Why Fairness is the Most Sustainable Competitive Advantage: Part III

“The worship of premium pricing always creates a market for the competitor. And high profit margins do not equal maximum profits. Total profit is profit margin multiplied by turnover. Maximum profit is thus obtained by the profit margin that yields the largest total profit flow”  Peter Drucker: #1 of his 5 deadly business sins

Bill Gurley – a highly successful venture capital investor, and blogger- wrote a piece called  The Rake Too Far, discussing the optimal pricing strategy for internet platforms. The “FANG’s” (Facebook, Amazon, Netflix, Google) are the most famous variants of these business models today.

So what does he mean by “The Rake Too Far”?

Taken from the casino industry, the “rake” is the share that a player must pay the house to participate. It’s what you have to pay to play. The more attractive the game is, the more tempting it is for the house to increase their rake.

Bringing it back to internet platforms, you can imagine that given the huge network effects and potential for global scale the internet can offer, it must be very tempting for a successful platform to increase its rake. As Gurley explains though, this can be exactly the wrong thing to do if you want to build the most profitable business model.

“There is a big difference between what you can extract and what you should extract”  Bill Gurley

When the world is your oyster (i.e. you have a scalable platform and a very large addressable market) the key goal should be to minimise transaction friction. The rake is a form of friction. Too much friction and transaction volume will fall. Alternatives will be sought. It may be very difficult to find an alternative, but as I mentioned in my previous blogs in this series (Part I and Part II), unhappy customers are spring loaded to go elsewhere when they are being taken advantage of.

“A sustainable platform or marketplace is one where the value of being in the network clearly outshines the transactional costs charged for being in the network…. Everyone wins in this scenario, but particularly the platform provider. A high rake will allow you to achieve larger revenues faster, but it will eventually represent a strategic red flag – a pricing umbrella that can be exploited by others in the ecosystem, perhaps by someone with a more disruptive business model.”   Bill Gurley

Whilst the rake charged by many internet platforms is high (often 20-30%), the most extreme example highlighted by Bill Gurley (in this table below from 2013) is Shutterstock, which took an astounding 70% rake from its customers in 2013.

Source: Above the Crowds: A Rake Too Far, 2013

That is vicious and the market has been equally vicious in return. Gurley was spot on – looking at how this has played out, there seems to be clear link between excessive rake and platform failure. Whilst Apple’s iOS remains a dominant platform, it could arguably have been a much larger portion of Apple’s profits (whilst also more effectively containing competition from Amazon and Google) had they not been so greedy with their unnegotiable 30% rake. Note, OpenTable was acquired by Priceline (now called Booking Holdings) in 2014 at a 46% premium.

Source: Factset

Greed is obviously not good. Building a sustainable business and maximising your total profits and returns over the long-term requires fairness and respect for your customer. These are valuable lessons for any business manager or investor. This might seem obvious but the key point is that it’s actually very difficult, and is thus a way for companies and investors to differentiate themselves. It requires the courage to think strategically (i.e. long-term) rather than thinking tactically (i.e. short-term). Long-term sustainable thinking involves sacrificing near-term profitability to maximise total profitability in the long-run. Gouging your customer is a risky business, as is chasing short-term returns if you are an investor.  Perhaps it is best summed up by a pithy quote from the disruptor-in-chief and leader of the biggest platform winner in of all.

 “Your margin is my opportunity”  Jeff Besos

Previous Articles in series
Is fairness the most sustainable competitive advantage of all? Part II
Is fairness the most sustainable competitive advantage of all?


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The (sustainable) Founder

If you’ve not seen the movie ‘The Founder’, I highly recommend it. Michael Keaton brilliantly plays the archetypal ruthless businessman Ray Kroc who is recognised as the founder of McDonalds.  This is a key scene that defines the Kroc character….. ruthless Kroc

Hollywood usually likes to portray successful businessmen in this way and whilst these types undoubtedly exist, history shows that the most successful are usually good at heart. From the philanthropy and global peace initiatives of Andrew Carnegie to the Gates Foundation of today, it’s clear that not all successful businessmen and women are bad. So we would be wise to treat negative media narratives – usually targeted at the most successful – with scepticism.

