Kleiner
Perkins Caufield and Byers, heard about the company and flew up to Seattle for a visit.
Doerr went on to invest $8 million in Amazon and acquired a 13% stake. Valuing Amazon at
$60 million.
In the circuitry of Bezos’s brain, something then flipped. Budding optimism about the
Internet in Silicon Valley was creating a unique environment for raising money at a
historically low price in ownership. Doerr’s optimism about the Web mixed with Bezos’s
own bullish fervor and sparked an explosion of ambitions and expansion plans. Bezos was
going to do more than establish an online bookstore; now he was set on building one of the
first lasting Internet companies. “Jeff was always an expansive thinker, but access to capital
was an enabler,” Doerr says. James Marcus, an editorial employee, saw it too, writing in his
2004 memoir Amazonia that “the cash from Kleiner Perkins hit the place like a dose of
entrepreneurial steroids, making Jeff more determined than ever.”
Employees soon learned of a new motto: Get Big Fast. The bigger the company got, Bezos
explained, the lower the prices it could exact from Ingram and Baker and Taylor, the book
wholesalers, and the more distribution capacity it could afford. And the quicker the
company grew, the more territory it could capture in what was becoming the race to
establish new brands on the digital frontier. Bezos preached urgency: the company that got
the lead now would likely keep it, and it could then use that lead to build a superior service
for customers.
The company then focused on customizing the site for each visitor, just as Bezos had
promised his original investors it would. Its first attempt relied on software developed by a
firm called Firefly Network, an offshoot of the MIT Media Lab. The feature, which Amazon
26
called Bookmatch, required customers to rate a few dozen books and then generated
recommendations based on their tastes. The system was slow and crashed frequently, and
Amazon found that customers were reluctant to go through the extra effort of evaluating
books. So Bezos suggested that the personalization team develop a much simpler system,
one that made recommendations based on books that customers had already bought. Eric
Benson took about two weeks to construct a preliminary version that grouped together
customers who had similar purchasing histories and then found books that appealed to the
people in each group.
That feature, called Similarities, immediately yielded a noticeable uptick in sales and
allowed Amazon to point customers toward books that they might not otherwise have
found. Greg Linden, an engineer who worked on the project, recalls Bezos coming into his
office, getting down on his hands and knees, and joking, “I’m not worthy.” Similarities
eventually displaced Bookmatch and became the seed that would grow into Amazon’s
formidable personalization effort. Bezos believed that this would be one of the
insurmountable advantages of e-commerce over its brick-and-mortar counterparts. “Great
merchants have never had the opportunity to understand their customers in a truly
individualized way,” he said. “E-commerce is going to make that possible.”
And on one walk, Kaphan asked Bezos why, now that they had accomplished some of their
earliest goals, he was so bent on rapid expansion. “When you are small, someone else that
is bigger can always come along and take away what you have,” Bezos told him. “We have
to level the playing field in terms of purchasing power with the established booksellers.”
Before going public Bezos began recruiting executives for senior leadership position.
Amazon recruited executives from Barnes & Noble and Symantec and two from Microsoft—
Joel Spiegel, a vice president of engineering, and David Risher, who would eventually take
over as head of retail. Risher was swayed by the Amazon founder’s aggressive vision. “If we
get this right, we might be a $1 billion company by 2000,” Bezos told him. Risher personally
informed Microsoft cofounder Bill Gates of his defection to the bookseller across the lake.
Gates, who underestimated the Internet’s impact for too long, was stunned. “I think he was
honestly flabbergasted,” Risher says. “To some extent he was right. It didn’t make any
sense.”
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Another new arrival was Joy Covey as chief financial officer. Covey began working on an IPO
a month after joining the company. Amazon did not urgently require the capital of a public
offering—it had yet to begin launching new product categories, and its ninety-three-
thousand-square-foot warehouse in South Seattle was serving the company’s needs. But
Bezos believed a public offering could be a global branding event that solidified Amazon in
customers’ minds. In these days, Bezos took every opportunity to appear in public and tell
the story of Amazon.com. (Always Amazon.com, never Amazon; he was as insistent on that
as David Shaw had been on the space between the D. and the E. in his company’s name.)
Another reason Bezos pushed to go public was that competition was looming online in the
form of the reigning giant of the bookselling business, Barnes & Noble.
Here is a short video of 60 minutes interviewing Bezos in 1999, click here.
Competition
Barnes and Noble, a chain store was run by Len Riggio, a tough-as-nails Bronx-born
businessman with a taste for expensive suits and for fine art, which he lavishly hung on the
walls of his lower Manhattan office. Over two decades, Barnes & Noble had revolutionized
bookselling. It introduced discount prices on new releases and, with archrival Borders,
spread the concept of the book superstore, driving many mall-shops and independents out
of business. As a result, between 1991 and 1997, the market share of independent
bookstores in the United States dropped from 33 to 17 percent, according to the American
Booksellers Association, whose membership dropped from 4,500 to 3,300 stores in that
time.
Now Barnes & Noble was faced with what must have seemed like a pipsqueak upstart.
Amazon had a measly $16 million in sales in 1996; Barnes & Noble notched $2 billion in sales
that same year. Still, after the Wall Street Journal article in 1996, Riggio called Bezos and
told him he wanted to come to Seattle with his brother Stephen to talk about a deal.
Inexperienced at the time in these kinds of discussions, Bezos called investor and board
member Tom Alberg and asked him to accompany him to dinner with the Riggios.
Beforehand, they decided on a strategy of caution and flattery.
The foursome had a steak dinner at Seattle’s famous Dahlia Lounge, on Fourth Avenue near
the Columbia Building, an iconic Seattle restaurant with a memorable neon sign of a chef
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holding a strung-up fish. The Riggios wore suits and came on strong. They told Bezos and
Alberg that they were going to launch a website soon and crush Amazon. But they said they
admired what Bezos had done and suggested a number of possible collaborations, such as
licensing Amazon’s technology or opening a joint website. “They didn’t come right out and
offer to buy us. It was not particularly specific,” Alberg says. “It was a pretty friendly dinner.
Other than the threats.”
Afterward, Alberg and Bezos told the Riggios they would think about a partnership. Later
Alberg and Bezos spoke on the phone and agreed that such a collaboration was unlikely to
work. “Jeff was always a big believer that disruptive small companies could triumph,” Alberg
says. “It wasn’t the end of the world. We knew we had a challenge.” Rebuffed, the Riggio
brothers went home and started work on their own site. According to a person who worked
at Barnes & Noble at the time, Len Riggio wanted to call the site the Book Predator but
colleagues convinced him that was a bad idea. Barnes & Noble would take many months to
back up its threat and spin up its own Web operation, and during that time, Bezos’s team
accelerated the pace of innovation and expansion.
Three days before Amazon’s IPO (May 15, 1997), Barnes & Noble filed a lawsuit against
Amazon in federal court alleging that Amazon was falsely advertising itself to be the Earth’s
Largest Bookstore. Riggio was appropriately worried about Amazon, but with the lawsuit he
ended up giving his smaller competitor more attention. Later that month, the Riggios
unveiled their own website, and many seemed ready to see Amazon crushed. The CEO of
Forrester Research, a widely followed technology research firm, issued a report in which he
called the company “Amazon.Toast.”
Rory Sutherland, who is the ‘Ad Man’ from Ogilvy Mather (UK), spoke about the mistake
most executives made about brand strength translating online. When the internet came
along, the assumptions about brand strength fell apart, and Rory spoke about Amazon in
particular. It was believed by several well respected marketing executives that once Barnes
& Noble got serious about selling books online it will overtake Amazon in quick time. But as
Rory pointed out, brand strength is very dependent on its context. Rory said: “What is a
