In defense of small businesses

Big is better in America, bigger cars, bigger houses, bigger businesses.  Americans are applauded when they buy a big house, or car, or toy even if they can't afford it.  The bigger is better movement is so strong there has even been an extreme backlash, the minimal lifestyle movement.  This is where people live in tiny houses, or give up everything they own except for a Macbook and some cool vintage clothes, or live an "authentic" life with few possessions and travel the world.  Americans are extreme, lost is the praise of modesty.  Instead of praising someone with a late model car paid for with cash they're ridiculed for being cheap and told to upgrade.

The bigger is better mentality extends to business as well.  To become a business leader all one needs to do is fill the top seat at one of our largest companies.  Big companies grow into their size because they fill a large and scalable customer need.  Take a Wal-Mart for example, they sell a lot of things at low prices.  If a consumer needs a pair of socks, or tupperware chances are Wal-Mart will have the best price.  We need big companies, big companies can get big things done.  A small company can't build an airplane or construct a new chip fab, that's something only a large company with a lot of capital can do.

Too many small companies want to be large.  A mistake they make they try to compete on the terms of their large competitor.  I remember back in 2002/2003 the media rage was to cover the story of how Wal-Mart was killing small town stores.  We were being told to lament the loss of stores whose prices were high and selection was poor.  The problem was these small companies were trying to compete directly with Wal-Mart.  A small business will always lose when going head to head with a big company.  The big company has far more resources, power, and mindshare compared to the small company.

What wasn't killed by Wal-Mart were small stores that were different.  Wal-Mart didn't put the local hardware store that sells hard to find parts out of business.  Wal-Mart didn't put the unique vintage clothing store out of business, or the high end furniture store.  This is because those companies differentiated themselves, they thought and acted different.

A big company usually delivers a product that's 'good enough'.  For most purchases most consumers simply need something good enough.  A good enough product meets the needs of the masses and can be manufactured in quantity.  Because a large company is focused on capturing the largest part of the market they often ignore edge cases, or specialized cases.

Specialization can't be scaled.  There are only so many people with extra wide feet, or only so many people who want swing sets shaped like pirate ships.  The specialized edges of a larger market aren't big enough to support large companies.  Smaller specialized markets don't generate enough revenue for them to be meaningful for large companies either.

It might come as a surprise to someone who's had their head in business books and never peeked out at the real world, but any business that's surviving has a competitive advantage.  Academics in ivory towers can debate this, but for a business to survive they need to have something unique that makes them different from competitors.  Think about your local plumber, there is a reason you call them back for repeat business.  Maybe it's as simple as they pick up the phone and are always on time.  If their competitors don't do this that's their advantage over them.  Maybe you frequent a certain gym because it's cheaper, or their facilities are cleaner.  We all have reasons for choosing companies over each other.  If you think about it the reason you call your specific plumber is probably also the reason others call them as well.

A company that has no competitive advantage ends up out of business.  These are the small companies being killed off by Wal-Mart.  Why would someone want to shop at a store with less selection and higher prices, especially in a small town where salaries have been flat for years?  If a business does the exact same thing as a competitor and does nothing better or nothing different eventually one will go out of business.

Small companies that want to survive need to differentiate themselves and serve a niche.  Serving a niche doesn't always guarantee great profits.  This past weekend I took my son to a hobby store to look at model rockets.  The store has been around since the 1930s and is filled with model tanks, miniature trains, and model rockets.  A hobby shop like this is clearly a niche.  Model rockets and model trains aren't exactly widespread.  Yet this owner has a profitable business that he enjoys working at that's lasted for decades.  The owner is in his 80s and had the same excitement about the toys that my son did.  He raised a family on earnings from the store and by many measures is living the dream.  Yet by Wall Street or investor standards he's most likely failing.  I would be shocked if he's making more than 2-3% on his company's equity, and the location has little resale value.

If business were only about economic returns then this hobby shop should close.  As you readers like to point out this business isn't earning its cost of capital.  In this perfect economic world the owner would just close up and somehow deploy the capital for higher returns.  What the theory misses is the role this small niche company plays.  If this store were to close where would the model railroaders who meet in his basement go to drive trains?  The friendships and connections his club has created have value that can't be quantified on paper.  Customers could still buy model rockets online and save a few bucks, but they'd miss out on getting advice from someone who's done it for decades.  It's also debatable that the capital released from an underperforming business could be re-deployed by the owner elsewhere for a higher return.

