If you were to make a list of desirable traits for a business to have, I think the following would be at the top of the list:
- A large total addressable market (or “TAM”) with a high growth rate
- High gross or net margins
I believe the value of a business is the present value of all its future cash flows discounted back to today. In determining that value, two factors regarding that cash flow are very important: both the magnitude and duration of those cash flows. The two factors I mention can give some certainty to the former, but not necessarily the latter. In fact, they may even be factors that make the duration of those cash flows harder to achieve. In this piece, I’d like to take a closer look at both of these traits and make us think a little more deeply about what they mean for businesses and competition.
Large TAM / High Growth
I have opened countless investor presentations that state they are in a large and growing market. This is thought to be a good thing and it may be, but in order for that to be true the business needs some sort of moat to be able to fend off competition to actually create value, or in this case durable free cash flow. There is a concept in economics called minimum efficient scale (or “MES”) and its the smallest level of output at which scale economies have been exhausted. This basically means what is the smallest market share a company needs to be able to have as efficient of cost structure as that of the market leader. The reason this is relevant is essentially the market size divided by the MES will determine how many competitors you may have. If a business is in a large market but has a small MES, there will likely be many competitors and fights for market share. This will be a tough market to generate sustainable free cash flow without some sort of barrier to protect the company or differentiation in its product or service.
Now, lets consider the market growth angle. Paradoxically, a higher growth market signals a larger opportunity to competitors and it could encourage entry. Additionally, consider above when I stated the number of competitors is the market size divided by MES. Well, if the market is growing that creates more “room” for competition it could dilute the MES advantage the incumbent has. So, in certain case, a small TAM coupled with a slower growth can actually insulate a company from competition. In most cases, what actually ends up happening is as a market grows, there are niches created in that market a company can focus on to survive and generate profits.
A good example of the small TAM coupled with slower growth is Shimano, the bicycle gear maker. It has over 70% market share in bicycle gears and breaks with large profits to boot. Why do they have such large profits? Most likely because they have a large MES relative to this market size. A competitor could enter this market, but it is not economically rationally for them to do so so they don’t and Shimano enjoys an enviable position in this market.
A large and growing TAM may only be good if a company has a moat to protect itself or has discovered some niche in which it has strong relative scale to the market size.
High Margins
A business with high margins certainly has more options than a business with lower margins. A company with high margins can do a lot more in terms of reinvesting in its business or can possibly return cash to shareholders via dividends or buybacks. High margins may even indicate the presence of a moat. However, high margins can also come under attack without a moat. There are many businesses with low margins that actually generate a lot of free cash flow such as Amazon, Walmart, or even Costco. The fact these companies have low margins serve as a competitive barrier to new entrants as its difficult for them to make the economics work without scale. In short, high margins may be a nice feature, but if they are not defensible they could make you a target.
Paradoxically, high margins can also be a deterrent that sinks the incumbent in certain situations. In his book, 7 Powers, Hamilton Helmer identifies a concept called “Counter-Positioning”. It is when an entrant adopts a superior business model and the incumbent is unwilling to respond because of collateral damage to its existing business model. In this example, an entrant comes in with the new business model and the incumbent will wait to respond and often by the time they do respond it is either a half-hearted effort or too late. For example, Netlfix’s DVD subscription business model had the Power of Counter-Positioning over Blockbuster’s brick and mortar model. Blockbuster’s choices were either to 1) respond to Netflix directly and waive its late fees, or 2) continue to lose customers to Netflix. I am sure the high margin revenue provided by late fees was part of the reason Blockbuster did not respond aggressively.
Helmer notes that in Counter-Positioning the incumbent may not respond because of its high margins. A lot of companies do not want to kill the golden goose. The problem is if the entrants business model gains traction, you will not only lose your market share, but also you will lose those margins eventually. Essentially, high margins create an opportunity cost and deterrent to act when you need to.
Conclusion
I would like to conclude by saying that a business in a small market with slow growth and low margins is not better than the opposite type of business. What I am trying to explore is that large high growth markets and high margins are subject to competition without a moat, so having a defensible business is what creates value, not just those characteristics themselves.
In addition, when thinking about value, you must not only consider magnitude of free cash flows driven by the factors we discuss above, but also duration of those free cash flows which is driven by a moat. Most things in life are trade-offs, so even if the magnitude of free cash flow is lower because of a smaller market size, growth, and lower margins, the duration of cash flow may more than make up for that allowing for more value creation in the aggregate.
This piece by Andreessen Horowitz really made me think more deeply about this and I suggest you give it a read.
Please let me know what you thought of this piece. Thank you.