strong brand walking down a high street, can be a completely invisible brand when you are
sitting at a computer seen.”
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Back to Stone: Straining against the regulatory shackles that required him to stay silent,
Bezos wanted to send mimes wearing Amazon T-shirts to skulk around the Riggios’ launch
event. Quattrone put the kibosh on the plan. Later Bezos recalled speaking at an all-hands
meeting called to address the assault by Barnes & Noble. “Look, you should wake up
worried, terrified every morning,” he told his employees. “But don’t be worried about our
competitors because they`re never going to send us any money anyway. Let’s be worried
about our customers and stay heads-down focused.” For the next year, Amazon.com and
BarnesandNoble.com competed, each asserting that it had a better selection and lower
prices. Barnes & Noble laid claim to a deeper catalog; Amazon ramped up efforts to find
rare and out-of-print books, assigning employees to track down books in independent
bookshops and at antique-book dealers.
In 1998, Barnes & Noble would spin off its dot-com subsidiary with a $200 million
investment from German media giant Bertelsmann and later take the company public.
Amazon would then outflank the bookseller by rapidly expanding into other product
categories like music and DVDs. Bezos had predicted that the chain retailer would have
trouble seriously competing online, and, in the end, he was right.
The Riggios were reluctant to lose money on a relatively small part of their business and
didn’t want to put their most resourceful employees behind an effort that would siphon
sales away from the more profitable stores. On top of that, their company’s distribution
operation was well entrenched and geared toward servicing physical stores by sending out
large shipments of books to a set number of locations. The shift from that to mailing small
orders to individual customers was long, painful, and full of customer-service errors. For
Amazon, that was just daily business. Just as Bezos predicted when he spoke to students at
Harvard, story a bit further along.
The Initial Public Offering (IPO) and Amazon’s Business model
That spring, Bezos and Covey travelled the United States and Europe to pitch Amazon to
potential investors. With three years of sales data, they now felt they had a unique story.
Unlike traditional retailers, Amazon boasted what was called a negative operating cycle.
Customers paid with their credit cards when their books shipped but Amazon settled its
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accounts with the book distributors only every few months. With every sale, Amazon put
more cash in the bank, giving it a steady stream of capital to fund its operations and
expansion. The company could also lay claim to a uniquely high return on invested capital.
Unlike brick-and-mortar retailers, whose inventories were spread out across hundreds or
thousands of stores around the country, Amazon had one website and, at that time, a
single warehouse and inventory. Amazon’s ratio of fixed costs to revenue was
considerably more favorable than that of its offline competitors. In other words, Bezos and
Covey argued, a dollar that was plugged into Amazon’s infrastructure could lead to
exponentially greater returns than a dollar that went into the infrastructure of any other
retailer in the world.
Robert Hagstrom, in his book INVESTING: The Last Liberal Art, described how in the months
after the tech crash the majority of analysts believed Amazon was massively overpriced and
Hagstrom wrote: “By year end 2002, Amazon was trading ninety times cash flow and posted
a $2.4 million dollar loss. The bear case rested on the fact that as a book retailer, Amazon
appeared massively overpriced relative to brick-and-mortar bookstores. Even when the
company diversified into DVD’s, CD’s computer software, video games, electronics, apparel,
furniture, toys and food, the brick-and-mortar description stuck.”
When we put a company through our process and come a conclusion, we are creating a
thesis about the company, and it is very important to change the thesis/conclusion when
the facts change. Clearly the analysts didn’t account for the change in products sold and
didn’t update their thesis which lead to them a wrong conclusion.
Note: I would say this to my brother: an investor who tries to value a company based upon
the superficial measures of a Price to Earnings Ratio or Price to Cash Flow Ratio or any other
quick market price metric will do no better than a monkey throwing darts at a dartboard
over their lifetimes.
What I’m advocating is ‘second level thinking’, a term coined by Howard Marks from
Oaktree Capital. ‘First level thinking’ is essentially what I just referred too, relying on market
ratios.
Hagstrom continued: “The bears first compared Amazon to Barnes & Noble then later to
Wal-Mart. In both cases, Amazon’s price to earnings and price to cash flow were
31
significantly higher than the traditional retailers. Conversely, the Amazon bulls looked at the
company and saw something different. To them Amazon didn’t look like a Barnes & Noble
or Wal-Mart but instead resembled Dell Computer (Dell). Initially, the bears were shocked
by the comparison. Dell was a direct distributor of personal computers and computer
products. It was one of the best-performing stocks during the 1990s. Between 1995 and
1999, the stock was up 7,860 percent compared to the S&P 500 Index, which had gained
250 percent. The bears quickly chided the Amazon bulls for latching on to a proven winner.”
Hagstrom makes this important point: “If you step back and look at Amazon, the company’s
business operations are more similar to Dell than Wal-Mart. Dell assembles and ships
personal computers form various distribution centres located around the country. Orders
for computers taken online negate the need for a large and costly sales force. Amazon, like
Dell, takes orders online. Also like Dell, Amazon ships products to their customers from one
of their distribution centers, bypassing expansive brick-and-mortar retail stores. The
business model allows both companies to operate with negative working capital (they get
money from customers before they have to pay supplies/manufacturers), and thus both
companies are able to achieve returns on capital above 100 percent.”
And “does it make sense to compare Amazon to Wal-Mart? It is true that they sell
essentially the same merchandise to customers, but the similarities stop there. Wall-Mart
has 9,500 brick-and-mortar stores with over 2.1 million employees, each of whom helps to
generate about $200,000 in sales. Amazon has 69 distributions centers with 51,000
employees, each of whom helps to generate $950,000 in sales.”
"The greatest deception men suffer is from their own opinions."
Leonardo da Vinci
***
In Early 1997, Jeff Bezos flew to Boston to give a presentation at the Harvard Business
School. He spoke to a class taking a course called Managing the Marketspace, and afterward
the graduate students pretended he wasn’t there while they dissected the online retailer’s
32
prospects. At the end of the hour, they reached a consensus: Amazon was unlikely to
survive the wave of established retailers moving online. “You seem like a really nice guy, so
don’t take this the wrong way, but you really need to sell to Barnes and Noble and get out
now,” one student bluntly informed Bezos. Brian Birtwistle, a student in the class, recalls
that Bezos was humble and circumspect. “You may be right,” Amazon’s founder told the
students. “But I think you might be underestimating the degree to which established brick-
and-mortar business, or any company that might be used to doing things a certain way, will
find it hard to be nimble or to focus attention on a new channel. I guess we’ll see.”
“This was a key part of Amazon’s early strategy: maximizing the Internet’s ability to provide
a superior selection of products as compared to those available at traditional retail stores.”
Stone
***
Bezos wanted capital from an IPO but didn’t want to give his rivals a road map to use to
follow in his footsteps. “There was a lot of skepticism on the road show,” says Covey. “A lot
of people said, you are going to fail, Barnes and Noble is going to kill you, and who do you
think you are not to share this stuff?” The IPO process was painful in another way: During
the seven-week SEC-mandated “quiet period,” Bezos was not permitted to talk to the press.
“I can’t believe we have to delay our business by seven years,” he complained, equating
weeks to years because he believed that the Internet was evolving at such an accelerated
rate.
Amazon’s IPO, on May 15, 1997, was a success, though a relatively mild one compared with
the debauched dot-com affairs that would come later. Bezos battled his bankers to boost
the price of the offering to eighteen dollars a share, and the stock traded underwater—
below its IPO price—for more than a month. But the IPO raised $54 million and got
widespread attention, propelling the company to a blockbuster year of 900 percent growth
