The Mental Model That Explains Any Business's Success

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This week's newsletter is an adaptation from my recent YouTube video on The Piton Network.

What if you could predict the future and know exactly when a startup entering an industry would be likely to beat the incumbent?

Or when a new competitor entering a new area was actually well-suited to win that market, despite the fact that the existing product was loved by many?

I can't promise you that we will be able to predict the future, but I can promise you the next best thing, which is this powerful mental model, which will allow you to analyze businesses in a whole new light.

This is one of the most powerful mental models I've ever come up with, and it is the byproduct of thousands and thousands of hours of investment research.

How come in certain cases, someone who is worse funded and in a subpar position, at least seemingly, actually ends up succeeding?

Is that knowable ahead of time?

Because as an investor, if we are able to see where a company is going to go in the future, then we may be able to invest well before they actually end up there, which could mean a very successful investment for us.

The concept of this week’s Five Minute Money is going to be on something called the Piton Network.

The Piton Network.

If you don't know, like I didn't know originally, a piton is a metal stake that a mountain climber will stake into the side of a mountain and then suspend their rope from it.

They are simultaneously being held up in the air by this piton, while at the same time it is constraining their ability to move because of the rope.

This is where this idea comes from.

It is a metaphor for decisions that businesses make that both simultaneously support some elements of the business while constraining them in other aspects.

Let's imagine that we're playing chess.

With every move that you make in playing chess, you at the same time are changing your future decision space.

A good chess player will think out many moves ahead, thinking about how different moves on the chess board will influence potential future decisions that they can make.

Before you make your first move in chess, you have this decision space that is wide open and clean, and every time you're making a move, your decision space is basically shrinking.

Maybe there's certain things that can happen in chess that expand your decision space.

But by and large, the more decisions and the farther along you are in this game of chess, the more your decision space is decreasing.

The Restaurant Example: One Decision, Many Consequences.

Now I want you to imagine that you are going to open up a restaurant, and you're figuring out what kind of restaurant should I open up?

But before you fully figured that out for yourself, you went ahead and you leased out a storefront for the restaurant.

This storefront was kind of actually really like a shack, with maybe just enough room for one table and a couple stools.

It's kind of not in a great area, but it does have a lot of traffic that moves through, and there's parking nearby.

And so right then, you may have thought that you were making just one decision.

But no, that is not what happened.

When you made that one decision, you actually limited your future decision space of all of these other potential decisions you can make.

Because it is a small restaurant, and you can't fit a lot of tables in there, you've just eliminated the possibility of having a real sit-down restaurant, let alone a full service restaurant with waiters and waitresses.

Because you don't have a lot of seating, it means that you're gonna probably have to have a very big takeout business.

You're going to have to be able to generate a lot of volume, and if you're generating a lot of volume, that means that your food can't be that expensive either.

You probably shouldn't try to have a Michelin, five-course meal to go.

Instead, what will work best is something more like very good, cheap food to go and very quickly served, because you have a lot of traffic and parking available.

So right there in that one decision, you see how all of these other decisions are kind of downstream of that.

I like to call this a decision cluster: we think we're making one decision, but very often we're making several simultaneously.

If we go back to the chess example, this idea of the more moves you make and the more your future decision space shrinks, this to me is this idea of a mountain climber taking these pitons and climbing up the mountain, and the further up the mountain they go, the more limited in direction they have that they can ultimately achieve.

When you're thinking about this from a business perspective, the more decisions a business makes, the more pitons it's laying down over time.

Every decision a business makes is like a piton staked into the side of the mountain: it both constrains them from making other decisions while supporting them on their current path.

How One Decision Impacts a Business’s Climb.

Now, think about just one decision a business can make.

Very simple.

I want to sell products cheaply.

But with that one decision, you've probably just made a bunch of other decisions as well.

The first one being that you're probably going to end up outsourcing, since it's probably cheaper to buy your products internationally.

If you are buying products internationally, that means you're going to have long lead times, the amount of time it takes from an order placed to the inventory received.

Since you have long lead times, you're going to have to figure out where to store excess inventory, because you can't have customers waiting months and months.

If you do have inventory domestically stored in a warehouse, that also means you now need to be perfect with estimating inventory demand and consumer taste.

You buy the wrong inventory, now you may be stuck having to discount, and that could hurt your brand.

Or maybe you need to figure out an outlet strategy to get rid of this inventory that doesn't sell, or potentially risk not ordering enough inventory, and then your customers are disappointed and go elsewhere.

You thought you were really just making one decision, but you see how that one decision is impacting all of these other elements of the business.

Floor & Decor Example.

Let's take a company that we had a deep dive on in the past, Floor & Decor, a specialty flooring retailer.

They sell all sorts of hard surface flooring, not even carpet, and they sell it out of these big warehouses.

The value prop Floor & Decor is offering is that they want to have 1) the most selection, 2) the lowest prices, and 3) the most in-stock inventory.

