How Great Businesses Win Without a Moat

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This week's newsletter is an adaptation from my recent YouTube video on Meta-Optimizations.

At its simplest level, a great business does only really 3 things:

1. Create value

2. Capture a portion of that value

3. Protect that value

We typically call the ability to protect value a competitive advantage, or a competitive moat.

If a business earns an outsized return, other companies will come in and compete that return down, and the only thing preventing that is a competitive moat, which is why Warren Buffett always talks about investing in businesses with moats.

But there is a certain circumstance where a business has an outsized return, and what's protecting it is not a competitive moat at all.

It has more to do with how the business is structured and the strategy they've employed.

In this week’s Five Minute Money, I’m going to explain scenarios where a business has an advantage that may be invisible to most investors and analysts, and even to other competitors.

We're going to do case studies on Netflix, Square, Amazon, Southwest, EVs and Tesla, and ghost kitchens.

The Netflix and Roku Story.

In 2008, Netflix actually had a hardware business, and they ultimately decided to spin it off.

That business is now Roku, a hardware device that helps enable regular TVs to become smart TVs.

It made sense for Netflix to want this business, since a lot of TVs at the time couldn't stream.

So why did they spin it off?

Because to maximize its distribution, Netflix had to be hardware agnostic: if they were also competing in the hardware space, they wouldn't have gotten fair treatment from Amazon's Fire Stick or Apple TV, and it would've been harder to create tight partnerships with TV manufacturers.

After spinning out Roku, Netflix partnered with smart TVs, including Samsung and Toshiba, got actual Netflix buttons on the remote, and had early partnerships with Xbox and PS5.

This advantage had nothing to do with the typical competitive advantage, yet it was a strategic necessity for them to grow as a global streamer as quickly as they did.

What I would describe this idea as is a piton, a mountain climbing tool that enables a mountain climber the ability to keep climbing while also constraining their ability to move.

This idea of a piton in business is something that both enables and constrains a certain aspect of the business.

By Netflix keeping the hardware business, that would've been a piton constraining their other business and making it much harder for them to operate freely.

Meta-Optimization: Building From What You Have vs. What's Possible.

The first idea I want to start with is a meta-optimization, a concept from mathematics.

An optimization equation is how you change variables to optimize an outcome.

A meta-optimization is how you change the parameters to optimize the entire process of optimizing that outcome.

Said simpler: if you're baking a cake, you go into your kitchen cabinet and use whatever ingredients you currently have, which is suboptimal to bake the best possible cake.

A meta-optimization is going out and sourcing the best possible ingredients that could exist, rather than just using what's already in your kitchen.

That's the same idea applied to businesses: are they optimizing based off of the existing assets they have, or off of the best possible assets they could be having?

In a previous issue, I gave an example of Walmart getting into Amazon's business of fast delivery, but doing it from a store footprint, an inferior position to having fulfillment centers built to quickly fulfill and deliver orders.

Walmart realized this and transitioned some stores to have fulfillment centers on site.

Beforehand, when you ordered from Walmart for quick delivery, someone actually went through the store shelves and picked stuff out, which is much slower than a building set up like a fulfillment center, where people and robots can move things quickly.

The Piton Network.

A piton is a decision a business made that both constrains and enables some aspect of the business.

If Costco decides to have a warehouse store, that is a piton: it constrains their ability to be a luxury retailer, but positions them well to sell a lot of stuff in bulk, since it's a big place with little spent on fixtures, so they can offer lower prices.

Because they picked a warehouse, they're probably not going to have the best locations in a city center, so people have to drive out far, and if they're driving far, they're also more likely to buy in bulk.

With one piton, you can see how it enables and constrains all of these ways they build the business.

The next layer is the piton network: all of the pitons a business is placing together.

For Costco, there's also the decision to make everything in bulk, which enables them to sell stuff cheaper and buy directly from manufacturers for volume discounts, but constrains their ability to carry a lot of SKUs, which is why the average Costco has many fewer SKUs than an average supermarket.

Another piton is the membership model: it enables the business because members are less likely to steal, provides a stream of income, and increases your commitment to buy more since you paid for it, but it also constrains them, giving up purchases from people who would've just wanted to buy one thing once.

All of these pitons placed together need to work together to be optimized for the consumer value prop, which is why people who try to copy Costco usually don't succeed.

How Southwest Airlines Was Profitable for 30 years.

Airlines are really bad businesses with high fixed costs, volatile input costs, and very price-sensitive, low-loyalty customers, and they fluctuate a lot from profit into loss.

There's an exception, though, with Southwest Airlines, which run by Herb Kelleher for over 30 years, it consistently made a profit and grew through that period, even through 9/11 and the financial crisis, when a lot of other airlines struggled.

I'd venture to say this was because of their piton network.

