Unpacking Nick Sleep's Robustness Ratio: A Deep Dive into Customer-Centric Moats

Nick Sleep's concept of the "robustness ratio," introduced in his 2005 Nomad Partnership letter, offers a profound lens for assessing a company's competitive advantage.

At its essence, the robustness ratio compares the value a company delivers to its customers against the profits it retains for its shareholders.

This simple yet powerful metric sheds light on how businesses balance their interests with those of their customers, revealing insights into their long-term sustainability and market positioning.

“We are drawn to companies whose products or services are regarded as irreplaceable by their customers.” Nick Train

Ultimately, I believe that a company's customers are its most valuable asset, and the ratio helps quantify whether a company is delighting its customers by creating a win-win proposition.

I’d argue that you cannot apply this concept to every company. It is probably most applicable to companies that share economies of scale with their customers. Nick Sleep seems to agree:

This ratio is more appropriate for some companies than others, the prime criteria being that the customer proposition is based on price, such as exists at Costco, as opposed to an advertising-reinforced purchase such as Nike trainers.

Understanding the Robustness Ratio

The robustness ratio is calculated using the following formula:

Robustness Ratio = Customer Value Proposition (Savings or Benefits)​ / $ Retained for Shareholders

A higher ratio indicates that a company is providing more value to its customers relative to what it keeps for itself.

This often translates into a strong competitive position, as customers are more likely to remain loyal to a business that offers them greater benefits.

Conversely, a lower ratio may suggest that a company is retaining more value at the expense of customer savings, potentially making it more vulnerable to competitors who can offer better value.

Case Studies:

GEICO: A Balanced Value Exchange

Consider GEICO, the insurance subsidiary of Berkshire Hathaway. Nick Sleep pointed out that GEICO saved its customers $1 billion while also earning $1 billion in profits. This results in a robustness ratio of 1, indicating an equal distribution of value between customers and shareholders. GEICO's ability to provide substantial savings to customers while maintaining healthy profits demonstrates a balanced approach to value creation.

Source: 2005 Nomad Partnership Letter

Costco: Delivering Exceptional Customer Value

Costco, the membership-based warehouse club, presents an even more compelling case. Sleep estimated that Costco saves its customers around five dollars for every dollar it retains in profits, leading to a robustness ratio of 5x. The high ratio highlights the company's commitment to passing on savings to customers, sometimes at the expense of short-term shareholder returns, but fostering the long-term sustainability of the business.

"At Costco we think the customer saving is around five dollars, compared to shopping at most supermarkets, for every dollar retained by the company." Nick Sleep

Such a model has helped Costco build a loyal customer base and a formidable moat against competitors.

Sleep once quipped about Costco, “You can’t lose money shopping at Costco, but you can investing.”

Wise: A Modern-Day Example

Let's apply the robustness ratio to Wise, the UK-based financial technology company formerly known as TransferWise.

Wise's mission is to create a world of money without borders—making international money transfers instant, convenient, transparent, and eventually free. They aim to empower people and businesses to send, spend, and receive money globally as easily as sending a text message, eliminating the hidden fees and excessive costs typically associated with traditional banking systems. By leveraging technology and innovative solutions, Wise strives to make financial transactions more accessible and fair for everyone, regardless of geographical location.

According to Wise's FY2023 report, the company saved its customers over £1.5 billion compared to traditional banks, emphasizing that they are "up to 8 times cheaper." In the same period, Wise reported a net income of £114 million.

Using the robustness ratio formula:

Robustness Ratio = £1.5 billion / £114 million ≈ 13x

This translates to Wise delivering approximately £13.2 in savings for every £1 of profit retained.

Such a high ratio underscores Wise's substantial value delivery to customers, solidifying its competitive advantage in the financial sector.

Competitors would find it challenging to match this level of customer benefit without significantly altering their business models.

The Investment Industry Through the Robustness Lens

Nick Sleep also critiqued certain segments of the investment industry using the robustness ratio. Funds operating on high management and performance fees, such as the traditional "2 and 20" model, often offer limited value to clients relative to the fees collected. This results in low robustness ratios, indicating that the funds retain more value for themselves than they deliver to clients. Sleep's perspective suggests that such models may not be sustainable in the long term, as savvy investors seek better value elsewhere.

Amazon: The Challenge of Quantifying Customer Value

Applying the robustness ratio to every company isn't straightforward, especially when customer value isn't easily quantifiable. Take Amazon, for example. The e-commerce giant operates on a scale economies shared model, continuously investing in efficiencies to lower prices and enhance customer experience.

Source: TDM Investment: Scale Economies Shared (a Business Breakdowns Follow-Up)

Quantifying the exact savings Amazon provides to its customers compared to competitors is complex. Beyond price comparisons, Amazon offers intangible benefits like fast delivery, vast product selection, convenience, and trustworthiness.

Jeff Bezos, in his 2020 shareholder letter, touched upon this by emphasizing that companies should "create more than you consume."

He highlighted that Amazon's focus on customer obsession leads to significant value creation, even if it's not directly reflected in financial statements.

"In 2020, Amazon’s global consumer business alone had revenue of $386 billion, up 38% year-over-year, with operating income of $13.5 billion. We estimate that Amazon saves customers time and money, amounting to more than the company’s annual revenue." Jeff Bezos

In his 2020 letter, Bezos also stressed that Amazon saved customers A TON time—perhaps the most valuable commodity—by reducing the need for physical shopping trips. While this time saved is hard to quantify monetarily, it represents a substantial value proposition that strengthens customer loyalty and reinforces Amazon's market position.

The Broader Implications of the Robustness Ratio

The robustness ratio highlights the importance of a customer-centric approach in building a sustainable business. Companies that deliver significant value to customers often enjoy:

• Strong Customer Loyalty: Satisfied customers are more likely to return and recommend the company to others.

• Competitive Moats: High customer value creates barriers for competitors, as matching such benefits may be challenging without sacrificing profitability.

• Long-Term Growth: By prioritizing customer value over short-term profits, companies can foster sustainable growth and shareholder value in the long run.

However, it's essential to acknowledge the limitations of the robustness ratio. It may not capture intangible benefits like brand reputation, customer service quality, or time savings. Moreover, not all companies publicly disclose sufficient data to calculate the ratio accurately.

Conclusion

Nick Sleep's robustness ratio offers a valuable framework for assessing how companies balance value between customers and shareholders. By examining this ratio, investors can gain deeper insights into a company's competitive strength and long-term prospects.

Companies like Costco and Wise demonstrate that prioritizing customer value doesn't just benefit consumers—it can also build robust businesses that withstand competitive pressures. As markets evolve and customers become more discerning, businesses that "create more than they consume," as Jeff Bezos puts it, are likely to thrive.