That in-stock inventory piece is especially important because very often they cater to professionals, over half of their business now.

Professionals need to be able to pick up flooring the same day and install it.

If you're an independent flooring installer, you don't have a warehouse, so you don't have places to store all of this flooring.

Instead, you go to a Floor & Decor, and they store your flooring for you.

Then the question becomes: how do you support having the most in-stock inventory across the broadest selection and the lowest prices?

You're going to basically figure out that if that is your value prop, you're going to have to make two decisions.

The first one is you need a warehouse store.

It essentially collapses the back room with the front room to a large extent, giving more storefront square footage to become available selling space for flooring.

Instead of the typical model of having a lot of inventory at a distribution center far away, it now all gets stored at the actual store level.

Because it's an 80,000 square foot warehouse, that means there's just a lot more room for storing different SKUs.

Secondarily, you are also going to need to be a specialty flooring retailer.

You can't do a warehouse model and then devote only 10% of it to flooring, which is what Home Depot does and what Lowe's does.

How Floor & Decor differentiates from them is they devote the entire warehouse to flooring.

These two decisions allow them to make all of these other downstream decisions.

By devoting themselves just to flooring and having these warehouses, it also means that they can directly source.

They have enough volume because of this model to go directly to the manufacturers, and cutting out middlemen means lower prices.

It also means more selection because they can directly contract out to the manufacturers instead of going through a distributor who may limit the amount of SKUs.

Floor & Decor works with over 240 different suppliers and will sometimes create their own custom SKUs.

The warehouse model also means they have excess space that they could devote to things like in-store designers to help you pick what flooring you should order.

And because you are known to just be a flooring specialty retailer, you are very well-positioned to become the one-stop shop for flooring professionals.

Why Lowe's Couldn't Copy Floor & Decor.

We have a beautiful example in Lowe's, where Lowe's saw the success Floor & Decor was having and wanted to copy them.

They expanded their flooring section and added more hard flooring selection.

What they quickly found out was they can't, because their warehouse is devoted to all sorts of different things, and Lowe's isn't known as a flooring retailer.

By analogy, imagine I told you to bake the best cake in the world, but you can only use what you currently have in your kitchen cabinet.

That is exactly the situation Lowe's was facing, given the prior pitons they had already placed down.

It was Lowe's decision in the past to be a general home improvement retailer rather than a flooring specialty retailer, and that piton couldn't be pulled out after the fact.

LL Flooring: Killed by the Wrong Pitons.

Floor & Decor also had another flooring competitor, LL Flooring, that got killed by them and is now bankrupt.

The flooring value prop LL Flooring had was not as good as Floor & Decor's, and could never improve to that level without ripping out the pitons in the business model and restaking them differently.

The way that business operated was through storefronts.

People had to go in and order flooring, and it would come a couple days later from a distribution center far away.

That model doesn't work when you need in-stock inventory the same day to avoid losing a job.

Having a storefront is a piton.

They could have stores in the middle of cities, more of them, less expensive to run, higher touch service.

But it constrained them, meaning they would never be able to have in-stock inventory or cater to the pros the way Floor & Decor can.

Amazon vs. Walmart: Logistics Built for Different Pitons.

This model is bigger than flooring, and can be applied to all sorts of different businesses.

If we think about Amazon and the way they built from the ground up their entire logistic structure, it is optimized just to do last mile delivery to individual homes.

Walmart, trying to get more and more into e-commerce, had a sub-optimized position in order to go after last mile e-commerce.

We could see this clearly with how Walmart's logistics work, where a full truckload of goods goes back to an individual store, they have to unpack it, and stock all of the shelves.

If someone wanted to order from Walmart, all of the inventory currently stocking the shelves is not easily accessible.

I remember experimenting with Walmart Plus before, and Walmart sent someone to the individual store, who individually picked up that item and drove it to me.

Walmart has had to go back and redo their fulfillment for e-commerce because their existing asset base wasn't going to cut it compared to what Amazon was able to do, because Amazon has distribution centers with robots and individuals optimized for one thing: quickly moving millions of items into a box and getting that box onto a truck to someone's house very quickly.

They have been fairly successful in e-commerce, but it's not because of what they were doing before, it's because they built out new distribution centers, MFCs, or market fulfillment centers, sometimes carved out of the square footage of their actual stores.

The broader theme here is: are you optimizing for the optimal variables to address the consumer value prop, or are you optimizing just for the existing pitons a business has placed?

In Walmart's example, their pitons are their stores.

But if they started fresh, they wouldn't build out that store base, they'd go directly to fulfillment and distribution centers.

RH: Climbing the Luxury Mountain.

Now I want to give one last example here, which I think will clarify a lot of this.

The company is Restoration Hardware, or RH.

If you're not familiar with them, 25 years ago this business was entirely different than what you see today.

It was a business that sold a lot of home furniture that was pretty expensive, a lot of kinda traditional American-looking stuff.

