Nuggets

# In Investing

## Charlie Munger deconstructing what made the success of Coca-Cola possible

11 Sep 2020 · via Charlie Munger: Turning $2 Million Into$2 Trillion 📚

A master class by Charlie Munger — a step-by-step deconstruction of the lollapalooza that made Coca-Cola possible. How Coke exploits the human biochemistry and psychology, and have successfully blocked competitors from doing the same:

We can see from the introductory course in psychology that, in essence, we are going into the business of creating and maintaining conditioned reflexes (a.k.a. habits). The “Coca-Cola” trade name and trade dress will act as the stimuli, and the purchase and ingestion of our beverage will be the desired responses.

And how does one create and maintain conditioned reflexes? Well, the psychology text gives two answers: by operant conditioning, and by classical conditioning (often called Pavlovian conditioning to honor the great Russian scientist). And, since we want a lollapalooza result, we must use both conditioning techniques – and all we can invent to enhance effects from each technique.

The operant-conditioning part of our problem is easy to solve. We need only (1) maximize rewards of our beverage’s ingestion, and (2) minimize possibilities that desired reflexes, once created by us, will be extinguished through operant conditioning by proprietors of competing products.

For operant conditioning rewards, there are only a few categories we will find practical:

1. Food value in calories or other inputs
2. Flavor, texture, and aroma acting as stimuli to consumption under neural preprogramming of a man through Darwinian natural selection
3. Stimulus, as by sugar or caffeine
4. Cooling effect when man is too hot or warming effect when man is too cool

Wanting a lollapalooza result, we will naturally include rewards in all the categories.

To start out, it is easy to decide to design our beverage for consumption cold. There is much less opportunity, without ingesting beverage, to counteract excessive heat, compared with excessive cold. Moreover, with excessive heat, much liquid must be consumed, and the reverse is not true. It is also easy to decide to include both sugar and caffeine. After all, tea, coffee, and lemonade are already widely consumed. And it is also clear that we must be fanatic about determining, through trial and error, flavor and other characteristics that will maximize human pleasure while taking in the sugared water and caffeine we will provide.

We must avoid the protective, cloying, stop-consumption effects of aftertaste that are a standard part of physiology, developed through Darwinian evolution to enhance the replication of man’s genes by forcing a generally helpful moderation on the gene carrier. To serve our ends, on hot days a consumer must be able to drink container after container of our product with almost no impediment from aftertaste. We will find a wonderful no-aftertaste flavor by trial and error and will thereby solve this problem.

And, to counteract possibilities that desired operant-conditioned reflexes, once created by us will be extinguished by operant conditioning employing competing products, there is also an obvious answer: we will make it a permanent obsession in our company that our beverage, as fast as practicable, will at all times be available everywhere throughout the world. After all, a competing product, if it is never tried, can’t act as a reward creating a conflicting habit. Every spouse knows that.

We must next consider the Pavlovian conditioning we must also use. In Pavlovian conditioning powerful effects come from mere association. The neural system of Pavlov’s dog causes it to salivate at the bell it can’t eat. And the brain of man yearns for the type of beverage held by the pretty woman he can’t have. And so, Glotz, we must use every sort of decent, honorable Pavlovian conditioning we can think of. For as long as we are in business, our beverage and its promotion must be associated in consumer minds with all other thing consumers like or admire.

Such extensive Pavlovian conditioning will cost a lot of money, particularly for advertising. We will spend big money as far ahead as we can imagine. But the money will be effectively spent. As we expand fast in our new-beverage market, our competitors will face gross disadvantages of scale in buying advertising to create the Pavlovian conditioning they need. And this outcome, along with other volume-creates-power effects, should help us gain and hold at least 50 percent of the new market everywhere. Indeed, provided buyers are scattered, our higher volumes will give us very extreme cost advantages in distribution.

Moreover, Pavlovian effects from mere association will help us choose the flavor, texture, and color of our new beverage. Considering Pavlovian effects, we will have wisely chosen the exotic and expensive-sounding name “Coca-Cola,” instead of a pedestrian name like “Glotz’s sugared, caffeinated water.” For similar Pavlovian reasons, it will be wise to have our beverage look pretty much like wine, instead of sugared water. And so we will artificially color our beverage if it comes out clear. And we will carbonate our water, making our product seem like champagne, or some other expensive beverage, while also making its flavor better and imitation harder to arrange for competing products. And, because we are going to attach so many expensive psychological effects to our flavor, that flavor should be different from any other standard flavor so that we maximize difficulties for competitors and give no accidental same-flavor benefit to any existing product.

