The Capital Cycle Podcast - Robustness Ratio Revisited

Episode Date: February 28, 2025

How companies which share the benefits of scale with customers win in the long-run compared with value extractive rivals. Presented by Edward Chancellor with Alice Li, an investment analyst.For more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello, this is Edward Chancellor with another edition of the Capital Cycle podcast. I have with me, Alice Lee, who's a research analyst at Marathon Asset Management. And we're going to talk about how companies that offer good value propositions to their customers also often make good investments. The non-gouging companies that don't price gouge their clients are often good investment. Tell me a bit about that. sort. So we think that one of the best ways to predict a company's ability to compound in the long term is to look at the gap between its value creation and value extraction relative to competitors. And you mention an earlier global investment review from May 2005, which talks about the so-called robustness ratio. Can you explain that? The idea is that you can measure the company's mode by analyzing its division of profit. And the robustness ratio was defined as the distribution of profit to customers and employees, divided by the distribution to shareholders. And the higher the ratio, the more robust the businesses. And I think this original idea was drawn from comments

by Warren Buffett about Berkshire Hathaway's insurance subsidiary, GEICO, which, according to Buffett, at least, was highly profitable owing to its great scale and was able then to deliver great value to its customers, but also part of the excess returns could be shared by employees and shareholders. This robustness ratio, as Marathon called it, provides a barrier to entry or what Buffett would call a moat. But you're also suggesting in this piece that some companies don't really have a very high robustness ratio. Aren't really that robust, but are, if you will, draining the moat through their repacious activities. So companies that are undercreating and over-extracting are going to be the losers

because they have to face unpleasant options. They can either continue to extract while bleeding market share, or they have to give back some of the customer surplus in the form of lower prices or higher investment in products or services. And we'll talk about a couple of instances of those a bit later. But first, you think that when a company has delivered a lot of surplus value to its customers, it can then profit from that in a particular way. So if a company has created a lot of customer surplus,

it has the option to claw back some of that surplus in future. One could argue that the beginning of a period of clawback is usually, the best time to invest in an under-earning business because you usually get rapid profit inflection as well as multiple expansion. Or if the company decides to leave the surplus intact, it will gradually gain market share and benefit from further economies of scale. Let's discuss a couple of examples you give of companies with a good robustness ratio that are delivering surplus for their customers. And you start by talking about Netflix, which I suppose in a way like Buffett's Geico, enjoys tremendous economies of scale,

that it can pass the benefit onto its clients. So in 2022, Netflix had about 220 million subscribers globally, but there were nearly 100 million non-paying users using Netflix with shared passwords. So you could easily argue that Netflix was under-earning. And since the crackdown on password sharing, the company has gained over 80 million subscribers, and the incremental revenue from those previous free riders has a high flow-through rate to the bottom line. And Netflix was able to implement this successfully because it was only taking back some of its right for profits, and customers are

still getting good value for money. If you look at the cost per hour of viewing on Netflix, it's much lower compared to competitors because Netflix has industry leading, engagement hours per user. And you cite, for instance, that its average charge per hour is 14 cents for Netflix versus, say, 41 cents for Disney, the Disney Plus product. Now, moving away from streaming businesses, you cite a very efficient global stockbroking outfit called Interactive Brokers. Can you tell us a bit about that? So it's a stock we bought in early 2024. Its value proposition is that it offers the best. best technology at the lowest prices, customers can trade almost any financial instrument across

150 markets, so the offering is much broader than competitors. And interactive brokers provides industry leading execution with its smart routing technology, which reduces trading slippage for customers. And it charges lower trading commissions than competitors, lower margin rates, and pays customers higher interest rates on invested cash. It's the company's founding principle to keep prices low and transparent. And because of the superior value proposition, it's been growing client assets more than twice the speed of its competitors. Can you describe a bit about why Interactive Brokers are able to deliver lower trading costs and lower margin costs than its competitors? Because it has a cost advantage. First, it doesn't

have to spend much on marketing because customers naturally gravitate towards superior value proposition. So it spends less than 1% of its revenue on marketing, while competitors have to spend a lot more. And second, it has a strong engineering culture. So over the years, it has achieved a high degree of operational efficiency through automation of manual processes. To measure that efficiency, revenue per employee for interactive brokers is nearly twice as high as competitors. And because of its superior cost structure and its philosophy to share more surplus

with customers, we think that it will likely continue to take market share in the long term, which will lead to further scale advantages. And now let's consider a couple of examples of firms that you consider are not really delivering great value to customers, but possibly price-coaching. And you cite an example of another financial services business, the UK-based company, Hargreaves Landsdown. First of all, to tell people what it does and then where it went wrong. So it's the largest investment platform in the UK with a nearly 40% market share in DIY investing.

