A business model explains, in abstract terms, how a company makes (or should make) more money than it spends. Knowing each company’s business model is also a necessary part of due diligence.
In the leadoff to chapter 19 of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma argued that not only must investors determine the quality of the business model, they also must ask how effectively management has monetized it.
At the core of a business model is a value proposition. It comprises desirability and distinctiveness, with the former referring to some functionality for which specific groups of customers are prepared to pay. Distinctiveness sets one company’s products/services apart from other offerings. In addition, “Distinctiveness turns general desire into demand and sales”.
To illustrate how business models work—and how they can fail—Sharma provided case studies for Best Buy (BBY, Financial), Coach (which changed its name to Tapestry (TPR, Financial) in 2017) and Walmart (WMT). We will briefly review the first two models.
Best Buy
An electronics retailer was founded in 1966, changed its name to Best Buy in 1983 and then became one of the speciality big-box retailers. By 1990 it had become the biggest player among specialty electronic retailers and enjoyed a lengthy run of growth.
The big-box business model is based on a retailer’s ability to generate high volumes of traffic to its stores. They attract consumers by carrying full ranges of many products and large volumes of sales allow them to lower their prices, setting up a virtuous circle of low prices and high traffic. From another perspective, we could say they used economies of scale to dominate their industries.
Sharma wrote that Best Buy added to its value proposition of selection and price with well-executed distribution and logistics capabilities. Based on those strengths, the company’s revenues rose 46-fold between 1990 and the end of 2005. Investors who committed $10,000 to Best Buy stock at the beginning of fiscal 1990 would have seen the value of their shares rise to $3.4 million by the end of fiscal 2005.
However, what worked so well in the 90s began to fail in the first decade of the 2000s as online retailers like Amazon.com (AMZN, Financial) began to proliferate. Without having to pay for real estate or floor inventory in each location, the online retailers gained a competitive edge. As Sharma noted, it was ironic that the strengths of big-box retailing, floor space and wide selection, turned into weaknesses. Some of these businesses had lost their value propositions.
Best Buy management responded to the online threat, but slowly and ineffectively. By the time Sharma did his analysis on the fiscal year 2011, the company was flailing.
At the same time, though, a new business model was emerging—the store within a store. This involved specialized display centers for manufacturers such as Apple (AAPL, Financial) and Microsoft (MSFT, Financial). And, how have investors responded to Best Buy since then? This chart, covering the years between 1987 and 2020, shows renewed strength since 2013:
Coach
For his second example of business models, Sharma chose the handbags retailer Coach. Its value proposition was “affordable luxury”, meaning it sold designer handbags that were stylish and well made, but selling for prices well below those of foreign competitors. Targeted to style-conscious young women, it provided products that ranked above mass merchandise but below names such as Gucci, Hermes and Prada.
Coach had an effective business model and an efficient operating model that supported the value proposition. Between 2001 and 2012, its revenues grew by an average annual compounded rate of 20% and its average return on capital was 41.5%. Its stock rose 13-fold over those 12 years.
In about 2010, Coach’s model began to change, as it put less emphasis on its traditional stores and more emphasis on factory outlet stores. With this came a new target audience in the form of value-oriented consumers who were supplanting style-conscious young women who prized luxury and exclusiveness.
There were repercussions for this erosion of the business model and value proposition. Sharma wrote, “Coincidentally, the emerging incoherence between its value proposition and operating model was beginning to show up in Coach’s financial performance.” In 2014, it began to tack back to more of a luxury position.
The above chart shows investors have not regained full confidence in Coach/Tapestry. The share price peaked in April 2012 and hasn’t recovered to that level in the eight years since then.
For Sharma, business models must be tested. Investors must try to disprove or refute them because, as we saw in the two examples above, business models or their value propositions can fail. When they do fail, an investment is no longer safe.
From my perspective, in 2020 and looking back at Best Buy and Coach/Tapestry over the 2010s, I’m struck by the dynamic nature of business models. Both companies started out with well-conceived models that worked in their current environments, but times changed. For Best Buy it was the emergence of online retailing, for Coach/Tapestry it was apparently a response to the financial stress induced by the crisis of 2008.
So, if we think of business models as being somewhat fluid, should we not judge management by its ability to change as needed, as well as sticking to the model when it is working?
We may need to revisit business models as the Covid-19 crisis retreats, in my opinion. With the economy on serious pause, it seems likely that many firms will have to revisit their business models and value propositions in the years ahead.
Conclusion
One of the ways in which we test a company’s fitness for investment is to examine its business model. Made up of a value proposition and ancillary elements, models are an abstract way to explain how a company plans to become, and stay, a sustainable generator of ongoing profits for investors.
In the case of Best Buy, it involved becoming a big box retailer, but with the rise of online retailing, it was forced to search for a new model. According to Sharma, that involved becoming a store of stores. For Coach, it involved selling mid-range luxury, designer handbags at a price well above mass-merchandise products, but well below high-end European manufacturers. Later, it shifted to a model that emphasized factory outlet stores and targeting value-conscious rather than style-conscious shoppers.
Chapter 19 of “Book of Value: The Fine Art of Investing Wisely” provided numerous insights and ideas for assessing business models to determine if they were worthy of investment.
Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Book of Value: How Well Is Management Using its Equity, Debt and Assets
- Book of Value: Turning to the Qualitative Side
- Book of Value: 3 Tests of an Investing Case
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