What else, from the psychology textbook, can help our new business? Well, there is that powerful “monkey-see, monkey-do” aspect of human nature that psychologists often call “social proof.” Social proof, imitative consumption triggered by mere sight of consumption, will not only help induce trial of our beverage. It will also bolster perceived rewards from consumption. We will always take this powerful social-proof factor into account as we design advertising and sales promotion and as we forego present profit to enhance present and future consumption. More than with most other products, increased selling power will come from each increase in sales.

We can now see, Glotz, that by combining (1) much Pavlovian conditioning, (2) powerful social-proof effects, and (3) wonderful-tasting, energy-giving, stimulating and desirably-cold beverage that causes much operant conditioning, we are going to get sales that speed up for a long time by reason of the huge mixture of factors we have chosen. Therefore, we are going to start something like an autocatalytic reaction in chemistry, precisely the sort of multi-factor-triggered lollapalooza effect we need.

The logistics and the distribution strategy of our business will be simple. There are only two practical ways to sell our beverage: (1) as a syrup to fountains and restaurants, and (2) as a complete carbonated-water product in containers. Wanting lollapalooza results, we will naturally do it both ways. And, wanting huge Pavlovian and social-proof effects we will always spend on advertising and sales promotion, per serving, over 40 percent of the fountain price for syrup needed to make the serving.

A few syrup-making plants can serve the world. However, to avoid needless shipping of mere space and water, we will need many bottling plants scattered over the world. We will maximize profits if (like early General Electric with light bulbs) we always set the first-sale price, either (1) for fountain syrup, or (2) for any container of our complete product. The best way to arrange this desirable profit-maximizing control is to make any independent bottler we need a subcontractor, not a vendee of syrup, and certainly not a vendee of syrup under a perpetual franchise specifying a syrup price frozen forever at its starting level.

Being unable to get a patent or copyright on our super important flavor, we will work obsessively to keep our formula secret. We will make a big hoopla over our secrecy, which will enhance Pavlovian effects. Eventually food-chemical engineering will advance so that our flavor can be copied with near exactitude. But, by that time, we will be so far ahead, with such strong trademarks and complete, “always available” worldwide distribution, that good flavor copying won’t bar us from our objective. Moreover, the advances in food chemistry that help competitors will almost surely be accompanied by technological advances that will help us, including refrigeration, better transportation, and, for dieters, ability to insert a sugar taste without inserting sugar’s calories. Also, there will be related beverage opportunities we will seize.

## John Collison on the challenges of accounting for R&D and intangible capital

05 Sep 2020 · via John Collison – Growing the Internet Economy – [Invest Like the Best, EP.178] 🎙

John Collison talks about the challenges of quantifying OpEx vs CapEx, and intangible capital and R&D versus tangible capital of a software company:

Accounting standards are invented by us humans to give us a view of a business and they’re up to us to choose. They’re generally in kind of long boring committees, but we humans choose how we look at businesses. I have absolutely no patience for the crowd that’s all this winging about non-GAAP metrics. [In fact, the GAAP standards are just] relatively arbitrarily chosen and constantly tweaked set of standards for looking at a business. If they’re constantly tweaked, presumably you would expect that they can be improved upon.

One of the areas in which I think the standard way we look at businesses is just completely wrong, is in reasoning about R&D and intangible capital.

Capital has really moved over the past 100 years away from heavy machines to intellectual capital and intangible capital. Traditionally, if you read a balance sheet and a company has a bunch of stuff, then it has a bunch of assets on its balance sheet. If you’re a cafe, maybe your assets are the coffee machine, maybe a really expensive coffee machine. These days with technology businesses, what are the capital within the business? One of the assets that the business have, it’s probably software that has been developed in house by the business. At Google, for instance, it is the search engine that’s it. Now for 20 years, Google engineers have laboriously worked on to make it good.

Capital used to be about something really tangible, like an espresso machine. Something you can reason about its value really easily. Its value doesn’t change that much over time, and there’s a clear market for it. You could go out and sell this espresso machine for some amount of money. So, one of the accounting principles is that you just carry things at cost, before depreciation. But it’s really hard to reason about the value of intangible capital, like Stripe Radar, how does the value of that system that we built?