in annual revenues. Bezos, his parents, and his brother and sister (who had each bought ten
thousand dollars’ worth of stock early on) were now officially multimillionaires. And
Amazon’s original backers and Kleiner Perkins all saw a healthy return on their investments.
But even that was peanuts compared to the coming exponential growth in Amazon’s stock.
***
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Wal-Mart
The above ending value would be higher if you ‘averaged down’, that is continued to buy
stock each time the share price fell. As the below chart points out, it’s ok to wait before
leaping, Mr. Market will always present buying opportunities at a later date. (Figures are not
inflation adjusted to today s values)
34
As we can see from our this graph, Wal-Mart’s Market Cap is adjusted into today’s dollars,
that Wal-Mart entered the S&P 600 small cap index in 1983 (Red X).
35
Wal-Mart effectively entered the S&P 400 in 1991 (Yellow X), and then eight years later
entering the S&P 500 in 1998 (Green X).
Amazon
That’s how you turn $10,000 dollars into $7.5 million. All without paying any tax and you’d benefit
from the 50% capital gains tax credit when you sell.
36
The red line is the S&P 600 small cap index tipping point, the yellow is the S&P 400 mid-size index
tipping point and the green is the S&P 500 index tipping point.
***
Bezos had imbibed [Sam] Walton’s book thoroughly and wove the Walmart founder’s credo about
frugality and a “bias for action” into the cultural fabric of Amazon. In the copy he brought to Kathryn
Dalzell, he had underlined one particular passage in which Walton described borrowing the best
ideas of his competitors.
Bezos’s point was that every company in retail stands on the shoulders of the giants that came
before it.
The book clearly resonated with Amazon’s founder. On the last page, a section completed a few
weeks before his death, Walton wrote:
Could a Wal-Mart-type story still occur in this day and age?
My answer is of course it could happen again. Somewhere out there right now there’s
someone—probably hundreds of thousands of someone’s—with good enough ideas to go all
the way. It will be done again, over and over, providing that someone wants it badly enough
to do what it takes to get there. It’s all a matter of attitude and the capacity to constantly
study and question the management of the business.
“Jeff Bezos embodied the qualities Sam Walton wrote about. He was constitutionally unwilling to
watch Amazon succumb to any kind of institutional torpor, and he generated a nonstop flood of
ideas on how to improve the experience of the website, make it more compelling for customers, and
keep it one step ahead of rivals.” Brad Stone
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“Everybody was singing in the shower and thinking they were
great.” Mark Cuban4
Why did eToys.com and Pets.com fail and Amazon.com succeed?
Where should holiday shoppers go when they want to buy toys online? For the second year
in a row eToys.com has named the #1 full service online toy site, according to eMarketer, the
authority on business online.
That was the opening paragraph of a Business Wire article in Nov 22, 2000. eToys will file for
bankruptcy in March 2001.
And Henry Blodget, at Merrill Lynch, would become famous, in 1998, for predicating that
Amazon’s share price will would go from $240 to $400 within 12 months. He also predicted
that Pets.com and eToys will soar too, which they didn’t.
Amazon invested in Pets.com, obtaining 50% equity stake before its IPO. "We invest only in
companies that share our passion for customers," said Jeff Bezos, Amazon.com founder and
CEO. "Pets.com has a leading market position, and its proven management team is
dedicated to a great customer experience, whether it's making a product like a ferret
hammock easy to find, or help in locating a pet-friendly hotel."
How did most people, including Jeff Bezos, get it so wrong?
A C|NET reporter wrote this observation:
Like Buy.com, which went public earlier this week, Pets.com is operating on negative
gross margins, meaning that the goods and services it sells cost the company more
than it earns back in revenue. For the fourth quarter, Pets.com's gross margin was
negative $6.4 million. Since inception, the company has lost $7.6 million on its sales
alone.
4
Mark Cuban was referring to the behaviour of dot.com start-up founders during the Dot Com Boom of the
late 90s & early 2000s.
38
Although Amazon has lost hundreds of millions of dollars, including a pro forma net
loss of $185 million in the fourth quarter alone, even it operates on positive gross
margins. During the fourth quarter, Amazon's gross margins were 13 percent, down
from 19.8 percent during the third quarter. Meanwhile, eBay, which posted a $4.9
million profit for the fourth quarter, had gross margins of 71 percent during the
quarter.
The first mistake was the fundamental business model, during the Dot Com Boom a lot of
pressure came from Wall Street to get listed on the share market too take advantage of the
euphoria of any new internet business or anything with dot com at the end their name.
Pets.com, like any new start up, hadn’t gone through what, Silicon Valley Angel Investors
term ‘the valley of death’ and thus proving that its business model works.
A consequence of an IPO at such an early stage lead to misallocation of capital. For instance,
Pets.com spent $3 million on a Superbowl, when it had only $1 million in revenue.
At the height of the Dot Com Boom, people with money were tripping over themselves to
hand over millions to dot com start-ups, this lead to many founders becoming over
confident not only in their own abilities but also believing that new funds will handed over
when needed for expansion. Pets.com instant success was its achilles heel, there was no
need to be fugal or test its products. They spent the millions5 just as quick as they poured in,
they expanded too aggressively, spent millions in advertising and forget to first test the
market to see if people would want to buy pet food online.
While it is easy to look back with the benefit of hindsight, we can add questions to our
checklist to help us avoid these companies and conditions in the future. This leads us into
the next topic, development of your checklist.
5
$76 million from the sale after IPO expenses.
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“The quality of your stock selection will be determined by the quality
of your questions”
Opened ended questions lead to better questions… A great question leads you to answer
more in depth questions. Yes and No questions are too limiting.
Consider the simple question of debt, which others recommend you just ask and then act
accordingly; ‘Is Total Debt to Equity below 50%? If yes, tick the box and if no, ignore the
business altogether.
This is inadequate, a better question to ask is this:
‘What is the total level of debt against equity? Why is the debt at this level? If high, what
caused it? And is it harmful? If low, could management increase its level without harming its
financial position? If unsure where can I go to find out?
Now we gain a better understanding of the business by asking open ended questions, while
it will take longer to find an answer, that’s ok, for we are pragmatic investors who know we
don’t make rash decisions but only thoughtful decisions.
Returning back to our previous topic about failed dot com companies, here are a few
questions to add to your checklist.
Q. How does the business model work? Are there past examples?
Q. Why is this person promoting this company? What will they gain from doing so?
Q. Has the company proven its business model? Who are the angel investors, venture
capital investors and institutional investors involved in financing it?
Q. Where is management/founder allocating the funds raised? Does the founder exhibit
similar characteristics as Sam Walton or Jeff Bezos as described above?
40
Valuation Techniques
"To invest successfully over a lifetime does not require a stratospheric IQ, unusual insights or
inside information. What's needed is a sound intellectual framework for making decisions
and the ability to keep emotions from corroding that framework."
- Warren Buffett
41
42
As the tipping point is an approximation, it requires us to patiently wait for a stock to grow
its market cap until it is large enough to be purchased and enter by the medium to LHFs &
IFs. To give you confidence while waiting for the event to happen, we need the stock to
meet specific financial and non-financial conditions, and by doing so, it will increase our
chances of success and importantly allow us to sleep soundly at night.
If the stock does not meet the following financial and non-financial conditions there is high
chance it will never grow and fulfil our objective. To give you a feel for some of the
conditions we are looking for in a company, Buffett wrote in 1982, the following: (Bolded
and underlined emphasis is mine).
In fairness, we should acknowledge that some acquisition records have been