And actually, in its early years, it was offering a best in class platform and services at very competitive prices. And that's what enabled them to take market share from the banks and financial advisors. But as it became dominant, it became complacent. So over the years, it underinvested in prices. and has been losing market share to lower price competitors such as Vanguard. And to slow the bleeding, it had to cut prices on various products. But even after the price adjustment, its pricing is still uncompetitive. And on top of that, it underinvested in technology and suffers from inefficient manual processes.

Operating costs as a percentage of AUA has been rising over the last few years, which is the opposite of economies of scale. in 2022, we announced 175 million investment in technology and suspension on the special dividend. The market didn't like it. And the share price plunged. We should say that how it lands down long-suffering shareholders been put out of their misery by accepting a takeover offer last year from a private equity consortium, including the Abu Dhabi Sovereign Wealth Fund.

Let's turn to another sector now, which is the relative. relatively beleaguered luxury goods sector, which as far as I understand, has seen a decline in its growth prospects owing in large measure to contraction of Chinese demand on the back of the ongoing real estate bust. Tell me which companies you think have treated their customers less generously and therefore undermined their competitive position and which do you think will come out on top from this. There's some interesting data from Bernstein, from 2020 to 2023, like-for-like prices on some evergreen products increased by 66% at deal and 59% at Chanel. This magnitude of price hikes was not justified by inflation and not accompanied

by more value delivered to customers. There's some data from BCG showing that over half of luxury products are sold to middle-class consumers and they're spending less than 2K on luxury items annually. So many of those middle-class consumers are priced out of the market. Now we're starting to see certain luxury brands decrease the listing price of some items by 10 to 20% and send more items to discount channels. This can be quite brand damaging because it's essentially cheating on their old customers who have already bought the items at higher prices. And it is hurting the perception that those luxury items can hold value over time.

But you suggest that not all luxury brands are in trouble and not all of them have price gauged their customers. So Richmond is the owner of Cartier and Van Clif and Arbos, and it's a long-term marathon holding. Richmond has been much less aggressive on pricing compared with peers. The management has a strong philosophy that pricing should be fair. It is focused on building long-term brand equity and customer loyalty, rather than hiking prices to boost short-term profits.

So you believe that Richemont will weather the problems in the luxury industry better than some of those competitors? Yes. So how does one identify the firms that over-deliver from those that under-delivered to customers? I think consistent market share expansion is a useful indicator. We also like companies with significant family ownership because they usually operate with a long-term mindset, whereas companies run by professional. with very short 10 years are more prone to underinvestment and over-extraction to optimize

for the next quarterly earnings. In the GIR, I mainly talked about customer surplus, but when we are researching companies, it's important to think about surplus and deficit for all the stakeholders, because if any part of the value chain is severely squeezed, the company is likely built on shaky ground. For example, if you are a restaurant franchisor and your franchisee, are under margin pressure. It won't immediately show up on your P&L, but over time, it's going to impair your ability

to grow franchising numbers, and at some point, you have to share more profit with franchisees to help them restore profitability. Or if you are an auto-o-e-m and your distributors are under a lot of pressure, they will gradually exit or revolt against you, which is what happened in China. So I think it's important to not look at a company in isolation, but to look at it in the context of value creation and value extraction in the entire ecosystem.

And finally, one has to bear in mind that one can overpay for great companies that deliver great value to their customers. Warren Buffett himself in the late 1990s was constantly extolling the profitability and the high returns of two of his investments at the time, Coca-Cola and Gillette. They delivered such great returns, such great shareholder value, that he referred to them as the inevitables. And Buffett's huge fan base then bid up the price of these inevitable until they became sort of inevitably loss-making or value-destroying from an investment perspective.

You cite another example from that era, namely Walmart, a great business, which historically has always offered great value to its customers, but became overpriced. Yes. So if you bought Walmart at 55 times earnings at the beginning of 2000, you'll be lost making for 10 years because all the benefits of the underlying compounding was eroded by valuation derating. So it's very important to keep valuation discipline. And finally, you earlier mentioned Netflix as a company that delivered good value, but it's not a marathon holding, as far as I understand. Is that because the valuation is deemed somewhat lofty at the moment?

Yes. Thank you, Alice. Nice speaking to you. Well, thank you, Edward. Thank you for your time today. I hope you will listen to the next edition of the Capital Cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important.

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