One piton was the decision to only purchase airplanes from the same manufacturer and have the same model across the entire airline, which gave them a discount and meant pilots could easily be swapped out across different planes.

The second piton was not assigning seats: people lined up by number and picked any seat once inside, which sped up onboarding.

They also flew into secondary airports, which were easier and cheaper to get slots in.

What Kelleher figured out was that to have the most successful airline, you want your airplanes in the air as long as possible, minimizing time onboarding and off-boarding.

At the time, their real competition was people not flying at all, and Kelleher believed that if flights were cheap enough, people would much prefer to fly.

JetBlue tried to copy Southwest and did almost everything the same, except assigned seats, which meant onboarding was much slower and the plane sat down for much longer, so it wasn't as optimized.

Since Kelleher left, Southwest has undone a lot of these things; for instance, they now do assigned seating.

Electric Vehicles vs. Internal Combustion Engines.

There are even clearer examples if we look at electric vehicles versus ICE, internal combustion engine, cars.

Say you're a traditional manufacturer like Ford, and you see EVs coming.

What you find out quickly is that your competency in building an ICE car doesn't translate well to electric vehicles.

Manufacturers tried to use their existing manufacturing base, thinking there were synergies, but found there were dis-synergies: these businesses were not similar enough for a traditional ICE manufacturer to build EVs with the same efficiency as if they started from a clean slate, which is exactly what Tesla did.

Do you think Tesla would be more efficient if they also owned an ICE division?

They optimize fully for one outcome, and because they're not balancing multiple competing interests at once, it leads to a better result overall.

The most optimized business would pull out these pitons and move them around.

Ford figured that out with their EV division, which they split off from ICE because it's basically an entirely different business.

You can only fully optimize for one variable; if a company has multiple businesses, you need to keep them largely separate.

Let me give you another example with ghost kitchens.

Ghost Kitchens and Micro-Fulfillment Centers.

If you order groceries from Instacart, someone goes into the supermarket, picks from the aisles, and brings it to their car, which slows the process down.

A quicker approach is these dark micro-fulfillment centers popping up: a fulfillment center set up just for picking and delivery, rather than using the supermarket itself.

Businesses often optimize for solving a problem using what's already there, because it's too hard to build all these micro-fulfillment centers, the same as baking a cake from whatever's already in your kitchen.

Apple Music vs. Spotify.

Think of Apple Music, which has become so tied to the iPhone that it's very hard for them to sell it to anyone off of the iPhone.

Their business model is integrated across the Apple ecosystem, so when they roll out a service that in theory should be device agnostic like Spotify, people mostly on Apple devices tend to subscribe, since it's not as strong an offering to someone on Android.

This is another example of how a business's pitons make it hard to offer certain things to different customer bases: easier to their Apple base, since they can integrate it into their other apps, but it doesn't really work on Android.

Why Startups Often Beat Incumbents at New Value Props.

This gets at the bigger idea that a business's structure is going to be its destiny.

A startup is often best positioned to address a totally new value prop rather than an existing incumbent, because the incumbent keeps trying to use its preexisting assets to address the new opportunity, the same as Walmart with its store footprint or Ford with ICE manufacturing.

So very often it's new startups that are best placed to attack a new opportunity, because a startup, if it does its job correctly, can optimize everything for the value prop it's going after.

Square was started to solve the problem of how a small merchant could easily and quickly take payments in an inexpensive way.

They started with the idea that they needed a very cheap reader, so they could onboard people inexpensively, and to keep it cheap, it had to be a fully online process, intuitive and simple, since they couldn't afford live support.

They couldn't use FICO scores because they were too slow, so they created their own risk underwriting model, but the bank wouldn't accept that, so they changed the structure so Square was the merchant with the bank, and everyone they signed up was a sub-merchant, with Square responsible for their credit risk.

This let them move faster, but put fraud detection on them.

Because they changed the system this way, it also let them remit money to sellers daily, which built a lot of trust.

I like to think of this as a mountain climbing metaphor: you're at the bottom of the mountain you want to climb, how do we enable payments cheaply, and the obvious path up is constantly solving new problems that haven't already been solved.

I interviewed Square's co-founder, Jim McKelvey, who has a book called "The Innovation Stack."

He calls this process of finding all these innovations an innovation stack, and it's why it's hard for a competitor to copy them: every time you solve a problem, there's another one, and maybe there's 20 problems you solved.

What's the likelihood a competitor solves all 20 at once?

McKelvey was trying to answer: how come Amazon didn't end up crushing Square?

Amazon came along in 2014 offering payments at 1.75% instead of Square's 2.75%, plus live support and the Amazon brand.

Square had an emergency meeting and concluded they should change nothing at all, which makes sense once you think about the piton network: once you're fully optimized for a value prop, there's nothing more you can do, because you've already optimized all the pitons in the correct order.

