Small But Important
A funny thing that happens when you’re living two thousand and twenty-four years after the start of the common era, but haven’t yet read everything written up until now, is that you can have an epiphany that you believe is novel, but turns out that many, many others have had before. So it went as I was reading Capital Returns, which was graciously gifted to me by one Michael Newton after he recommended I should read it (happenstance?).
A theme that keeps arising in the book (which is a collection of investor communiques published by London-based Marathon Capital between 2002 and 2015) is that companies that earn high returns are often ones that do a small, but important thing for their customers. In other words, they are a low cost, but critical part of a project or value chain or supplier to a company. Some examples…
August 2011: Another class of business whose weight in our portfolios has expanded…has been companies with annuity-like revenue streams…The common theme here is a longer-term commitment made by the customer, together with an element of inertia when it comes to renewals. These factors…make for significant barriers to entry and high and sustainable returns. This is particularly true where the cost of the service is only a small proportion of the customer’s total spending.
February 2013: Pricing power is further aided [when a component]...plays a very important role…but represents a very small proportion of the cost of materials.
May 2014: Sometimes a product is so embedded in a customer’s workflow that the risk of changing outweighs any potential cost savings…The very best economics appear…in a situation in which the cost of the product or service is low relative to its importance.
February 2015: Our preferred growth stocks undertake apparently unglamorous activities that are essential to their customers – so essential, in fact, that customers pay little attention to what they’re being charged…Here, reliability weighs more highly than price.
Marathon Capital is not wrong! (Though they got their Baidu bet wrong, but who among us has not been wrong about China?)
Anyhow…
One of my biggest learnings over the past five-plus years at Permanent Equity is that the place to be in business with your customer is small, but important (see for example among others waterproofing and commercial fencing). Because small, but important, businesses, for all of the reasons Marathon cited, have the best of everything: pricing power, margins, cash conversion, growth opportunities, etc.
The reason is that small, but unimportant businesses are undifferentiated afterthoughts, large, but unimportant businesses are commodities, large, but important businesses are highly scrutinized, but small, but important businesses have carte blanche. And carte blanche is some place to be.
-Tim