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ARP Observations

Why bother with profit to make money

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As long as investors find it desirable to pay exorbitant amounts of money for companies that have never made a decent profit, you can understand the companies’ desire to pursue such a strategy.

The best known example of this would probably be Amazon. Despite having seen a huge increase in turnover, profits continue to be tiny. For that accomplishment, Wall Street has rewarded Amazon with a valuation of around $400 billion.

Amazon’s business model has ensured that it cannot earn a decent profit – at least not in the short term. Having said that, one could also argue that its business model has virtually guaranteed that nobody else can either. In the mid-1990s, before Amazon entered the stage, U.S. department stores generated decent profits (3% of sales on average).  They no longer do.  So the disruptor doesn’t earn much money, and the disrupted earn no money at all.  Now, that is what I would call a disruptive business model.

The obvious winner is the consumer, who benefits from the ongoing pressure on consumer prices. How he or she will react when there are no department stores anymore, only time can tell.  In the meantime, the ‘volume over profit’ business model will ensure that consumer inflation stays muted.

The head of a technology firm that designs and builds complex x-ray and scanning devices I spoke to the other day understands this dynamic well. “We are working with many billion dollar companies and everyone is saying – ‘We need Chinese volumes, Chinese prices and North European/North American quality and service’. At the moment, this is the recipe that works, how long it lasts is another matter.”

On the other hand, it could be that new entrants can exploit this. Many larger companies are trying to produce lower-cost products at high volumes. For large companies, with entrenched systems and culture, it is hard to overcome the inertia of the large organisation and so, they get caught in a vicious cycle - not enough volume to increase purchasing power to reduce costs and maintain quality to attract the volume business. And so the wheel spins.

Nevertheless, parts of the electronics industry are following the ‘Amazon model’. One only has to look at what has happened with TV prices and quality to see it. Is there a place for the Bang & Olufsens of this world anymore? Virtually everything out of China applies to this technique, with the solar panel industry being a prime example. China has decimated Germany in this field.

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.