dazzling. Two major categories stand out.
The first involves companies that, through design or accident, have purchased only
businesses that are particularly well adapted to an inflationary environment.
Such favored business must have two characteristics: (1) an ability to increase prices
rather easily (even when product demand is flat and capacity is not fully utilized)
without fear of significant loss of either market share or unit volume, and (2) an
ability to accommodate large dollar volume increases in business (often produced
more by inflation than by real growth) with only minor additional investment of
capital. Managers of ordinary ability, focusing solely on acquisition possibilities
meeting these tests, have achieved excellent results in recent decades. However,
very few enterprises possess both characteristics, and competition to buy those that
do has now become fierce to the point of being self-defeating.
The second category involves the managerial superstars – men [& women] who can
recognize that rare prince who is disguised as a toad, and who have managerial
abilities that enable them to peel away the disguise. We salute such managers as
Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at
National Service Industries, and especially Tom Murphy at Capital
43
Cities Communications (a real managerial “twofer”, whose acquisition efforts have
been properly focused in Category 1 and whose operating talents also make him a
leader of Category 2).
From both direct and vicarious experience, we recognize the difficulty and rarity of
these executives’ achievements. (So do they; these champs have made very few
deals in recent years, and often have found repurchase of their own shares to be the
most sensible employment of corporate capital.) [End]
Category 2, the managerial superstars, is one of the essential elements to checkoff when
looking through small cap companies, and we will cover the elements to look for after
covering the financials below.
We’ll cover the Valuation of the Entity and Assessing the Earnings Power steps before the
Search Process, as it will become easier for you to spot investment opportunities if you
know what you are looking for, like duck hunting, you want to be shooting ducks, not
pigeons.
Before we kick off, throughout this exercise, we will use the 2016 Annual Report of a
company called Footlocker (NYSE: FL) listed on the New York Stock Exchange (NYSE), as our
guinea pig.
Valuation of the Entity
Here we are looking at the balance sheet. Bruce Greenwald, in his book Value Investing:
from Graham to Buffett and Beyond; recommends starting at the balance sheet to examine
the value of the company’s assets and liabilities at the end of the most recent operating
period, as determined by the company’s accountants. We make adjustments to the asset
and liabilities values up or down.
44
As we work down the balance sheet, we accept or adjust the stated number as analysis
dictates. For example, no need to adjust cash but we need to adjust deferred taxes to
present values, the tax payment are deferred to later financial periods.
Working down the asset list on the balance sheet, from cash at the top, whose value is
certain, to various intangible assets like goodwill, whose value is often problematic to
determine with accuracy, it reminds us of the decreasing reliability of the stated values.
Benjamin Graham would only rely on current asset values, as these are often realized within
a year and the values do not vary far from the actual sale of those assets.
And after going down the liabilities side, we finish off by subtracting liabilities from assets to
obtain the current net asset value.
“Our principal purpose in valuing a firm is based on its assets is to discover if the economic
value of the assets is accurately reflected in the price at which the firm’s securities are being
brought and sold. Opportunities lie in the gap between price and value.” Bruce Greenwald
[emphasis mine]
Warren Buffett noted in his 1993 Berkshire Hathaway annual report, that "one question I
always ask myself in appraising a business is how I would like, assuming I had ample
capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete
with Mrs B and her progeny. They buy brilliantly, they operate at expense ratios
competitors don’t even dream about, and they then pass on to their customers much of the
savings. It’s the ideal business - one built upon exceptional value to the customer that in
turn translates into exceptional economics for its owners." [emphasis mine]
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In 1926, Benjamin Graham - author of the Intelligent Investor – was a professional investor
in his early thirties and was working in the Washington, D.C., record room of the Interstate
Commerce Commission when he came across something he considered “treasure.” It
appeared in the prosaic form of a twenty-page document detailing the financial condition of
Northern Pipeline, one of eight pipeline companies established when the Supreme Court
broke up Standard Oil, the monopoly created by John D. Rockefeller.
Northern Pipeline’s shares were trading at sixty-five dollars, and the company generated an
annual six dollars of earnings per share. That was generally known. What Graham
discovered was that Northern Pipeline was sitting on a fat pile of holdings in other
companies. According to his calculations, the company could make a one-off payment of
ninety dollars per share to all its stockholders, without having any impact on its ongoing
earnings. That’s as sweet a deal as you’ll ever find, so Graham, after an unsuccessful
attempt to persuade the company’s senior managers to distribute the cash, loaded up on
shares and travelled to the Northern Pipeline annual shareholders’ meeting, in Oil City,
Pennsylvania.
The location should have been a warning. Why would a company whose offices were in New
York, at 26 Broadway, and most of whose shareholders were also in New York, choose to
have its annual meeting in a place that most New Yorkers could get to only after taking an
overnight train to Pittsburgh and then a cold, rickety local train ninety miles north? Graham
found out when he arrived. Of the six people present, he was the only one who wasn’t an
employee. He asked the chairman if he could read a memorandum. The chairman asked him
to put his request in the form of a motion. Graham did. “Is there any second to this
motion?” the chairman asked. Silence. “I’m very sorry, but no one seems willing to second
your motion,” the chairman said. “Do I hear a motion to adjourn?” Meeting over. Ben
Graham went back to New York, humiliated and angry, and vowing revenge.
In the next six months, Graham bought more shares in Northern Pipeline, turning himself
into the second-biggest holder of the stock, and then wrote a letter to the body that owned
more shares than he did, the Rockefeller Foundation. The letter called the state of affairs at
Northern Pipeline “absurd and unfortunate,” and made a cogent case for giving back the
excess cash to its real owners, the shareholders: “The cash capital not needed by these pipe
46
line companies in the normal conduct of their business, or to provide for reasonable
contingencies, should be returned to the stockholders, whose property it is.” The
Rockefeller Foundation listened to Graham politely, then told him that it did not interfere in
the running of its holdings. Graham, who later taught economics at Columbia when he
wasn’t managing his investments, wasn’t put off. He lobbied the other shareholders,
collected their proxy votes for the next annual meeting, and won two of the company’s five
board seats. Northern Pipeline caved in, and distributed the cash to its shareholders.
Graham’s discovery of Northern Pipeline’s holdings in other companies, amounting to his

