Why You Should Never Invest in a Pure E-Commerce Business?
Don't try to invest in next Amazon, invest in those like Amazon.
First things first:
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I wanted to start by saying this because it’s really easy to forget appreciating how special of a community we have here!
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So, thank you all!
I have been recently asked many times about Alibaba.
I liked the company, I invested in the company when it was grossly undervalued under $75 per share and I exited that position when it broke above $100 last year.
It has now dropped around 25% from its highs last year, heavily buying back stock and still trading at only 9 times forward earnings.
On top of these, the Chinese Government turned on the printer to fight deflation!
I see on other platforms people asking often about Pinduoduo and JD.com too.
This only makes sense as Alibaba, JD and Pinduoduo are the three largest e-commerce players in China and they generate most of their revenue from domestic sales. If domestic consumption recovers, they’ll be the natural beneficiaries.
All these are essentially good companies but given the increasing interest in e-commerce companies, I feel compelled to make my warning:
Investing in e-commerce is actually a very bad idea!
“What the hell are you talking about? You praise Amazon every day and you even confessed you bought and sold Alibaba last year,” you may say.
You would be right and the answer lies in the question itself.
All successful e-commerce businesses are not just e-commerce businesses. They have built an ecosystem of interconnected businesses leveraging the power of their e-commerce platforms.
Think about Amazon.
It started its e-commerce business in 1994, yet this segment still lost money in 2022 while the cloud business it established in 2006 is literally a cash printer.
Amazon knew it would be doomed if it remained solely as an e-commerce business. It had to evolve into a diversified tech giant to survive and it did this by leveraging the strength of its e-commerce platform.
Today it’s a giant ecosystem of interconnected complementary businesses.
Now these businesses create a flywheel for Amazon and strengthen each other’s competitive position. One can start as an e-commerce customer, and may later find himself as a Prime Video customer, Whole Foods customer, Amazon Care customer etc.. Once a user gets into the ecosystem from one point, the ecosystem locks him in.
Think about MercadoLibre, payments, logistics, credit card, classifieds etc… Alibaba is the same model, a giant collection of the businesses that form an ecosystem through integration or high level of interoperability.
There is a reason all successful models follow the same blueprint: e-commerce is actually a messy business.
There are five main reasons for this.
1. Entry Barriers Are Low
If you were an adult or a teenager between 2000-2020, you should remember the e-commerce companies mushrooming everywhere on the internet.
Even beyond that, if you are an entrepreneurial person, you or somebody in your friend group might have tried to start an e-commerce business.
In 2000, e-commerce businesses were all over the place: Boo.com, Pets.com, Books-A-Million, Broadband Sports, Cyberian Outpost, eToys.com are just a few ones that I could remember…
All those businesses went bankrupt or had to be sold except for Amazon.
Why does this happen? What is the allure of e-commerce companies?
Simple: They are so easy to start.
You literally don’t need anything, not even capital.
Put together a decent looking website.
Create your catalogue and advertise online.
Once you get orders, drop-ship them through a supplier.
Pay the supplier, keep your markup, create your capital base.
Once you accumulate enough capital, buy your own inventory.
Of course, if you have capital to risk, you can skip three steps and directly order your own inventory.
This is actually how Amazon also started.
They neither had money nor space to keep inventory. They were working from Bezos’ garage:
Once they got an order, they would buy it from the supplier and ship it to the customer.
There was a problem though…
Wholesalers required orders to be in at least batches of 10. Amazon didn’t have that much traffic. If they piled up the orders, they would upset the customer.
They found a loop instead. They noticed that the system required them to order at least 10 books but it didn’t have to deliver them. They found a book in the system that was long out of print so whenever they needed to order, they ordered the book they wanted and 9 copies of the out of stock book. It got them off the ground.
Entry barriers are so low that you can start doing things that don’t scale like Bezos and once you have enough traction, you can scale things up.
This makes e-commerce an easy business to start but a bad one to invest in.
If the entry barriers are so low, how can you be sure that the company you invested in will remain dominant long enough so you’ll see a significant return on your investment?
You can’t.
The Chinese e-commerce sector is a good example of this.
Until 2019, the market was dominated by Alibaba and JD while Pinduoduo was feeding on breadcrumbs. In 2020, you see Kuaishou started to gain some market share and after 2021 Douyin also got in the race.
Who are you going to bet on now?
Alibaba’s return? JD’s revival? Pinduoduo’s strong growth? Douyin that dug itself a space in the market from zero? Who would you bet on?
If your bet only depends on the e-commerce success of the business, more likely than not that you are going to end up in disappointment.
2. Margins Are Laser Thin
This is a natural consequence of low entry barriers and intense competition.
After all, e-commerce businesses deliver products and if you aren’t selling a unique product, other players will compete with you.
If there are many suppliers, who do you think people choose?
They overwhelmingly choose the cheapest one.
You can only sell to so many people by having prettier packaging, better website, and better copywriting. If you want to scale, you have to sell cheap.
Amazon again illustrates the point.
Despite its over 40% market share in the US retail e-commerce, its operating margin in e-commerce is around just 5%.
Even if you are Amazon, you can’t set your own prices. The market sets the prices and if you aren’t willing to match the market price, you will lose business.
