Tuesday, May 20, 2014

Scalable businesses and growth

Value investors have a reputation for not caring about growth.  They want to buy a dollar for fifty cents regardless of any growth prospects.  While value investors might not care about growth, businesses do.  Businesses have an innate desire to grow, a longing to become larger and more prominent.  I've spent a lot of time recently thinking about growth and scalable businesses, what follows are some of my thoughts on the subject by way of an analogy.

I want you to think of the market as a forest.  A healthy forest is filled with a variety of trees and plants.  There are tall trees, short trees, pine trees, oaks, maples, beeches, bushes, grasses, weeds, as well as numerous other plants.  A forest doesn't grow all at once, it starts with a few grasses and slowly evolves into something mature.  Markets are similar, they don't develop at once, they grow into maturity.

In a forest not all saplings grow into towering trees.  Many saplings thrive for a while only to be deprived of enough sunlight or good soil before perishing.  Sometimes a sapling falls victim to a grazing deer, or other destructive animal.  Likewise there are more smaller companies in the market and not all of them will grow large.  Some are small trees won't ever grow tall.  Some fall victim to a predator, or are crowded out of the market place.

Given the right conditions, the right soil, and the right seeds a tree can grow large.  A tree doesn't grow all at once, it takes decades.  As a tree journeys from a sapling to a stalwart many things can happen destroying its progress.  A tree might drop hundreds or thousands of seeds of which only a few become full fledged trees.  Even less seeds become giant trees.  A giant tree needs perfect conditions to crest above the other trees.  Once it obtains a certain size it's own size becomes a strength.  A larger tree can steal sunshine and nutrients from the rest of the forest.  Size becomes a strength for a while.

Trees don't grow to the sky, eventually all trees, even the giant sequoias face an untimely end.  Large trees are more susceptible to violent wind storms, they aren't as flexible as smaller trees.  If the soil or environment changes large trees they have trouble recovering.  Large trees are also targets for lumberjacks whose wood is more valuable.

The location in a forest helps determine the size of a tree.  Have you ever noticed that the trees in a valley grow larger than the trees at the top of a hill?  The trees at the top of a hill have less competition for light.  The trees at the bottom of a valley need to grow above other trees in the valley plus the trees on the sides of the hill if they want light.

Companies trying to grow large face the same challenges as trees.  For every large company there are hundreds of small companies attempting to grow quickly.  Sometimes a small company successfully makes the journey from small to large, but often small companies remain small.  People wonder why small companies stall out in their growth, why can't Second Cup become as large as Starbucks?  What I find interesting is that we don't ask the same questions of the forest.  Why don't we ask "why aren't all trees large?"  There is a place for large and small trees in a forest, a forest with all large trees isn't healthy, there is no new growth.  A healthy forest contains trees in all stages of growth.  A healthy forest even contains weeds, which in the market might be promotional pink sheet companies with no hopes of profit.

There's an idea in the market that certain companies have moats, sustainable advantages that help them grow large.  I believe the concept of a moat exists, but both small and large companies can have moats.  Some large companies simply have size.  They grew out of a set of circumstances that allowed them to capture marketshare faster than competitors.  Once they achieved a certain size they were able to grow even faster due to their size.  They are large, but they are also susceptible to storms or shifts in the market.

For a company to grow large it needs to exist in a perfect environment.  It needs to have a product that serves a customer need, it needs a business model that's scalable, and it needs competitors who are slightly smaller and less equipped.

Most businesses are not scalable.  Think about almost any local dining establishment.  What makes it special is probably the cook and the ambiance.  Those things can't be re-created, the cook can't be in two locations at the same time.  A scalable business has a product that serve a need that can be created through a replicable process.  There are many successful and profitable companies that are not scalable.  I was thinking about the Jim Cramer franchise this afternoon.  He's created a lot of wealth around his personality with books and TV shows.  Yet when he decides to retire there will no one to take his place.  There is not another Jim Cramer, his business will end.  There are many companies like this where the personality of the founder is deeply ingrained in the business.  Sometimes as investors this is hard to see.  A founder retires and suddenly sales lag unexplainably.  What we don't know is that the retired founder is the one who greased the wheels of the operation.

I would posit that almost all businesses are non-scalable.  If one looks hard enough there is always a choke point or bottleneck that inhibits growth.  Only a few companies are able to overcome this and grow into mega-cap companies.  Look at Wal-Mart, or McDonalds.  They have perfected the scalable business model.  The problem is that as companies scale their complexity increases.  Just like trees, as companies grow they become susceptible due to their size alone.  If a storm comes and consumers decide they no longer want greasy hamburgers, fries and sugar laden soda McDonalds will have a hard time reacting quickly.

Large companies cannot grow infinitely, eventually their growth slows to the rate of GDP growth plus whatever financial engineering the CFO employs.  As a company grows they need larger and large projects to move the needle.  A small energy company might drill small wells that can provide a bonanza, yet a large company would ignore the same wells because it isn't worth their time.  If a company is able to grow large enough their own size becomes an impediment.  I remember reading an article a few years back about the chefs at McDonalds.  They wanted to introduce a shrimp salad to their menu.  They couldn't because the volume of shrimp they'd need to serve customers would quickly deplete the world's shrimp supply.  As a result the company never introduced their shrimp salad (article).  They are limited by their size.

There is a lot of money to be made by investors who can identify small saplings that will grow into towering oaks.  If you find yourself owning a tree that's growing into a towering oak I'd recommend holding on tight and enjoying the ride.  But keep in mind the ride could last decades or longer.

At the same time it's important to recognize that not all companies will grow large.  Companies don't necessarily need to become towering trees to be successful.  One of my favorite sights in the woods is a stand of young beech or aspen trees clumped together.  What's vital though is to understand what you own.  Do you own something that can scale into a tall tree, or merely a shrub.  Some of the worst mistakes investors make are thinking shrubs or fast growing weeds will become sequoias.

When a tree finally dies it doesn't suddenly become useless.  A fallen tree in a forest is a habitat for small woodland creatures.  As a tree rots moss grows on it, insects inhabit it and it provides nourishment for the soil.  Sometimes a dead tree becomes furniture, or boards for a home.  Companies often face the same fate.  It's unusual for a failed company to lock their doors and cease to exist.  There are remnants of value, patents, intellectual property, and knowledge stored by former employees carried to their next ventures.  In this way a dead company nourishes the forest long after it ceases to exist.

7 comments:

  1. Excellent Nate! I use the analogy of the market as a forest myself often. The stratification and different survival strategies fit in well with the business ecosystem.

    I may have first come across the analogy in this video, I think you would find it interesting: http://youtu.be/-MEp0hJTGIA?t=1m45s

    Matt Joass

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    1. Thanks for the link, interesting, seems like I'm not the only person who thinks like this!

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  2. Loved the analogy. Thanks for writing this.

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  3. This analogy, it's scallable to include other things as well, yet at the same time it isn't scallable at all. This got me thinking a bit. I still haven't thought it trough well enough, while writing it's out the back of my hand.

    To explain what I mean better, with the forrest analogy:

    A forest is X m^2 big with a absolute limit of X m^2. This is because eventually land runs out for the forest to grow on(IE companies), yet we can scale it further to include ant's, animals and the sun. Ie supporting companies. So trees still can grow and the forest can move in all it's glory, eventually it will hit the absolute limit. Then there is also the problem of non reprehensible resources, when those run out every living thing has a problem.

    Nate what is your take on this?

    -Rens
    http://empireoftrade.com

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  4. Nate, How do you screen for companies on the over the counter market?

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    1. Cody,

      I don't, I look through them one by one.

      Nate

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