But the furniture business was supported by this gimmicky, compulsive, small product consumer goods business, where they would sell next to all their furniture random stuff like atomic robot man dolls, and literally sold dog food biscuit mix.

The founder of Restoration Hardware, Stephen Gordon, really liked all of these whimsical things, as he would call them, kind of like a higher end of a Temu store.

The reason they did this was because you don't buy furniture very often, so if you have a furniture store in a mall, you're not going to walk into it very often.

So his solution was to have a lot of these cheap knick-knacks to draw people in out of curiosity, and they might compulsively buy some of this stuff.

It's lower priced and lower margin, but higher frequency, whereas furniture is a low-frequency, high-margin good.

But the stores, after a while, weren't doing well.

People got tired of the knick-knacks, the gimmicky stuff, which weren't serving a very high-value prop; those tend not to be very enduring, lasting purchase behaviors.

They started to comp negative with same-store sales, and the business nearly went bankrupt, technically in violation of its debt covenants.

Gary Friedman, who had worked at Williams-Sonoma and was just passed over for his CEO job, saw Restoration Hardware, put $5 million of his own money into it, and took over the business.

His long-term vision was to make Restoration Hardware much more high-end, which was laughable at the time.

The reason this framework works so well here is that the past business owner, Stephen Gordon, had made decisions that were constraining their ability to be a higher-end store: the gimmicky products, for one, but also that they didn't directly source any of their merchandise, so everything was expensive without being high quality, impacting margins and inventory.

Gary Friedman had to continually improve the business and merchandising quality while simultaneously not totally alienating existing customers, since he couldn't go from a mall footprint to huge galleries in one day.

He would remove a lot of the knick-knacks and gift items, sales would slump, and he'd realize he needed to put some back.

In 2004 or 2005, after removing a lot of these gifts, he started reintroducing them again, realizing the business needed those sales to stabilize for now.

It was a lot of teetering back and forth until they finally started really pushing up higher end.

Today, RH has galleries sometimes 100,000 square feet, with marble, the finest stones, and restaurants inside that generate over $10 million in sales, some of the most profitable restaurants in the country.

What the restaurants did for RH was the same thing the knick-knacks did for the Stephen Gordon version of the business: you can go to a restaurant much more often than you buy furniture, so you visit, buy food, and next time you're in the market for furniture, you think Restoration Hardware.

They pulled out the knick-knacks as the piton driving traffic and, after a while, put in a new one, the restaurants.

Because RH is consumer-facing and customers can walk through the showroom themselves, they're not catering to interior designers, and lost a big flow of traffic that usually supports sales through designers, so they had to make it up with the restaurants and the big galleries that draw people in.

This value prop, being the highest end but also a convenient one-stop shop for the affluent, was only made possible by changing all of these underlying elements of the business over time.

They switched from the mall footprint to the gallery footprint, got rid of third-party logistics providers in favor of insourcing delivery, and got rid of the gimmicky products and replaced them with restaurants.

If you ever hear Gary Friedman talk, he talks about climbing the luxury mountain, and his climb has very often been held back by these pitons, which were supporting the old business but are now constraining the new one.

A piton can support some elements of a business while constraining their ability to go to another, and at some point you have to pull the pitons out and restake them to better accommodate the new value prop you're trying to offer.

3 Questions for Analyzing a Business.

Here are 3 questions you could ask yourself in order to analyze a business better.

Question 1: What Are the Load-Bearing Pitons?

In our Floor & Decor example, we said that if you want to have the same value prop as them, you're going to need to have a warehouse store, and you're going to need to devote all of the space to flooring.

So those are two load-bearing pitons, things the business must do in order to best serve that value prop.

Question 2: What Decisions Are Downstream?

We had the example again with Floor & Decor, where if you have that warehouse and you're devoted to flooring, now you're able to direct source materials, buy in more volume, have more selection, and cater better to pros.

Question 3: Does It Serve the Value Prop?

The last part of this is that I want you to now understand all of these downstream effects and whether or not all of that is actually going to serve the value prop they're trying to offer.

If you are trying to optimize for the fastest delivery, then it makes sense that you should have fulfillment centers and distribution centers, and you're probably not going to be able to have very fast e-commerce delivery unless you build those out.

So the next time you analyze a business, ask yourself these 3 questions and understand what are the pitons in the business.

The Piton is a strategic decision that other elements of a business are built off of and constrained by.

But at the heart of a Piton is a trade-off.

Every time you build towards something, you build away from something else.

Stack a few of these decisions together and you have a Piton Network— a group of decisions that optimize a business for a specific outcome, but critically do not allow it easily to be optimized for something else.

A company’s destiny is their Piton Network.

With each Piton a mountain climber stakes into the mountain side, they are making a decision on how to proceed.

The Piton both supports them and constrains them.

For more on The Piton Network, check out the video below.

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