The Art of Small Business Investing
In Sun Tzu’s (孫子) book The Art of War (兵法) he establishes several different types of terrain, and the appropriate action that a military leader should take for each. Interestingly, there are few situations where fighting is his recommended tactic and many where withdrawing is most advantageous. Below are a few excerpts from the section:
“On narrow terrain… If the opponent is there first, do not pursue”
“On steep terrain… If the opponent is there first, withdraw from there and do not pursue”
“On wide-open terrain, the force of momentum is equalized… disadvantageous to fight”
“On standoff terrain, even though the opponent offers you an advantage, you do not go for it”
We find the last two examples to be especially insightful. First, even if the field of play is even, it is best not to engage. Second, even if offered an advantage, in some cases it is still best not to engage. Our takeaway: only engage when you have a distinct advantage, and that advantage is large enough to provide a margin of safety and shield you from any unexpected or unforeseen challenges. At RPM Capital, we understand this and in response seek to exercise a small business investment strategy similar to Sun Tzu’s strategy for war.
A common concern when investing in a small business is its vulnerability to large companies that benefit from economies of scale and can provide a similar good or service at a lower cost. History is ripe with examples of large companies using their size to crush their competitors. Wal-Mart is one example that is commonly discussed in business schools and around dinner tables alike and has become known for using its immense buying power to obtain goods at a lower cost with the intent to sell at a price below the competition. They are the quintessential example of economies of scale. Many local mom and pop retailers were unable to compete and over time have closed their doors. Amazon is now applying the same strategy to the digital world, and while the landscape may be a net benefit for small manufacturers, it is certainly to the detriment of the smaller retailers.
There are many industries that are dominated by large businesses, and for good reason. Some spaces are best served by a very small group of very large players and we do not seek to engage on this type of terrain. Other industries, those with little to no economies of scale, offer to put large and small businesses on equal footing, but again we choose to look elsewhere for small business investments. The industries we seek to deploy our permanent, patient, and focused capital are those in which small businesses have a durable competitive advantage and are likely to retain that advantage long into the future.
When considering a small company's ability to compete with a larger one, it is crucial to understand the relative importance of economies of scale to the industry and the geographical area. Economies of scale for a route-based provider of services, such as a plumbing company, may not be as substantial as the economies of scale for an online distributor, given that the former primarily achieves efficiency through route density which is limited to a geographical area, while the online distributor achieves additional economies of scale from any customer gained. We seek industries with what could be termed “economies of density”; the marginal cost per unit is inversely related to the number of customers per local operating area. Certain service businesses require employees to be on location and a dispersed number of inexpensive assets. These features allow small businesses to compete effectively by removing the ability of larger companies to invest in superior assets or achieve a lower cost per unit from their buying power or national presence.
Consider the business of vending machine operators. Their assets are small and dispersed, removing the ability of a large company to invest significantly more dollars in superior assets. Additionally, the requirement to visit each location regularly removes the benefit of a nationwide presence and instead makes a local firm with increased density much more desirable than a national firm with more distance between stops. Which business would be more profitable, one with 100 vending machines in the same town, or one with 1,000 vending machines spread across the United States? The costs of transportation would quickly pressure the larger company’s margins below that of the smaller, more efficient company.
Sun Tzu understood the irreplaceable nature of a soldier and deemed it best to engage the enemy with this most valuable resource only if the field of play was determinately in his favor. We seek to apply the same mentality in the management of the scarce, permanent, patient and focused capital invested on behalf of our shareholders. The financial system and the market it operates provide a daily deluge of investment options and alternatives, each supported by a formula sheet filled with risk and return metrics, Greek letters, and optimistic projections. Instead, we believe in a careful weighing of objective and qualitative facts of the business and its industry and insist on investing dollars only in those businesses operating on the most advantageous terrain.