Should a local plumber, or baker shut down because they aren't earning a 10% return on equity?

A friend sent me an article today discussing the banking landscape.  The author in the article argued that since most banks don't earn 10% on their equity they should be merged into institutions that do.  The author had previously worked at Bank of America, so in many ways his stance was expected.  In this world the only banks that would be left are the Wells Fargo, US Bank, and JP Morgans.

I do all of my banking with a local bank, Dollar Bank.  I previously had accounts with PNC but closed them when I finally got tired of being treated like a number.  PNC is a large and efficient bank, and it shows in their operations.  When I needed to make a deposit I stood in lines that rivaled amusement park lines.  I would be given a number (literally) if I wanted to talk with a banker and then had to sit and wait for 30-45m.  For investors this works well, they earn nice returns and everyone is happy, PNC earns their cost of capital.  For many customers the bank is simply good enough and has what they need too.

On the contrast Dollar Bank went out of their way regarding customer service and inquiring about what I might need and helped me get started.  When I opened my business account I was invited to some local business happy-hours where I could mix with other customers.  Dollar's customer service went above and beyond what I expect from a bank.  Their bankers have called me asking if I had any questions or issues they could help me with.  And their perceived interest in me as a customer makes me feel valued.  

There are a lot of lessons small companies should learn from Dollar and PNC.  Dollar and PNC are both in the same market, and PNC should be running Dollar out of town, except they haven't.  The two banking experiences are dramatically different.  Dollar Bank creates no friction around my banking, I can deposit, withdrawal and go about my business easily.  PNC made it a chore to get my money out.  I was constantly being fee'ed to death because I wasn't a large account.  Dollar has decided that customer service is an area of emphasis, customers feel more like a parter with them rather than a client.  

Small banks in small towns need to focus on serving smaller market segments that large players are ignoring.  Serving those segments will never enable them to grow into a Wells Fargo or earn 15% on their capital.  But serving those segments will ensure their financial health, they will stay in business serving customers and providing community members with jobs.

I think it's easy for investors to become myopically focused on maximizing money.  Companies should earn as much as possible, investors should become as rich as possible, citizens should save as much as possible.  This is just a different spin on the bigger is better theme.  Bigger profits aren't always better if customers aren't being served.  Bigger isn't better if the big profits now come at the expense of a healthy company in the future.  There is more to life besides maximizing money.  Some people are content having enough and enjoying life.  Like the hobby store owner, he will never be rich, but his business has allowed him to play with toys his entire life and make money doing it.

There are thousands of businesses that are serving customer needs in tiny segments of the market.  These needs are often vital to their customers, yet they usually don't translate into fantastic profits.  It's okay for a business to be mediocre, it's okay for a business to stay small.  Bigger isn't always better.  For all of our needs that the big companies neglect there are a number of small companies waiting to fill the gap.

4 comments:

  1. One minor typo - "customers feel more like a parter with them rather than a client."

    Your article made my week though.

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  2. Nate,

    Thanks for such an insighful article. You had given much to think about. Great job!

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  3. Nice article Nate. Maybe I read too many investing blogs/boards, but I get fed up with everyone thinking that the sole goal of life is to make money.

    Reminds me of the parable of the Harvard MBA and the Mexican fisherman. The only thing missing in that article is a discussion of whether the fisherman earned his cost of capital.

    http://www.wanttoknow.info/051230whatmattersinlife

    The 3G guys are a good example. Most investors think these guys are great because they're all about "maximizing profits". Unfortunately, there's a downside to that....just google what happened to a bunch of small suppliers to Busch when 3G switched the payment terms to 90 days. I'm sure that switch helped AB's cash flow, but at what cost? (and all the value guys loved it...I can't count the times I've seen someone recommend the book "Maximizing Profits" (or whatever it's called)) Since you're a Pittsburgh guy, you've probably seen some effects on the city after 3G bought Heinz. They'll put a few more bucks in their pocket and Buffett's pocket, but a lot of people/institutions will be poorer for it. I don't mean to imply that cutting unnecessary costs is a bad thing, but like anything else, it can be taken too far.

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