From a business perspective, successful founder CEO’s tend to have an inordinate amount of power within the companies they start. The companies often have dual-class shareholder structures and use stock based compensation liberally. None of this tends to look good on traditional governance screens and is grist to the mill for detractors. But founders invariably care about their companies in a way that a ‘corporate MBA type’ never will. They usually know their businesses better than everyone else.  They are often billionaires and are usually motivated by delivering on a long-term vision rather than the next bonus cheque.

In my experience the combination of deep business knowledge, a long-term vision and the conviction to make bold decisions tends to deliver long-term shareholder returns.  Founders use their mandate to make tough decisions. I believe they share many similarities with long-serving management teams in this respect, which I discussed in a previous soapbox. Indeed, a 2016 Harvard Business Review study found that:

‘companies which have founders as their CEOs or actively involved in running the business are more likely to make bold investments to reinvigorate and adapt their business models showing that they are willing to take more risks to invent the future’[1]

Many (maybe even most) founders also identify themselves with delivering societal value via philanthropy or deploying corporate capital towards solving meaningful social or environmental problems.  We believe this is increasingly evident in the smaller and mid cap end of the market where #SustainableDisruptors often have a product vision that is inextricably linked to sustainability. When it comes to finding sustainable investments, this is where we are focussed and that is evident in a representative Kames global sustainable equity strategy from the number of companies that are run by founders.

Source: Kames Capital, as at 31 October 2018

We’ve acknowledged that unlike Hollywood movies, most founders are probably nice guys, so I suspect this is actually one of the key factors that has led to their success. Whilst Amazon has attracted negative press attention recently (with great size comes great responsibility), I strongly suspect that Jeff Bezos is not only a business visionary and exceptional leader, but also a nice guy as well. These highlights from a Jeff Bezos 60 minutes interview in 1999 seem to suggest that anyway. It’s 12 minutes long but definitely worth a watch.


[1] Lee, Kim and Bae; Founder CEOs and Innovation: Evidence from S&P 500 Firms; February 2016

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Is fairness the most sustainable competitive advantage of all? Part II

In September last year I wrote a Soapbox about fairness being a source of competitive advantage here. My focus was on the increasing price transparency in business-to-consumer (B2C) relationships and the risks to those companies that have historically abused their customers’ lack of price visibility. But what about abusing suppliers? Can companies still get away with this? Do consumers really care? The dominant business in any value chain usually has pricing power, but we believe there is a difference between pricing power and abuse of power. A business with a high return on capital that is built on the abuse of suppliers is every bit as frail as one built on the abuse of its customers.

As discussed in our recent Soapbox about Hotel Chocolat, the Fairtrade movement is an excellent example of society responding to supplier abuse. This ultimately resulted in companies changing their behaviour because real (or perceived) abuse of third world farmers was damaging their brands.

As part of the sustainability analysis of potential investments, we take great care to assess the supply chain of our investments, particularly when they involve low wage labour or the use of finite and polluting resources. Interestingly, we are regularly drawn to vertically integrated businesses that appreciate the value of controlling their entire supply chain, something that went out of fashion during the ‘outsourcing’ trend. These are often the most disruptive companies and we also find they are usually the most sustainable as well. Why? In my experience it’s because vertical integration means that these companies have a deep understanding of where their products come from, whilst also having a close relationship with their customers.

“It’s a bold move growing our own cocoa and it’s one that goes against the overall trend in the chocolate industry – to specialise more and more in a particular part of the chocolate making process. But Rabot Estate allows us to create a direct connection between our customers and the very origin of chocolate, cocoa. We’re one of the very few in the world able to do this.”

Angus Thirlwell, Co-Founder, Hotel Chocolat

Organisations that excel in managing their supply chain tend to see the benefits of this as self-evident. Quite simply, it creates a competitive advantage that helps improve the rate and sustainability of their returns on capital.

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Capitalists with a conscience

Nearly two-thirds of our proxy voting activity occurs in the approaching second quarter of the year. In terms of what we can expect, in the US at least, ISS (the leading provider of proxy voting services) suggest that 2018 promises to continue the recent trend of social and environmental shareholder resolutions overshadowing governance and compensation-related proposals. Political spending, board and workplace diversity, and climate and sustainability are expected to be key themes.

