International Smaller Companies: Under the Radar.
Part 4 - Scalability.
The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.
Under the Radar
International Smaller Companies
As with most professions, elements of what we do are often misunderstood. For us, mentioning the fact that we are investors to family and friends tends to elicit a particular response. There is an assumption that we dissect company financials forensically and are all accounting standards connoisseurs. Understandably, we don’t always argue against these misplaced assumptions! Numbers clearly matter – after all, a company’s intrinsic value reflects expectations for its future cashflows. Its financials help us understand how the business works, give a comparatively unbiased snapshot of its recent past, and help us imagine the company’s prospects. But numbers are just part of the story.
It surprises some who are less familiar with our industry that investors can approach analysis from various angles, depending on their investment mandate and style. Many people see analysis as being similar to a general healthcare check, or a vehicle inspection. That is not the case. The fundamental difference is that these checks are designed to detect what may go wrong, rather than what can go right.
By contrast, our work is perhaps more akin to running a screening programme for future Olympic champions, rather than spotting early symptoms for common diseases. Talent scouts in gymnastics looking for the next Simone Biles do not apply the same methods as those hunting for the new Michael Phelps in the swimming pool. However, the commonality is that finding a few superstars matters much more than avoiding the complete failures. It’s a fact of life that some prospects simply don’t work out, but there will be some star performers. Similarly, in equities investing, our success will likely be determined by the relatively small proportion of real winners.
We appreciate that potential returns are highly asymmetric. At a stock level, the most we can lose if we get it completely wrong is 100 per cent. If we get it right, the upside is often a multiple of our initial investment. Even moderately-growing companies can go up multiple times over five to 10 years (our typical holding period) as compounding effects take hold. Investors in smaller companies are particularly blessed with a fertile hunting ground for such opportunities, given the breadth of the universe, the diversity within it, and the inefficiencies of the market.
Besides using scalability as a model to help gauge the potential upside at the inception of an investment, it is also a powerful framework to monitor a company’s development.
The core message here is that, with an eye on the long-term upside, having a clear understanding of the company’s ability to scale up its business is what matters. Going back to our Radar research framework – if Opportunity addresses WHERE a company can get to, Edge looks at WHY this company may get there (as opposed to one of its competitors), and Alignment analyses WHO is driving the business forward; the question of scalability looks at how this will happen.
This raises several questions. How does a company grow into the opportunity that we identified and what are the underlying mechanics of that growth? Will progress likely happen through periods of dramatic growth spurts or steadily over the long run? Will this need multiple injections of capital or can growth be self-funded? Does the company benefit simply from increasing scale, or are there more powerful network effects at play? Answering these questions is a way of teasing out potential investment pay-off if the company succeeds.
Besides using scalability as a model to help gauge the potential upside at the inception of an investment, it is also a powerful framework to monitor a company’s development. The practical outcome in thinking about scalability is the clear identification of the key bottlenecks. When these bottlenecks shift (whether fundamentally, or simply our assessment of them), we pay attention. The rest of the time, ‘company news’ is often just noise.
Bottlenecks in our context come in many different forms, and every company has them. Some are related to the nature of the company’s markets and products. For example, we invest in a number of biotechnology companies that are commercialising novel therapies. It takes years for something to get from the lab to the clinic and eventually to become medical orthodoxy, almost regardless of the availability of capital and how promising the initial breakthrough is.
When Japan introduced a new conditional approval system for novel therapies based on regenerative medicine in 2015, it cleared the way for Japanese biotechs such as Healios to commercialise new therapies based on advances in induced pluripotent stem cells. For other markets, companies with innovative products are often fighting against inertia – enterprise software is one obvious product category where sales and implementation processes can be painfully long in some cases – almost regardless of how compelling the product is. Decision making within corporates often goes far beyond ‘does this make sense for the company?’. Understanding friction points in these processes is crucial. An example is Kinaxis – a Canadian software company that sells complex supply chain simulation tools to some of the largest enterprises in the world. It can take up to two years for the company to bring a new client on board, but we have been encouraged that implementation is now increasingly done through external partners, a shift that hints
at improving scalability.
Other bottlenecks can be internal in nature. Some businesses are naturally capital intensive, limiting growth as capital is tied up by the business for extended periods rather than reinvested to accelerate growth. For others, there may be operational constraints if parts of the operations are unable to keep pace with the rest of the business. For example, it may be difficult to recruit and retain a specific type of employee with sought-after expertise. Or perhaps there are constraints in the supplier base.
Nakedwines.com, an online wine retailer Naked Wines, is an interesting case study. The business model is that its customers, by paying a monthly subscription (effectively prepayment for wines), contribute towards a fund that in turn invests in independent winemakers. In return, these subscribers, known as Angels, get exclusive access to their products at wholesale prices. The main bottleneck is clear – independent winemakers with the right combination of ambitions and qualities do not roll off a production line. Thus far, the company has invested in over 150 winemakers from around the world, but there remains a waiting list to become an Angel. In a virtuous cycle where an increasing pool of committed Angels and winemakers stimulate the growth of each other, the limiting factor to growth appears to be the latter. An understanding of this underlying dynamic allows us to appreciate the strategic priorities of the company, and to assess the long-term potential of the business in a more nuanced fashion.
Finally, there are cases where the most pressing bottleneck is a company’s mindset. It may be shaped by the management’s motivations and experiences, the history of the business, or the circumstances of its shareholder base. These are intangible factors that are often poorly captured by numbers and underline why direct and open engagement with our investee companies is an integral part of our process.
Scalability is the capacity of an entity to be changed in scale. In a financial context, it is sometimes seen as a matter of mechanics describing revenue growth and how profitability follows. From our perspective, it is one of our core investment factors because it helps us to assess upside and ongoing progress.
Understanding scalability requires not just a grasp of the mechanics, but also an appreciation of the unique mix of tangible and intangible bottlenecks that a company has, as well as the recognition that progress is rarely smooth. Indeed, most companies that we invest in ultimately fall way short of what we might expect of them. However, the minority – those that at least get close to delivering on their potential and deliver multiples of the initial investment – make all the difference.
The views expressed in this article are those of the International Smaller Companies team and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in March 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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