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The Importance of Growth

Course Section 1 - Lesson 4

Have you ever noticed that some types of businesses tend to be small while others seem always to be large? Interestingly, every town in America seems to have a shoe repair store, a dry cleaner, and a tax preparer that are owner-operated businesses. Why is it that some types of companies tend to be small while others like consumer goods companies or social media companies always seem to be large? And more importantly, why does understanding this matter for investors?

Let's start with why answering this question matters. Some characteristics make it difficult for certain kinds of companies to grow. While these businesses may be very profitable and may make their owners wealthy, they are not the kind of companies that should excite investors.

Components of Return

The total return of a stock investment is composed of two components: Dividends and Appreciation. Both of these are strongly affected by how much opportunity a company has to grow.  

If growth opportunities exist and a business can take advantage of those opportunities, sales and earnings growth will likely follow. As a company earns more, it can distribute more to shareholders, and as distributions to shareholders increase, the price of the stock will rise along with it. All of these are attractive characteristics.

Characteristics that Limit vs. Propel Growth

To take advantage of these characteristics as investors, we need to know what to look out for. I'm going to walk through four sets of characteristics that both detract from and encourage growth so that you can be on the lookout while you are looking for investment opportunities.

Service Businesses vs. Product Businesses

Businesses that require a given input of human labor for every unit of customer output are service-based businesses. Examples of service businesses include dentists, accountants, auto mechanics, hair salons, and many others. The defining feature of these businesses is that they require a provider with a skill that the customer is willing to pay for.  Service-based businesses are challenging to scale.

Efficiencies of Scale is a highly desirable characteristic in the companies that you will invest in. We always want to see a company become more profitable as it grows. Unfortunately, this usually isn't possible for service-based companies. There are several reasons why but the biggest is that human labor is expensive, and most service-based businesses are heavily dependant on a human in the loop.  

Product-based businesses, on the other hand, typically have considerable efficiencies of scale. A standardized product can be marketed, mass-produced, and sold with little additional per-unit cost.

When you're evaluating companies, you should tend to assign more growth potential to product-based companies as opposed to service-based companies.

Niche Focus vs. Broad Market Focus

In business, going after a niche can be a double-edged sword. On the one hand, it can be easier to gain a foothold in a market if your product or service is laser-focused on serving the needs of one particular set of customers. On the other hand, if your company never figures out how to expand outside of that initial niche, it may forever stunt the company's growth.

Focusing on a niche market is an entirely valid strategy for a young company. However, when you evaluate companies to invest in, you should be conscious of how companies position themselves and whether their positioning may put them at risk of limiting their future growth.

Linear Model vs. Platform Model

Linear business models provide value for their customers by providing them with a good or service. Whether it's a haircut or a hard drive, a linear business will provide something in exchange for cash. Most businesses are linear businesses, and there are many highly successful linear businesses operating out in the wild today.

The internet has enabled a new type of competition for linear business models, one that connects service providers directly with customers. Platform businesses don't sell a product or service; they serve as the middle man between the two.  

While most linear businesses will remain small, platform businesses, at least the ones that can attract both buyers and sellers, are almost guaranteed a significant market opportunity.

An example of a platform-based business is Uber. Uber doesn't have cars and drivers out in the world transporting passengers. All that Uber has is an app that connects drivers with passengers.  

Investors (especially those in linear companies) need to be on the lookout for areas where a platform-based business could disrupt the operations of their current holdings.

A fascinating article in the course materials section describes why platform-based businesses are so transformative; I highly recommend giving it a read.

Regional Focus vs. National/Global Focus

While a company getting itself into a position where it geographically limits its growth is rare, it is crucial to be aware of situations where a company may be incapable of serving customers outside its current geographic footprint. Companies whose operations are geographically locked to a particular region are at a high risk of bumping up against a growth ceiling without making significant changes to how they run their business.

We Don't Really Care About the Size of a Business. 

What matters from an investor's perspective is how much opportunity exists for a given business. There are high-level characteristics of a business that have outsized effects on its future growth opportunities. Understanding what those characteristics are will help you weed out growth-stunted investments before they can drag down your investment returns.

Mark Complete