Amazon was only in this business for about a year before abandoning it.

McKelvey said Amazon only copied the visible things; what they missed were invisible things like fraud detection, and they were apparently losing a lot of money to fraud.

This is a little ironic, since Jeff Bezos is notorious for saying you need to be customer obsessed rather than focused on the competition, but in this instance, Amazon copied the competitor instead.

When you focus on the customer, the ability to solve problems falls out from that; when you focus on a competitor, you're just copying them.

This isn't just in business.

During the Cold War, the Soviets tried to copy the US semiconductor industry, but their focus on copying meant they were always behind, because they never learned to problem solve themselves.

As long as you're focused on copying, you're never going to take the lead.

There are also examples throughout history of people independently arriving at the same invention when focused on solving a problem: telephones, with Alexander Graham Bell and Elisha Gray; the periodic table, with Mendeleev and Meyer; evolution, with Charles Darwin and Alfred Wallace; and calculus, with Isaac Newton and Gottfried Leibniz.

When you're focused on one problem, the same solution keeps getting arrived at, because that's the most natural way to solve for it.

Amazon, in this instance, wasn't really trying to solve the customer's problem; they were focused on competing against Square.

From the piton perspective, there were things in Amazon's business that actually constrained their ability to offer what Square did.

They have a really big retail business, and merchants are skeptical of giving more data to Amazon.

This was also a smaller sub-business within a much bigger business, so it wasn't getting full resources and focus, whereas for Square it was existential.

Amazon was also more focused on growing and competing against a competitor than on being customer-obsessed, as they are in their other businesses.

How Netflix Transitioned to a Streamer Powerhouse.

Netflix started as a DVD rental company, mailing DVDs back and forth, then started getting into streaming around 2008, and by 2011 realized they couldn't keep supporting both businesses.

At the time, you could subscribe for $7.99 for streaming, and $2 more for DVD rentals added on, which they did to get more people comfortable with streaming.

Reed Hastings realized the DVD rental business was basically a piton to the streaming business: it would constrain them, because how could they be a global TV streamer and DVD mail company if every time they expanded, they had to open a new office to buy and mail DVDs?

They ultimately thought DVDs would become obsolete, and felt the two businesses were constraining each other, so they split them off: $7.99 for streaming with no DVD add-on, and $7.99 for DVDs, with the DVD business renamed Qwikster, which people roasted them for.

Customers were upset about the split itself, since most people wanted the DVDs more than streaming at the time.

They were making a bet on how the consumer hierarchy of preferences would change: that DVDs wouldn't remain a preference and streaming would, since instant delivery beats waiting days for a DVD.

So they ripped out this piton, and the stock plummeted 80%.

They lost 300,000 subscribers the next quarter, after gaining 2.5mn the prior quarter, and operating earnings dropped from around $375mn in 2011 to $50mn the following year as they subsidized streaming.

It looked like a total crap show.

This is now known as a legendary pivot, because they turned out to be correct: customers did want streaming more than DVDs, and eventually agreed.

They had to jettison the DVD business and fully optimize for streaming to grow globally.

There's a lot you can do with streaming that you can't with DVDs, like dubbing: it's much easier to localize into different languages, which mattered for shows like Squid Game.

If you were Disney or Universal and believed in streaming, you wouldn't have been able to take advantage of it the same way, because the other advantage Netflix had was that they were agnostic, not yet producing much of their own content, which let them license from a lot of different players.

If Disney had set up their own streamer, Universal wouldn't have licensed them content, and would've set up their own streamer instead, which is eventually what happened.

You can see several pitons here: not having the mail rental business let Netflix grow unchained; not having a big production studio let them be more agnostic in licensing; and getting rid of Roku let them cut deals with smart TV manufacturers, Xbox, and PS5, and avoid competing against Amazon Fire and Apple TV.

Summary.

At the core of the idea is almost a sense of humility.

Almost always, a business can only do one thing well⁶. The idea equally applies to your own life: how many things in your life can you truly optimize for at once?

In cellular biology there is a concept called pluripotency.

A pluripotent cell is one that has full capacity to differentiate into any sort of cell, but they must become only one type of cell.

Cells that are only partially differentiated are usually referred to as “cancer”.

Similarly, a company that tries to become too many different things at once is serving nothing well and may as well be cancerous.

When you look at things from the piton network perspective, what is enabling a company, what is constraining them, and whether it's properly optimized for their one aim, you'll be able to understand a business much better, and see when a business is going into an area they're not really optimized for.

You could've guessed that with ICE manufacturers getting into EVs, or with Walmart's e-commerce delivery eventually needing its own fulfillment centers.

The next time you analyze a business, study how the business is optimizing its piton network and see if they are using their pitons to best fulfill their value prop.

For more on How Great Businesses Win Without a Moat, check out the video below.

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