The reason this gets interesting is because you and I might very reasonably want to think about: What is the profitability of a business after you strip out all the investment in future growth? Because as you look at the technology sector, one of the things that kind of unifies technology companies is that they don’t tend to produce kind of huge amounts of cash flows until later in their maturity. Companies that are in their growth phase, either pre-public companies or recently public companies tend to be mostly reinvesting in growth.

As we look at how accounting works for this, it’s really basic. All you have is companies that are spending lots of money on operations, engineering salaries, operation salaries, lawyer salaries, kind of the general OpEx, and no real intelligent view on what is the capital that we’re developing. What is the multi-year value that we’re getting from this system that we’re building versus what is the actual ongoing cost of operating the system?

And so that’s something that we spent a lot of time at Stripe getting good internal management views into is as a system-by-system, line-by-line level. How much are we investing in kind of the future potential of this system vs. What is the existing profitability of the system? What is really the core question for a technology business which is: How much are you paying to operate this business, versus how much are you investing in a long lived technology advantage?

Patrick: Everyone will pay a lot of lip service to the concept of free cashflow, but I think for all the reasons you’ve pointed out, it’s a very hard metric to get to. And then there’s also just silly concepts. What is the useful life of a piece of software? Like how do you even reason about something like that? And therefore, think about something like depreciation. A lot of what is registered as operating expenses in a business is kind of like what we used to call capital expenses, because it’s going to be useful for a long time. And I think this is an important, it’s a really important topic for public investors with more of these businesses due to become public.

[I like] the concept Warren Buffett introduced in his 1986 letter of “owner earnings” (example).

The most interesting thing about that definition for me was splitting out the two forms of CapEx. CapEx spend that has a multiyear horizon or a multiyear payoff is split out into:

1. CapEx into what is just needed to tread water, investment required for the company to keep same competitive position and keep its unit volume
2. CapEx required to expand

We haven’t fully chased it through [in Stripe], but I think that’s a really interesting distinction.

Buffett obviously always talks about the example of the textile mill that Berkshire Hathaway got its start with. It was such an incredibly terrible business because you were spending all this CapEx just to tread water, just to stay in place.

I think it’s important for companies to be honest with, I mean, not only external investors, but companies be honest with themselves on this. Is this spend just the cost of doing business, the cost of operating our business, and we are maintaining our competitive position or are we expanding in some way? Are we growing our share of market? Are we expanding to a new country? Are we developing a new product that will monetize separately?

## John Collison on why it was a Telco Bubble, not a Dot-Com Bubble in the early 2000s

05 Sep 2020 · via John Collison – Growing the Internet Economy – [Invest Like the Best, EP.178] 🎙

John Collison talks about how the Dot-Com Bubble is a misnomer:

People don’t really remember this, but by market cap, the 2000 bubble was really a Telco bubble and not an internet bubble — in that the run-up of the WorldCom stock’s and companies like that, it was much larger in terms of total size than all the internet companies [at the time].

There’s some good reading to be done on what happened with that. It really drove a lot, you basically had all this investments and optimism around the growth of the internet.

I think it was WorldCom kept going around with this talking point of the internet is doubling every 4 months and it felt like it was going to the moon and bandwidth and things like this. That ended up with this incredible oversupply of internet capacity, fiber especially, that then made things really cheap for when everything washed out in 2001, 2002. And as a result, it was a platform on which everything else could build [upon] during that period following.

## John Collison on John Malone’s Liberty Media

05 Sep 2020 · via John Collison – Growing the Internet Economy – [Invest Like the Best, EP.178] 🎙

John Collison on how history rhymes:

I was pretty interested in the cable companies that emerged in the late 1980s, early 1990s. This is like a particularly American phenomenon. It was a new technology platform, new technology paradigm, laying coax cable to all these towns across America. And you had way more television bandwidth, number of channels possible, than previously was the case. When you read it, it actually rhymes a lot with some of the technology shifts that we see.

Firstly, [there is] John Malone, who’s one of the most successful serial acquirers of all time with Liberty Media, where they basically continue to roll up small cable companies and build a very large company out of acquiring kind of small little local cable companies.

The second thing that was of course, interesting is it was one of the original kind of new technology company from out of town versus local municipalities. And it was funny as I was reading Cable Cowboy: John Malone and the Rise of the Modern Cable Business, they describe how one of the cable companies, I can’t remember who, getting into spat with a local Colorado town and changing the programming to just be “Call your mayor and tell him you want cable in your town.” And you know, exactly like the tactics Uber might’ve used, during that period when they were getting into fights with local cities.

Again, there’s a lot of history repeating itself.