calculations of $90 per share, provides another example of why we conduct a systematic
valuation of assets and liabilities on the balance.
We too hope to discover our own “treasure.”
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Footlocker’s Balance Sheet
Figures Rounded & in Millions

Footlocker's Balance Sheet 2016 Revalued
Assets
Current assets
cash and cash equivalents $1,046 No Change
Merchandise Inventories $1,307 $914.90
other current assets $280 $267
Total current Assets $2,941 $2,228
Non-current assets
Property and equipment, net $765 $1,231
Goodwill $155 $148
Intangible Assets, net $42 No Change
Deferred tax assets $161 $154
Other assets $84 $80
Total non-current assets $1,207 $3,511
Total assets $4,148 $3,883

Liabilities
Current liabilities
Accounts payables $249 No Change
Accrued and other liabilities $363 No Change
Current portion of capital lease obligations - -
Total current liabilities $612 $612
Non-current liabilities
Long term debt and obligations under capital
leases $127 No Change
Other liabilities $391 $291
Total non-current liabilities $628 $528
Total liabilities $1,240 $1,234
Shareholders’ Equity $2,908 $2,649
Equity + Total Liabilities $4,148 $3,883
48
Current Assets
We start at the top the balance sheet with cash and cash equivalents, and we make no
change as cash is cash.
Merchandise Inventories: Here I deducted 30% off the reported total amount of inventories.
Sporting merchandise, including clothing, are mostly seasonal products and like most
clothing trends they come and go.
Other Current Assets: This requires us to read note 10. Other Assets – which provides a
breakdown of all amounts. Consists of restricted cash, deferred tax costs and pension
assets….all are expected to be turned into cash within a year. Here we simply discount to
present value.
You will notice a small change downwards on the current asset total, as all current assets
are expected to be turned into cash within the year, and is referred to as the operating
cycle. But an adjustment is needed with Inventories and other assets.
Non-Current Assets
Moving down to non-current assets, the longer term fixed assets is where opportunities are
more likely to present themselves but also become harder to accurately assess their value.
For example consider Footlockers Property (no plant) & equipment valued at $765 million
on the balance sheet, property, in particular, is reported by the company accountants at
cost less accumulated depreciation and amortization (carrying value). Property, plant &
equipment will be reported on a net accumulated depreciation and will be the largest non-
current assets for most companies.
The true value of their property is not reflected on the balance sheet. For example, an office
block (not Footlockers), purchased in 1990 for $1,000 per square metre and could be worth
$2,870 per square metre today. And if the office block doesn’t serve the company anymore
it should sell it and pocket the difference. The gap between book value and the net gain
from the sale should catch our eye.
Please Note: Countries that have adopted International Financial Reporting Standards (IFRS)
promulgated by the International Accounting Standards Board (IASB) a company can revalue
PP&E to fair values under the revaluation model. Under U.S. GAAP accounting practices
fixed assets are not allowed to be revalued upwards.
The retail industry had enjoyed higher barriers to entry before the internet came along, as
brick and mortars stores were the main point of sale for retailers, but as Amazon has
demonstrated, the barriers to entry have fallen. The cost to set up an online store is now
almost free.
49
If a company does have Plant, identifying what the plant is, is important. Examples of a plant
are; an oil refinery (BP or Shell), fiber-optic or copper cable installed (Telstra or AT&T) or a
string of motels across the country (Best Western).
There are two important forces creating large differences between book value and
reproduction cost.
The first is depreciation, as under the rules of the accrual basis of accounting, expenses are
recognized in the period in which the consumption of costs can be measured in a faithful
verifiable manner. The purchase of a building is considered as a prepaid expense, cash or
credit (corporate loan) and is paid before an expense is incurred (consumption of the asset
by the business) over 25-30 year period.
The company accountant will estimate the residual value (expected sale price) and deduct
the cost of the building to determine the estimated time over which the building is expected
to be consumed (referred to by accountants as Useful Life). This portion of the buildings cost
is assigned to expense is called depreciation.
Therefore, values will be reported on depreciation basis independently from the economic
value of the asset.
And the second is inflation, as the building is being charged depreciation to replace this
year’s use economic value of the asset, which is based on historical cost. The historical cost
is as relevant as the price paid for a train ticket in 1930.
“We may be overstating our income by understating the real expense." Greenwald
A new competitor today has to pay for plant into today’s dollars and their costs should
reflect today’s dollars.
Equipment is much as easier to reproduce, depreciated on a straight-line basis over its
useful life. Take note that a new competitor may spend the same amount of money but
receive new equipment that is more productive. Sound industry knowledge will give you an
advantage.
Goodwill arises when a company purchases another company above the market value of the
company’s net assets. Broadly representing the excess paid over what is the fair value of its
assets acquired.
Goodwill is normally justified on the grounds that the company can achieve synergies and
efficiencies (rarely happens) resulting in a suitable return on assets.
Deferred taxes needs to be discounted to present value.
Intangible Assets
Intangibles are the most disputed and ambiguous area of the balance sheet. Intangibles
divided into two groups’ brand names and goodwill. In brand names, I’m including
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trademarks under the banner of brand names. Coca Cola’s value is 90% intangible, they sell
sugar water and inspiration.
The valuation of intangibles has become a hot topic over the last 15 years, with the rise of
tech companies like Google, Facebook and Amazon.
This is a reflection of the evolution of western economies and changing business models
over the last 100 years. This chart shows how the S&P 500 has evolved over the last 60
years.6
6 Source: Wall St. Journal - Corrie Driebusch
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The business were heavy reliant on tangible assets during the industrial age right up to
1990s, intangibles mainly consisted of goodwill. Whereas, with the rise of new technology –
internet - tech companies have become a lot less reliant on tangible assets.
For instance, Microsoft today doesn’t need to pay the additional cost to produce an extra
CD with Windows 10 loaded on it to sell it, that cost has disappeared, as it can now be
downloaded free online. Same applies to Google’s advertising - Ad Words - What is the
additional cost of a click? You can watch a short video with Warren Buffett speaking about
Google here.
Because of this evolution and the fact that intangibles are hard to value, the voices are
getting louder to lower the recognition and measurement standards of intangibles. Such as
allowing ‘users’ to be added as intangibles assets.
How I got an approximate value for PPE

I added back all depreciation charges for the year, except for the real cash depreciation
charge of $158 as stated in operating cash flow statement. And finally, I charged a single
depreciation charge for the year over the equipment amount to deduct from our total. This
is too take into account the consumed amount of equipment the company actually used. It
is only an approximate value, not perfect, but at the end of the day it is not a deciding
factor.
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Alternatively
There is no harm is not changing the report value. But do read the breakdown of each value,
look at the land values and what land they own. Especially, if a company has subsidiaries, as
land owned by subsidiaries gets overlooked.
Current Liabilities
Same as current assets, you will nothing has changed, as all current liabilities are expected
to be spent within the year, but taxes payable needs to be discounted to present value.
Current liabilities arise naturally from normal conduct of the business and are essential for a
new entrant.
Non-Current Liabilities
Only one change, deferred taxes, which need to discounted to the present value.
There may be non-current liabilities that a new entrant will not need to compete with
Footlocker, such as physical retail space, such as a bricks and mortar shop front, preferring
instead to start online. And when assessing other businesses, keep in mind that a legal fine
or settlement case appearing on their current or non-current liabilities side of the balance
sheet, will not be needed by a new entrant and should be zeroed on the reproduction value.
Equity
Keep in mind that each share you purchase is a piece of the company’s equity, so it is
important to understand the moving parts that influence the changes in equity.
The change in net value decreased by $100 million. This is our estimated reproduction cost
of Footlocker.
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Assessing the Earnings Power Value (EPV)
Earning Power Value can be thought of as Intrinsic Value. In the 2013 Berkshire Hathaway
annual report, Buffett explained what intrinsic value means.
“Intrinsic value is an all-important concept that offers the only logical approach to
evaluating the relative attractiveness of investments and businesses. Intrinsic value can be
defined simply: It is the discounted value of the cash that can be taken out of a business
during its remaining life. The calculation of intrinsic value, though, is not so simple. As our
definition suggests, intrinsic value is an estimate rather than a precise figure, and it is
additionally an estimate that must be changed if interest rates move or forecasts of future
cash flows are revised. Two people looking at the same set of facts, moreover – and this
would apply even to Charlie [Munger] and me – will almost inevitably come up with at least
slightly different intrinsic value figures.”
It is important not to take earnings at face value, the reported earnings can be manipulated
and many companies report earnings via EBITDA. That is, earnings before interest
[payments], tax [payments], depreciation [on past capital expenditure spent on plant and
equipment] and amortization [on the purchase of past intangible assets]. Essentially
implying these items are not costs to the business, it’s their way of reporting earnings better
than what actually occurred. Ego and stock option compensation are the core reasons why
management participate in manipulating earnings.
The first step requires assessing the value of current earnings, properly adjusted. This
requires us to make certain assumptions about the relationship with future earnings and
currents earnings.
The equation for earnings power value is: EPV = Adjusted Earnings X 1/R
R = Your Discount Rate (think of it as your required rate of return).
54
Here we aren’t going to add forecasted earnings to our equation, instead, we are going to
arrive at an accurate estimate of the current earnings of the company by refining the
earnings data.
There is a sane approach to analysing the future cash flows that does not involve some
arcane highly complex mathematical formula. It involves assessing the strength of the
company’s competitive advantages, to determine if they can continue to generate growing
cash flows well into the future - 20 years’ time. That’s why investing is half art and half
science.
“I don’t have the first clue.” Warren Buffett
Embrace Buffett’s “I don’t have the first clue” to forecasting future earnings, it will free you
from wasting your valuable time and effort and allow you to focus on the variables that
matter.
Buffett’s observation is back up by research from two Noble Prize award winners Dr Daniel
Kahneman and Dr Herbert A. Simon, who was a brilliant polymath in the fields of A.I.,
cognitive psychology, economics, computer science and political science. Herbert pioneered
the concept of bounded rationality, which simply means in his words: “The limits of
rationality have been seen to derive from the inability of the human mind to bring to bear
upon a single decision all the aspects of value, knowledge, and behaviour that would be
relevant.”
Here is what we do…
The first step is to analyse the current net cash flow. Ideally, the net cash flow should
approximately equal reported net earnings. Companies may choose between reporting their
Statement of Cash flow in two methods, Direct and Indirect Methods.
The difference between Direct and Indirect is the layout of Cash flows from Operations, the
Indirect method begins with Net Income from the Statement of Income and reconciles to
cash provided by operating activities, deriving cash flow directly from net income.
The Direct Method presents actual operating inflow and outflows of cash. In our example,
you can see cash inflow from receipts of customers and outflow of payment for suppliers
55
and employees, subtracting the outflow to suppliers and employees provides the core
operating cash flow.
Figure 1 Reece Plumbing
The direct method requires companies to add in the notes a table showing the reconciliation
of cash flows from net income as reported in Statement of Income.
Figure 2 Reece Plumbing
56
Indirect Method.
Here, FL have reported in the Indirect Method.
Figure 3 Footlockers Operating Cash Flow
As you can see the indirect method requires that companies start with Net Income as
reported in the Statement of Income, and adds back noncash expenses like depreciation and
amortization, deferral expenses, and gains on the sales of assets (a reported gain in income
from the sale of an asset is added back as it is not income earned from operations), and
includes the cash outflows and inflows from changes in assets and liabilities notice that
these assets and liabilities are current assets and liabilities.
“There is no foolproof standard for tracking how revenue growth is consistently translating
into earnings. But one-yard stick clearly comes closest: cash flow from operations, that is,
the amount of money that the ongoing business throws off. Why? Because that measure is
least subject to accounting distortions.” CFO Magazine, 2000, "The Disconnect Between
Earnings and Cash Flow"
While the cash flow statement is harder to manipulate than the income statement, it pays
to understand and compare the operating cash flows within an industry.
57
Footlockers Cash Flow History.
FREE CASH FLOW

