Kennon-Green & Co. Fiduciary Financial Advisor, Wealth Management, Global Value Investing

Mental Model: Addition Through Subtraction

Sometimes, in order to make something better, or work more effectively, you must take something away.  This principle is called addition through subtraction.  The theory behind addition through subtraction is that reducing components and complexity can add value if you make something:

  • Simpler
  • Faster
  • More reliable
  • More profitable
  • Less expensive (though not always; certain strategies and business models allow you to charge more because the value of the other considerations has utility to your target customer)

Addition Through Subtraction in Consumer Goods

A brilliant example of addition through subtraction leading to success is the Bose corporation.  The flagship product of Bose is the Bose Lifestyle home theater system, which introduces surround sound into a family’s television area.

[mainbodyad]Starting at a couple thousand dollars for the simplest systems, the Bose Lifestyle product line consists of one giant box.  You open the box, hook it up, turn on your television, have it automatically adjust for the room environment through a ten minute test, and you’re ready to go.  Instant, on-demand, near perfect surround sound.

Some audiophiles complain that it is possible to build a system just as good as a Bose Lifestyle setup for far less money, you just have to educate yourself on the minutia of setting up, running, and maintaining a good surround sound environment.  These critics are ignorant of the fact that the very thing they are complaining about is the very reason Bose is successful.  The company is not just selling an audio product.  It is selling simplicity, functionality, and quality.  They have reduced the process of installing surround sound to such an art that even your grandmother could set it up using the on-screen instructions.

By subtracting all of the complexity, Bose won.  When my parents put in their Bose system, and my family put in our Bose system, it didn’t matter that there was better value in terms of the same quality for less money because we weren’t just buying surround sound; we were buying no-stress setup and maintenance.

Addition Through Subtraction in Engineering

The principle of addition through subtraction is powerful in fields such as electrical engineering.  Every time you introduce a working component, you introduce a new breakpoint; a source of potential problems.  Each moving part can be a source of trouble, breakdown, maintenance, or frustration.  In many cases, there is an apparent paradox in that, adjusting for redundancy, the fewer working parts necessary in a creation, the simpler and cleaner the construction, the longer it is likely to last.

Addition Through Subtraction in Your Investments and Business Strategy

One of my most successful investments early on in life was American Eagle Outfitters.  At the time, the company was still rolling out stores across the United States, had a long way to go before reaching market saturation, was trading at a very low valuation multiple, had a controlling family that grew the firm from its start-up days, and generated very attractive returns on equity.  Just as importantly, it was still relevant with my age group.

[mainbodyad]When performing my intrinsic value calculation, one thing I did was subtract the losses from a chain of stores American Eagle owned in Canada that were perpetually underperforming, wracking up losses.  At some point, it was clear that this division would need to show results, be sold, or shut down entirely.  For various reasons, I thought that moment was sooner, rather than later.  I turned out to be correct.  The moment it was shuttered, earnings per share expanded, resulting in a direct increase in the stock price.  The company added more value to owners by subtracting something.

Don’t Use Addition Through Subtraction As An Excuse for Mindless Cost Cutting

Cost cutting can be great.  In an poorly run, or complacent organization, cost cutting can be vital to making people realize there is a cost of capital and that owners won’t allows others to use their money if they aren’t putting it to good use, generating an acceptable after-tax, inflation-adjusted return.

What you should not do is think cost cutting is the answer to everything.  There is a difference between expenditures and investments.  A retail giant cutting the number of checkout registers may not be intelligent if it leads to greater consumer frustration, longer waits, and lost revenues.  If you can’t tell the difference between wise capital expenditures and foolish expenses, you shouldn’t be in charge of a company; you should be in the back accounting office tracking debits and credits.