Social and environmental proposals outnumber governance and compensation proposals

Source: ISS Analytics – An overview of US shareholder proposal filings, Feb 26, 2018 – Based on an analysis of 450 proposals filed at Russell 3000 companies

As shareholders, we are happy to support social and environmental-related shareholder resolutions where there is a strong case that the resolutions will provide a better understanding of the companies we invest in. Or even make them better investments.

There is a mug on my desk that says ‘capitalist with a conscience’. Note the capitalist bit. We ‘do’ ESG because we believe it is in the best interests of our clients. And that means we don’t just support every nice sounding environmental and social-related shareholder resolution that is proposed. Investors need to encourage companies to make the right sorts of disclosures, which investors will genuinely find useful, or make changes that will enhance the company’s prospects. In contrast, investors should be aware of the potential to overburden already stretched management teams with bureaucracy and unnecessary costs.

Our experience is that quite often the companies that are targeted with environmental and social-related resolutions are the same companies that are the most progressive in their ESG behaviours. Why do they get targeted then? Because the resolution proponents know that these companies take their various stakeholder relationships seriously – they have a ‘way in’. Is that fair though?

Of course, that’s not always the case. There is also the issue of companies being disingenuous in their responses to shareholder resolutions that have merit. The US oil majors recently published their responses to requests from shareholders to formally consider the risks of a carbon-constrained future. As we said here, ‘Don’t expect anything too telling, especially from the US majors.’ We were right!

We’ll never get to know how shareholders (you know, the owners…) of ING Groep viewed the recent Supervisory Board proposal to make a share award to the CEO in recognition of the excellent work he is doing. Reconciling being ‘the 44th best paid out of the 50 companies in the Euro Stoxx 50 index’ with ‘widely regarded as one of the top performing bank chief executives in Europe’ against ‘instant backlash from politicians, who are gearing up for local elections next week’ was always going to be challenging. We will just have to wait and see whether or not paying Mr. Hamers in line with his European peers turns out to be in investors best interests.


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Is fairness the most sustainable competitive advantage of all?

Unfairness is ripe for disruption. Everyone hates being exploited and companies that do it to their customers feel their wrath when the ruse is unearthed. This usually happens when another option comes along and increases transparency within the transaction. In a system like this, the customer is spring-loaded to switch to the alternative when they realise they are being duped.

I define an unfair company-customer relationship as one where the company deliberately masks the real cost of an item. As a customer, you know it’s happening when quality falls whilst prices keep going up, and yet you still keep buying it. This is often referred to as ‘pricing power’, but in my mind pricing power is most powerful when it is sustainable, and it is most sustainable when the customer participates in the upside.

As a student companies repeatedly took advantage of me. Which is why I don’t feel sorry for them today as they suffer terminal decline. Let me take you back to 1997…

  • Record labels and music shops: Music CDs cost £15 per album;
  • Book shops: Academic books cost of £whateverthepublisherswanted;
  • TV companies:  Limited channel options, average content, expensive cable movie options and an ever-increasing number of adverts to suffer through.

As a consumer, I hate being ripped off but I love companies that offer me price transparency and choice. Today there is a cohort of global internet platforms that have used fairness – particularly price transparency – to disrupt incumbents. They are maligned by traditional media (which they are disrupting) yet Google and Facebook, for example, bring us price discovery engines and a vast range of entertainment offerings and consumer goods at a transparent price. And they bring it now… or next day delivery.

These businesses are powerful because they empower their customers. We own them in the Kames Global Sustainable Equity Fund in part because of this, and we look to own other companies that exhibit the same sustainable characteristics. We also invest in:

  • MarketAxess: a bond trading platform which is increasing market efficiency and price discovery in a historically opaque market;
  • Tencent: Chinese social media platform embedding entertainment and digital payments in a seamless and transparent way;
  • AutoTrader: No longer owned in the Fund but a great example of price transparency empowering the consumer, and getting-one-over on the stereotypical dodgy used-car salesmen.