$600
$500
$400
$ in Millions
$300
$200
$100
$0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Year
---
58
Now to the Adjustment of Reported Net Income.
Before we jump straight into discounting the cash flows of a business, we need to adjust the
current earnings and assess the quality of those earnings. Presented below in the table are
the calculations, no need to create your own excel spreadsheet, just download the excel
spreadsheet accompanying this PDF.
The purpose of the adjustments is to arrive at a figure that closely represents distributable
cash flow, or think of it as the money an owner off a private company can receive from the
company, while leaving its operations humming along.
The steps taken to arrive at the distributable cash flow figure.
Step One: [From table 3, page 61] we start with operating income which is EBIT adjusted for
any special one off charges. Keep an eye out for special one off charges on the income
statement, look to see if they become a regular occurrence. You will know it when you see
it, it is best to assume that they are regular occurrence and to spread the cost out over 5
years. Footlocker has no special off charges.
Step Two: Calculate the tax rate (tax paid divided by net income) and deduct the tax
payable and interest payments paid from the operating income to get the operating income
after tax and interest payments.
Step Three: Add back Depreciation and Amortization, these charges are non-cash expenses
and don’t affect the current cash flows of the company. You will notice from Figure 4
Footlockers Operating Cash Flow [page 57] that depreciation and amortization is added back
to operating cash flow, we are doing the same. But make no mistake, depreciation and
amortization expenses are real costs to any business, which is why in the next step, we
deduct the cost of investment required back into the firm in the form of PPE to maintain the
current level of sales, referred to in the table as maintenance CapEx. This is why reporting
earnings based EBITDA is foolhardy.
Step Four: Here we calculate what we call maintenance capital expenditures (Maintenance
Capex).
59
Below are the calculations for determining the amount of money needed for capital
expenses to maintain current sales, excluding capital spent on growth.
Table 2: Maintenance Capex Calculations. Figures are in thousands ‘000’
Firstly, we collect the capital expenses for 5 years, found in the cash flow statement under
the heading investing activities. Secondly, collect the depreciation and amortization
expenses from the income statement [third column]. Thirdly, we create the second table to
work out the Growth Capex Rate. We simply divide Plant Property and Equipment total,
found on the balance sheet under non-current assets, by gross sales. Once we have all the
percentages, we calculate the average in our case it is 9%.
And finally, we divide the 5 year average (9%) by the each year’s capital expense to calculate
the maintenance capex number. The workings for our example in 2012 are: $163m – (163m
X 0.09) = $148m
Step Five: [From table 3] we simply, add back depreciation & amortization to operating
income after tax and interest expense. Then, deduct the maintenance capex expense from
operating income after tax & interest payments. Then we arrive at the operating income
after tax adjusted or EBIT after tax adjusted. This is the distributable cash flow figure we
want to know.
Step Six: We add the reported net income at the end so we can compare both ending
figures.
60
Table 3: The six steps to calculate Distributable Cash Flows.
Here you will notice that once we adjust earnings by removing or adding transactions that a
difference of $59 million between reported earnings and our adjusted earnings appears.
Providing us with a truer picture of Footlocker’s earnings.
Our final operating income after tax & interest payments figure will now be referred to as
our adjusted earnings for Footlocker throughout the booklet.
I wrote about ‘first and second level thinking’ by Howard Marks, earlier and this also applies
to excel spreadsheets. Too many financial analysts will recommend a buy or sell based on
their excel worksheet calculations.
This is first level thinking, the purpose of the excel worksheet is inform us of the business
transactions that have taken place and think about their implications in line with the
business strategy set out by management, and by assessing the business transactions we
assess management’s ability to allocate capital effectively.
61
Buffett wrote in 1982 the following:
Equity Value-Added
An additional factor should further subdue any residual enthusiasm you may retain
regarding our long-term rate of return [at Berkshire Hathaway]. The economic case
justifying equity investment is that, in aggregate, additional earnings above passive
investment returns - interest on fixed-income securities - will be derived through the
employment of managerial and entrepreneurial skills in conjunction with that equity capital.
Furthermore, the case says that since the equity capital position is associated with greater
risk than passive forms of investment, it is “entitled” to higher returns. A “value-added”
bonus from equity capital seems natural and certain.
But is it? Several decades back, a return on equity of as little as 10% enabled a
corporation to be classified as a “good” business - i.e., one in which a dollar reinvested in
the business logically could be expected to be valued by the market at more than one
hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt
bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth
some premium to investors over the equity capital employed. That was true even though a
combination of taxes on dividends and on capital gains would reduce the 10% earned by the
corporation to perhaps 6%-8% in the hands of the individual investor.
Investment markets recognized this truth. During that earlier period, American business
earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at
valuations far above that equity capital (book value), averaging over 150 cents on the dollar.
Most businesses were “good” businesses because they earned far more than their keep (the
return on long-term passive money). The value-added produced by equity investment, in
aggregate, was substantial.
62
That day is gone. But the lessons learned during its existence are difficult to discard.
While investors and managers must place their feet in the future, their memories and
nervous systems often remain plugged into the past. It is much easier for investors to utilize
historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is
for either group to rethink their premises daily. When change is slow, constant rethinking is
actually undesirable; it achieves little and slows response time. But when change is great,
yesterday’s assumptions can be retained only at great cost. And the pace of economic
change has become breathtaking.
During the past year, long-term taxable bond yields exceeded 16% and long-term tax-
exempts 14%. The total return achieved from such tax-exempts, of course, goes directly
into the pocket of the individual owner. Meanwhile, American business is producing
earnings of only about 14% on equity. And this 14% will be substantially reduced by
taxation before it can be banked by the individual owner. The extent of such shrinkage
depends upon the dividend policy of the corporation and the tax rates applicable to the
investor.
Thus, with interest rates on passive investments at late 1981 levels, a typical American
business is no longer worth one hundred cents on the dollar to owners who are individuals.
(If the business is owned by pension funds or other tax-exempt investors, the arithmetic,
although still unenticing, changes substantially for the better.) Assume an investor in a 50%
tax bracket; if our typical company pays out all earnings, the income return to the investor
will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist - if all
earnings are paid out and return on equity stays at 14% - the 7% tax-exempt equivalent to
the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt
bond. Such a perpetual 7% tax-exempt bond might be worth fifty cents on the dollar as this
is written.
63
If, on the other hand, all earnings of our typical American business are retained and
return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio
remains constant, the price of our typical stock will also grow at 14% per year. But that 14%
is not yet in the pocket of the shareholder. Putting it there will require the payment of a
capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course,
works out to a poorer rate of return than the currently available passive after-tax rate.
Unless passive rates fall, companies achieving 14% per year gains in earnings per share
while paying no cash dividend are an economic failure for their individual shareholders. The
returns from passive capital outstrip the returns from active capital. This is an unpleasant
fact for both investors and corporate managers and, therefore, one they may wish to ignore.
But facts do not cease to exist, either because they are unpleasant or because they are
ignored.
Most American businesses pay out a significant portion of their earnings and thus fall
between the two examples. And most American businesses are currently “bad” businesses
economically - producing less for their individual investors after-tax than the tax-exempt
passive rate of return on money. Of course, some high-return businesses still remain
attractive, even under present conditions. But American equity capital, in aggregate,
produces no value-added for individual investors.
It should be stressed that this depressing situation does not occur because corporations
are jumping, economically, less high than previously. In fact, they are jumping somewhat
higher: return on equity has improved a few points in the past decade. But the crossbar of
passive return has been elevated much faster. Unhappily, most companies can do little but
hope that the bar will be lowered significantly; there are few industries in which the
prospects seem bright for substantial gains in return on equity.
64
Inflationary experience and expectations will be major (but not the only) factors affecting
the height of the crossbar in future years. If the causes of long-term inflation can be
tempered, passive returns are likely to fall and the intrinsic position of American equity
capital should significantly improve. Many businesses that now must be classified as
economically “bad” would be restored to the “good” category under such circumstances.
A further, particularly ironic, punishment is inflicted by an inflationary environment upon

