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Finding the next google

John Addis looks at what investors on the hunt for the next Google can learn from flywheels and roundabouts.

You may think value investors have little to learn from the UK Roundabout Appreciation Society. I beg to differ.

Over the next thousand or so words I shall make my case, taking you from a 2001 napkin drawing that describes how Amazon could conquer the world to a roundabout 80 miles west of London as a metaphor for how it did so. All this, you understand, in search of a way to help you spot attractive, growing businesses that might one day acquire monopoly characteristics.

Identifying existing monopolies is as easy as stepping out the door. If you want to fly from Melbourne to Sydney and then drive to the Hills district and (ambitiously) aim to arrive the same day, Sydney Airport and Transurban's M2 are unavoidable, as are either Virgin or Qantas Group airlines. If you want to buy their shares on the way, add an ASX toll to the list.

Then there are sectors dominated by a handful of companies, none of them technically monopolistic but collectively behaving as one. These are typified by poor products and low levels of customer satisfaction.

If purchased at attractive prices (a hefty caveat), both kinds of monopolies offer shareholders the prospect of handsome returns. But neither are likely to match the profits of an immature but quickly-growing business that might one day establish a monopoly of its own. These businesses can drive portfolio returns from above average to astounding.

This is an area where we've invested considerable resources over the past six months, examining a number of new stocks in the hope of uncovering the next Xero, Cochlear or ResMed. Only time will tell if the best candidate our search uncovered thus far - Audinate - will reach its promise.

What has been lacking is a framework to support that task. The objective here is to put that right. As Charlie Munger has said, "you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form."

Munger's mental models, from circle of competence and thought experiments to inversions and probabilistic thinking, offer a systematic way of interpreting the world and thinking more intelligently about it. I'd like to add roundabouts, or flywheels, to use Jim Collins' description, to the list.

A "latticework of theory" is not easily grasped. But everyone is familiar with roundabouts and their ability to accelerate traffic flow. Good businesses, like roundabouts, have at their core an accelerating momentum that just seems to work.

Amazon is an obvious example. At the age of 26, Jeff Bezos joined hedge fund DE Shaw, specialising in potential online investments. Having made a list of 20 products he thought could be sold online, he landed on books as the most viable. His superiors knocked him back and so, in 1994, Bezos left to start Amazon.

The customer proposition was brilliantly simple; deliver to customers a larger range of books at lower prices than competitors. That got the business going. Then, in 2001 at an Amazon shindig, Bezos codified the strategy on a napkin. The company, which generated revenues of US$233bn last calendar year, has abided by it ever since. This is Amazon's model in a nutshell.


Amazon's flywheel

Source: Sam Seely, The Amazon flywheel: part 1

Everything starts (and ends) with the customer experience. A huge selection of books made possible by the Internet, lower prices, made possible by the absence of a store network and a focus on volume, plus an easy-to-use website made Amazon irresistible to book lovers. With their cloth-eared leather bookmarks they came in their droves.

In aggregating demand, Amazon then opened its platform to third-party sellers of just about everything. Keen to access Amazon's extraordinary traffic, their growing presence created more competition, which lowered prices, and increased the range of available products, which attracted more customers. The costs of servicing each customer could then be spread over an ever growing number, reducing marginal costs.

In Good to Great, Jim Collins called this the flywheel effect. Once spinning, a business develops a momentum of its own. In Amazon's case, as long as management remained focused on customer experience - wider choice, quicker delivery, lower prices - the business would continue to grow no matter what.

The flywheel effect has another advantage. In feeding energy back into the business and increasing its growth velocity, management is free to innovate and experiment without sacrificing growth. You may giggle at Amazon's Fire Phone or Google Wave but the same motivations that led to these hilarious failures also delivered Amazon Web Services, Amazon Prime, Google Chrome and Android. A flywheel encourages businesses to take risks and to fail occasionally, without losing focus.

The purpose is to enhance and extend the flywheel effect. Xero, having established a first mover advantage in cloud-based accounting software, encouraged third-party developers to build products that would integrate with Xero, expanding its usefulness to customers. Xero's App Marketplace enhances the flywheel.

Apple's flywheel is built on the integration of superior hardware with bespoke software that delivers an experience users love so much they can charge far higher prices than competitors. It then reinvests a high proportion of those growing profits in new technologies and supply chain management to expand the flywheel, delivering more products and services that enhance the ecosystem. Cochlear's flywheel looks much the same.

Apple (and Cochlear's) flywheel


Once a business has established a flywheel and recognises how to maximise its impact, higher research and development (R&D) often ensues. This alone is not enough. Without an understanding of the flywheel, further investment can be misdirected. The same might be said of acquisitions.

The flywheel is a conceptual tool to help you recognise and understand high-quality growth businesses. The next step might be to re-examine some previous research (I suggest Mickey's From zero to Xero and Gaurav's Reconsidering Webjet) and see whether you can create a flywheel for each. If so, then sketch out what form it takes.

From personal experience, there is no better way of getting a bird's eye view of a company and what makes it tick. If you find the process difficult, either your understanding of the business is not yet fully-formed or the flywheel is weak or non-existent. Both are valuable perspectives.

Conventional analysts prefer to trawl through annual reports, industry research and ASX announcements, tinkering with a spreadsheet as they go. These things are important, but without an understanding of the business and how it connects with the customer in the real world, assembled facts and data points carry little meaning. A flywheel offers a framework through which facts and events can be interpreted.

Finally, to Swindon in the UK, an unremarkable town with a Magic Roundabout. In 2007, Auto Express magazine named it as one of the world's worst junctions, largely because it features seven roundabouts in one (see a video of how it works).

The Magic Roundabout is a perfect metaphor for how the likes of Google, Amazon and Alibaba have built multiple flywheels around the central proposition that Jeff Bezos landed on all those years ago. It is this that allows some of the world's biggest businesses, decades after their founding, to still grow revenue at astonishing rates.

These are the portfolio makers; the one or two stocks that can turn your prospective retirement from cat food to caviar. Swindon's Magic Roundabout - buy the £5.99 mugs here - might just help you to spot them sooner than everyone else.