Imagine your business has a monopoly position in your country with 100% market share.
What would happen if you start charging a premium?
People will quickly find the products you are selling at a premium, source them from the wholesalers and sell them cheaper, taking market share from you. It’s that simple.
This shortens the “profitable life” of the business.
Think about Apple. Even if it stops innovating and actually launches the same phone every year, it’ll be able to exploit its brand value and get away with it for years to come.
Wait? Apple has already been launching the same phone for years and it’s getting away with it!
Apple can do it. As long as the new phones don’t significantly slide behind the competitors’ products, it’ll be fine because of its immensely valuable brand image. In stagnancy, it’s profitable life is long.
The largest e-commerce player, Amazon, can't do that. If people discover a new e-commerce store where they can get a pair of Air Force 1's for $15 cheaper, they’ll buy it from there. In stagnancy, e-commerce’s profitable life is measured by months, not by years.
E-commerce is doomed to operate with thin margins, otherwise it is not possible because of the very low entry barriers.
3. Scaling Is Exponentially Harder
As easy as it is to start an e-commerce business, scaling one is equally difficult.
In early 2000, just before the dotcom bubble burst, there were nearly 2,000 e-commerce companies backed by venture capital firms or angel investors. Today, we only know about Amazon.
It’s because the extreme hardship of growing an e-commerce business.
The reason is simple and it again goes back to the extreme price sensitivity of the market.
Imagine you have a profitable e-commerce business but you can’t grow because operations aren’t big enough. You have to expand the warehouse, renew the infrastructure etc… All these require investment but there is a problem…
You are already operating with razor thin margins so investing for fast growth means negative cash-flow. This is a very narrow path to walk:
If you aren’t well capitalized, you could easily go bankrupt.
If the return on investment takes longer than expected, you are dead.
If the economy suddenly turns sour and orders decline, you can again die.
Even Amazon went through this in early 2000s.
They were still unprofitable but the business was growing fast and their warehouses were struggling to keep up with demand. They had to upgrade warehouse infrastructure and even open new warehouses.
Economy was going South and nobody was willing to invest in a 6 year old e-commerce business. Amazon was just 6 months away from bankruptcy.
Nobody in the US was buying their story anymore.
What did they do?
They went to European investors, who weren’t familiar with the story and thus were more gullible.
The plan worked perfectly. Amazon raised $600 million from European investors in 2000, which saved the company.
So it’s easy to assume that if an e-commerce business is successful at a small scale then it’ll be successful at larger scales too. Many investors got totally wiped off this way, trying to invest in the next Amazon.
It’s an easy business to start, but painfully hard to scale. You shouldn’t be too optimistic about the future of a fast-growing e-commerce stock you have found.
4. Niching Down Is Always Possible
Who sells more bakeries, a coffee shop with a small selection of bakeries or a bakery shop?
Easy right?
This is perhaps the oldest play in the book of business: If you have strong competitors, niche down.
It applies to everything.
This is why we have specialty coffee shops because they offer a larger selection and better quality of coffee than your neighborhood pastry shop. We have steakhouses because they serve better meat than general purpose restaurants.
It applies to e-commerce too.
You may not beat Amazon, but you may take bites from its meal.
Zappos did this back in the 2000s.
They focused just on selling shoes and their strategy was doing it best.
When you are as big as Amazon, you can’t give the overemphasis to any product category that doesn’t constitute a disproportionately large share of your sales. This creates an opportunity for those who are willing to do that, just like Zappos.
They reached $1 billion in sales in 2008 just by selling shoes.
They managed it because their vision was just that. They wanted to become an online shoes seller. Amazon took notice of them and even engaged in a pricing war to throw it out of the business but it couldn’t. Zappos has the reputation as the “best online shoe seller.” Amazon ended up buying Zappos in 2009.
These niche sellers will always keep getting market share from general purpose e-commerce stores like Amazon in their category. This creates a constant headwind against the big players. They are like whales surrounded by thousands of small fishes that are feeding on them.
This may be just a headache in the short term, but it can kill the business in the long-term.
🏁Conclusion: What’s the Right Way to Invest in e-commerce?
It’s simple, the business you are looking at should have evolved beyond an e-commerce company.
Amazon, MercadoLibre, Alibaba all have evolved beyond a pure e-commerce company. They are diversified tech ecosystems.
Think about it, if it wasn’t for its cloud business, what would Amazon be worth today? Even if you gave 30x earnings multiple to its e-commerce profits, it would only be worth around $600 billion.
Take Alibaba. Its revenue is steadily increasing despite its decreasing market share in China e-commerce. This is because it’s a diversified tech giant with other valuable businesses like cloud and logistics.
MercadoLibre is the same, it’s an ecosystem of complementary businesses that strengthen each other’s moat.
This is the case.
If you have an e-commerce company in your radar and you find it attractive, ask whether it has other complementary businesses in its ecosystem that could create additional value for customers. Without additional value drivers, it’s very hard to have a long-term competitive advantage in e-commerce.
If you can’t see what creates the durable competitive advantage, turn your eyes to somewhere else. You are almost always guaranteed to find something better.
I sold them, 0 profit)
great post!