the owners of the “bad” business. To continue operating in its present mode, such a low-
return business usually must retain much of its earnings - no matter what penalty such a
policy produces for shareholders.
Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5%
bond with many years to run before maturity, does not take the coupons from that bond
and pay one hundred cents on the dollar for more 5% bonds while similar bonds are
available at, say, forty cents on the dollar. Instead, he takes those coupons from his low-
return bond and - if inclined to reinvest - looks for the highest return with safety currently
available. Good money is not thrown after bad.
What makes sense for the bondholder makes sense for the shareholder. Logically, a
company with historic and prospective high returns on equity should retain much or all of its
earnings so that shareholders can earn premium returns on enhanced capital. Conversely,
low returns on corporate equity would suggest a very high dividend payout so that owners
could direct capital toward more attractive areas. (The Scriptures concur. In the parable of
the talents, the two high-earning servants are rewarded with 100% retention of earnings
and encouraged to expand their operations. However, the non-earning third servant is not
only chastised - “wicked and slothful” - but also is required to redirect all of his capital to the
top performer. Matthew 25: 14-30)
65
But inflation takes us through the looking glass into the upside-down world of Alice in
Wonderland. When prices continuously rise, the “bad” business must retain every nickel
that it can. Not because it is attractive as a repository for equity capital, but precisely
because it is so unattractive, the low-return business must follow a high retention policy. If
it wishes to continue operating in the future as it has in the past - and most entities,
including businesses, do - it simply has no choice.
For inflation acts as a gigantic corporate tapeworm. That tapeworm pre-emptively

consumes its requisite daily diet of investment dollars regardless of the health of the host
organism.
Whatever the level of reported profits (even if nil), more dollars for receivables, inventory
and fixed assets are continuously required by the business in order to merely match the unit
volume of the previous year. The less prosperous the enterprise, the greater the proportion
of available sustenance claimed by the tapeworm.
Under present conditions, a business earning 8% or 10% on equity often has no leftovers
for expansion, debt reduction or “real” dividends. The tapeworm of inflation simply cleans
the plate. (The low-return company’s inability to pay dividends, understandably, is often
disguised. Corporate America increasingly is turning to dividend reinvestment plans,
sometimes even embodying a discount arrangement that all but forces shareholders to
reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to
Paul. Beware of “dividends” that can be paid out only if someone promises to replace the
capital distributed.) [End]
66
Footlockers Margins
Return on Adjusted Equity
Buffett also noted this;

“If, on the other hand, all earnings of our typical American business are retained and return
on equity again remains constant [at 14%], earnings will grow at 14% per year. If the p/e
ratio remains constant, the price of our typical stock will also grow at 14% per year.”
67
And here is Footlockers EPV under different discount rates.
The market census [as at 3rd October 2017] is discounting at approx. 12%.
What discount rate you apply will depend upon your desired rate of return. From the table
above you see that a 10% discount rate produces $58.10 per share, and a margin of safety
of 16% ((48.42/58.10)-1).
So far we have excluded debt and a truer measure of EPV is to add the cost of debt. We
need to adjust the EPV formula by applying the weighted cost of capital rate instead of just
our own required rate of return.
Now because Footlocker’s debt is so low, it barely makes an impact. But to illustrate, we will
use Kors (NYSE:KORS) the fashion retailer as an example below.
EPV = Adjusted earning divided by weighted cost of capital.
We use have adjusted the earnings for KORS = $700,825,503.

The weighted cost of capital is the after-tax cost of debt times the fraction of capital plus the
after-tax cost of equity (here we apply our required rate of return on equity) times the
fraction of capital.
Kors paid $1.5 million interest in cash for 2016, so it paid approx. 4 percent interest on debt
and its debt is 20% of total capital. We will use 10 percent as our cost of equity and equity
made up 80% of the total capital. And finally, its tax rate is 35 percent.
R = (0.20 x (0.04 x (1 - 0.35))) + (0.80 x 0.10)

