My goal, through this website, is to help my readers become better investors. Not by telling them what to do, but by sharing with them frameworks, information, and good resources that has helped me to improve. One thing that many successful investors recommend is to learn, over time, about types of business models, their nuances, strengths, and weaknesses. This will help you analyze businesses effectively, and decide if they are good candidates for long term investing.
I plan to cover different kinds of business models, and how to use them to analyze businesses for investing (Subscribe, if you are invested in learning about it). In this post, I will dive deeper into a type of business model that successful companies like Meta, Amazon, Microsoft, Google used to become what they are today – “Scalable Businesses with High Fixed Costs“.
By the end of this article, you will learn:
- What is a scale business?
- What is a scale business with high fixed-costs.
- Why a Scale Business with high fixed costs is better than a Scale Business with low fixed costs?
- How to find such businesses to invest in?
What is a “Scale Business” ?
Simply put, a business is a scale business if it can increase it’s revenue, and profitability without a proportional increase in cost. As revenues grow, profits tend to grow at a faster rate than costs associated with it. This results in increased profitability per unit, and thereby margin expansion. Textbooks refer to this effect of margin expansion due to scale as “economics of scale”
Generally, Scale Businesses have:
- Huge market size to expand.
- Lower variable, and incremental costs.
- Ability to replicate their business model across markets, and geographies with less incremental effort.
These characteristics help them scale without much additional cost, resulting in high profit margins.
Example: Joe Rogan‘s podcast. His podcast has lower variable & incremental costs – the cost of creating, and publishing an episode doesn’t depend on the number of listeners listening to him. And the podcast gets listeners from different countries without much spending or effort from his end. And as viewership grows, revenue grows faster than costs, resulting in increased profit margins.
What is a Scale Business with high Fixed costs ?
Scale business with high fixed costs, as the name suggests, is a business that enjoy all the characteristics of scale business but require high fixed costs investments to start & run the business. Generally, this type of business need:
- High capital to fund fixed-cost requirements, unlike Joe Rogan’s podcast which only needs a microphone, camera, chairs and internet connection to start.
- Higher effort, and expertise to start the business.
Even though such companies enjoy the benefits of scaling in the long run, they tend of be unprofitable at the beginning due to high fixed-capital requirement.
Example: Amazon. Jeff Bezos, unlike Joe, required seed money of $1 million dollars to fund fixed costs to hire the team, build the website, develop a distribution center, etc. And also required many other rounds of incremental funding, and IPO, until it became profitable in 2003, 6 years after it started.
Why a “Scale Business with high fixed costs” is better than a “Scale Business with low fixed costs”?
Even though “Scale business with low fixed costs” tend to become profitable quickly due the scale, and its low fixed costs requirement, in the long run “Scale Businesses with high fixed costs” become the real winners. It’s because:
- High fixed costs creates barrier to entry, and therefore less competition. Not all can afford huge capital to fund the business, resulting in less market entrants, and participants.
- Less market participants helps with acquiring bigger market share.
- Bigger market share can provide more pricing power, better brand recognition, and many other benefits.
- High Cash Flow in the long run. Less market participants, pricing power, brand recognition, etc. eventually lead to high free cash flow if managed well.
- More cash allows more budget for R&D, and Innovation. This helps the company to find out new ventures to get into, and thereby deepen their moat even further. Example – Amazon’s cloud computing business.
Continuing with the example: Overtime, due to less capital requirement, many jumped in into the podcast world, resulting in increased competition for Joe. However, because of high capital requirements, there is not much competition to Amazon in the ecommerce space, and cloud computing world.
From an investment perspective, such businesses can provide high ROIC for a long time, high free cash flow, and predictability. If purchased at good valuations, these type of companies can do wonders to your portfolio.
How to find such businesses to invest in?
Now that we know that if such businesses are executed well, can be a great opportunity, let’s talk about how to find such businesses to invest in. To be honest, there is no fixed mantra that I can give you. But I can certainly provide a checklist that you can use as a starting point to make the investment decisions. Check the following:
- Is the market size huge? Do some research to find out what is the market share of the company, and the size of the total market. The goal is to see if the market share of the company is already too high or if there is room to expand further.
- Does it require large capital investment to start the business? – Look at the fixed asset value in the balance sheet, and figure out what kind of assets are these.
- Is the business able to scale quickly without much incremental costs? – Look into past income sheets and confirm that their margins have expanded as they scaled. There can also be scenarios in which the margins have not expanded due to some temporary costs like marketing & sales campaigns but has high probability of margin expansion. Reading management’s commentary in Annual Report or Earning’s call will help you find more information.
- Who are their competitors? Compare market share, margins, and management’s expectation w.r.t future growth.
Researching about these points will give you a good understanding on whether the business falls under the “Fixed-cost Scalable Business” category, and what are its future prospects. In case everything looks good, add it to your watchlist, follow this company, and wait for the valuations to become reasonable before investing in the business.
Parting Note:
The strength of “Scale Business with high fixed costs” is no secret. Many from the world of investing, and finance know it. Yet, only few are able to find out such opportunities, and achieve great returns from investing in such businesses. It’s because even after you know about the this model, and the associated checklist, it still needs work.
One who finds, researches, and analyzes more, and more of such companies will develop better insight over time. Therefore, my advice to you is to use this in practice. Overtime, you will develop an edge, and improve your returns.
Happy researching, Happy investing.
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Further Reading: Good Business, Bad Business: How Payment Terms reveal the Truth
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