= 0.0852 x 100
= 8.50%
68
Use the weighted cost of capital rate as the discount rate in the EPV.
EPV = $700 825 503 / 0.085
= $8 245 005 917
Back to Footlocker.
Asset Valuation & the EPV Valuation.
$4 billion dollars in
value created in
excess of Asset Value Margin of Safety
The assets are earning over $4 billion dollars in excess of their value. This will attract
competition, and only barriers to entry will prevent them from eroding this added value.
But if current declining trends in margins continue (including return on equity), due to
competition, the EPV will fall to the same level as the asset value. This commonly occurs
when a firm doesn’t enjoy competitive advantages.
If the inverse occurs, where the EPV is lower than the asset value, the value is being
destroyed. Most commonly occurs in the mining sector, especially mining exploration
companies.
69
There is one more step before making a decision to buy.
Understand that there are limitations to applying the whole investment process, and it is of
vital importance to incorporate a margin of safety into your process. You can apply a 30%
margin of safety to the purchase price of a stock, which will protect you to some degree
against any errors made during the investment process. As per the excerpt below, the
margin of safety concept can be applied in other ways.
“MARGIN OF SAFETY” as the Central Concept of Investment [Title of chapter 20, The
Intelligent Investor] Author Benjamin Graham
[Excerpt] All experienced investors recognize that the margin-of-safety concept is essential
to the choice of sound bonds and stocks. For example, a rail road should have earned its
fixed total charges better than five times (before income tax), taking a period of years, for
its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest
requirements constitutes the margin of safety that is counted on to protect the investor
against loss or discomfiture in the event of some future decline in net income……There are
instances where a common stock may be considered sound because it enjoys a margin of
safety as large as that of a good bond. This will occur, for example, when a company has
outstanding only common stock that under depression conditions is selling for less than the
amount of bonds that could safely be issued against its property and earning power. [End]
Cognitive bias will affect decisions you make during the process, and incorporating the
margin of safety concept is one way to protect you from falling prey to a variety cognitive
bias. Deep presence, cultivated through a meditative practice, will also help you avoid the
cognitive bias trap door. (Within the Peak Performance page - link in the free tools page - to
download Tara Broch’s 10 minute meditation podcast)
It is important to understand that once you find an undervalued stock, it will take some time
for the share market to catch up. It’s an element outside of our control. Skill plays a small
role compared to luck over the short term.
70
“We are responsible for some things, while there are others for which we cannot be held
responsible. The former include our judgement, our impulse, our desire, aversion and our
mental faculties in general; the latter include the body, material possessions, our
reputation, status – in a word, anything not in our power to control.” Enchiridion, Ch1 [1] -
Epictetus
A core tenant of Stoicism, is what Epictetus referred to as, focusing on what is in our power
to control, the quality of own thought process and investment analysis, and avoiding what is
not within our power to control, the short-term share price fluctuations and others people’s
opinions.
And Benjamin Graham’s most talked about quote, ‘in the short term the market is a voting
machine and in the long term is a weighing machine’ provides us with a great perspective
for viewing share prices movements.
One of the biggest mistakes made by investors is their intense focus on the share price
movements and not directing their focus at the investment process. As Warren Buffett has
pointed out: “Games are won by players who focus on the playing field –- not by those
whose eyes are glued to the scoreboard.”
Ben Graham taught readers in the Intelligent Investor, to focus on understanding the
business inside and out, as it’s the operating results of the business that will determine
which direction its share price will eventually go. The short-term fluctuations of share prices
are outside of control and should not be our primary focus. Do as Ben Graham said, treat
share prices movements as an opportunity to buy, sell or ignore them, but never too inform
you.
71
An Added Bonus: A Quick Story stood out to me about Bill Gates from
the book Hard Drive: Bill Gates and the Making of the Microsoft
Empire by James Wallace & Jim Erickson.
Bill Gates and Paul Allan - Founders of Microsoft
General George S. Patton liked to say, a good plan, violently executed now, is better than a
perfect plan next week, and Vern Raburn, former president of Microsoft’s consumer
products division, discussed with Fortune magazine this same ethos of Microsoft’s product
launches:
‘with a few expectations, they’re never shipped a good product in its first version. But they
never give up and eventually get it right. Bill is too willing to compromise just to get going in
a business.’
When Gates turned his attention, in 1983, to developing the original Microsoft Windows
operating system there was intense competition from competitors. What Gates couldn’t
foresee in 1983 was that his vision would consume the labors of as many as 30 of his best
programmers for the next two years while they worked around the clock on making Gate’s
vision a reality. Before the first version of Window was finished, those programmers would
spend some 80 work-years designing, writing, and testing Windows, in contrast to the 6
work-year investment originally approved by Paul Ballmer.
Gates’ ability to manage complicated development programs would be severely tested, as
would his relationships with his closet advisors. Several of his handpicked managers would
72
quit, unable to tolerate the screaming fits he and Ballmer threw as the project slipped
embarrassingly behind schedule.
Microsoft would be reorganised a year into the project to improve efficiency, but it would
nonetheless suffer its first significant loss of creditability with the press and the public. A
few computer writers would even venture that Gates had badly blundered when he chose
to champion graphical user interfaces (GUI). In time, Gates proved them wrong. It was in the
summer of 1981, Steve Jobs had given Gates a peek at the prototype of a new computer
Apple was developing, ‘the Macintosh’, which used GUI concepts developed at Xerox
research center.
By 1982 it become clear that other software companies were developing GUI programs of
their own for the IBM computer but Gates wanted to make Microsoft’s Interface Manager
(the prelude to Windows) the industry standard for the IBM PC, and only Lotus and VisiCorp
stood in his way.
Microsoft Interface Manager renamed Windows, Rowland Hanson came up with the name
as trade magazines at the time described GUI as a “windowing” system.
Wallace & Erickson described how Microsoft was being outflanked on several fronts by
competitors that were further along in the development of their own GUI system. Worse,
Gates was having a tough time selling IBM on the product. More than 20 other computer
makers, including Compaq and Radio Shack, had indicated their willingness to endorse. But
there was one name conspicuously absent from the Windows alliance - IBM. Gates wanted
Big Blue to endorse Windows, but it refused to do so. IBM executives, never particularly
happy about sharing revenues with another company, wanted to bring software
development in-house. IBM decided to design its own graphical user interface, called
TopView.
As Steve Jobs had done before him, Gates looked to Xerox PARC for software developers
experienced in GUI looked could put the spurs to Windows development. “Microsoft was
looking for somebody who had done this before,” Recalled Scott MacGregor, who was
poached from PARC to join Microsoft. “They didn’t want to reinvent the wheel. That’s why
they went shopping at Xerox.”
In 1983, VisiCorp started shipping VisiOn and Gates had boasted nine months earlier that
Microsoft would be the first to market with a graphical user interface evaporated like so
much hot air. Then another company called Quaterdeck, a start-up software publisher
announced it too, is building a graphical user interface, named DSQ.
Gates was furious. Gates decided to announce that Microsoft is working on Windows too.
This is a technique used by IBM to deflect attention from VisiCorp and Quarterdeck and also
people were willing to wait for the market leader’s product to come out. InfoWorld
magazine later coined the term for such a product ‘vaporware’.
The other reason why Gates announced Windows was as a pre-emptive strike against Apple
who was secretly working on Macintosh with its graphical user interface and mouse was
going to shake up the industry when released in 1984.
73
Before the release of Windows, that Gates announced it will be on 90% of IBM computers,
Lotus was the number one spreadsheet application and had greater revenues than
Microsoft ($200m vs $140m).
Fortune in early 1984, made the astute observation about the trouble with Microsoft’s
inexperienced management structure:
“…a lot is riding on Windows. If it fails to become an industry standard, Microsoft may not
get another chance to take the consumer market by storm. Momentum is an ephemeral
quality in any nosiness, and in an industry evolving as fast as microcomputer software, it can
be lost in the blink of an eye…Like other fast-growing companies racing to seize transient
opportunities, Microsoft has devoted little time to develop the kind of management depth
that will be needed to turn temporary victories into long-term dominance.”
Microsoft missed several deadlines continually pushing back the release date. The first
release of Windows 1 was a dud, “it would take two major revisions before Windows was
made right. Not till the release of Windows 3 in 1990 would it deliver as promised.
74
Sources & Books
https://www.youtube.com/watch?v=lNaCR0ZV5PM Ogilvy Mather – Rory Sutherland
eToys Named #1 Online Toy Store Website; eMarketer's Top 10 List Rates Outstanding Online
General Toy Merchants.
Amazon.com Announces Investment in Pets.com
C|NET: Pets.com raises $82.5 million in IPO
Behavioural Administration by Herbert A. Simon
Hard Drive: Bill Gates and the Making of the Microsoft Empire by James Wallace & Jim Erickson
The Everything Store: Jeff Bezos and the Age of Amazon by Brad Stone
Value Investing: From Graham, Buffett and Beyond by Bruce Greenwald, Judd Kahn, Paul D. Sonkin
and Michael van Biema.
75

The Tsunami Wave

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The Tsunami Wave

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The Tsunami Wave Strategy®

SEARCHING FOR VALUE®

A Journey of a thousand miles starts with a single

For example: Market Cap Size Ranges

Average Position Size

“There is an apparent inverse correlation between the construction of elaborate new

Look at the Walmart’s Growth in Net Earnings!

The House of Quants3

Tim’s real name was Jeff Bezos.

Capital Injection & Expansion

On August 9, 1995, Netscape Communications, the corporate descendant of the pioneering

Here is a short video of 60 minutes interviewing Bezos in 1999, click here.

The Initial Public Offering (IPO) and Amazon’s Business model

"The greatest deception men suffer is from their own opinions."

Could a Wal-Mart-type story still occur in this day and age?

Why did eToys.com and Pets.com fail and Amazon.com succeed?

How did most people, including Jeff Bezos, get it so wrong?

A C|NET reporter wrote this observation:

This is inadequate, a better question to ask is this:

In fairness, we should acknowledge that some acquisition records have been

Valuation of the Entity

Graham’s discovery of Northern Pipeline’s holdings in other companies, amounting to his

We too hope to discover our own “treasure.”

Figures Rounded & in Millions

Total assets $4,148 $3,883

Equity + Total Liabilities $4,148 $3,883

6 Source: Wall St. Journal - Corrie Driebusch

How I got an approximate value for PPE

R = Your Discount Rate (think of it as your required rate of return).

“I don’t have the first clue.” Warren Buffett

Here is what we do…

Figure 1 Reece Plumbing

Figure 2 Reece Plumbing

Here, FL have reported in the Indirect Method.

Figure 3 Footlockers Operating Cash Flow

FREE CASH FLOW

The steps taken to arrive at the distributable cash flow figure.

A further, particularly ironic, punishment is inflicted by an inflationary environment upon

For inflation acts as a gigantic corporate tapeworm. That tapeworm pre-emptively

Return on Adjusted Equity

Buffett also noted this;

EPV = Adjusted earning divided by weighted cost of capital.

We use have adjusted the earnings for KORS = $700,825,503.

R = (0.20 x (0.04 x (1 - 0.35))) + (0.80 x 0.10)

Asset Valuation & the EPV Valuation.

Bill Gates and Paul Allan - Founders of Microsoft

https://www.youtube.com/watch?v=lNaCR0ZV5PM Ogilvy Mather – Rory Sutherland

General Toy Merchants.

Amazon.com Announces Investment in Pets.com

C|NET: Pets.com raises $82.5 million in IPO

Behavioural Administration by Herbert A. Simon

and Michael van Biema.

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