Weekly Thoughts

Here are three things that caught our eye this week:
 

3D Printing

While we don’t concentrate on technology sector investments per se, we spend a lot of timing reading about the space because we fully appreciate the transformative effect that new innovation can have on a variety of industries. The rise of 3D printing represents exactly this type of game changer given its potential to revolutionize manufacturing processes, and, in some respects, the nature of the entire supply chain.

Assumed by many to still be a technology best suited for prototyping and one-off small runs, 3D printing has continued to evolve rapidly, and according to a recent Harvard Business Review article, is at a “tipping point” which will take additive manufacturing into the mainstream. From the article:

“It may be hard to imagine that this technology will displace today’s standard ways of making things in large quantities. Traditional injection-molding presses, for example, can spit out thousands of widgets an hour. By contrast, people who have watched 3D printers in action in the hobbyist market often find the layer-by-layer accretion of objects comically slow. But recent advances in the technology are changing that dramatically in industrial settings.

Some may forget why standard manufacturing occurs with such impressive speed. Those widgets pour out quickly because heavy investments have been made up front to establish the complex array of machine tools and equipment required to produce them. The first unit is extremely expensive to make, but as identical units follow, their marginal cost plummets.

Additive manufacturing doesn’t offer anything like that economy of scale. However, it avoids the downside of standard manufacturing—a lack of flexibility. Because each unit is built independently, it can easily be modified to suit unique needs or, more broadly, to accommodate improvements or changing fashion…[Moreover], a big part of the additive advantage is that pieces that used to be molded separately and then assembled can now be produced as one piece in a single run…That’s why GE Aviation has switched to printing the fuel nozzles of certain jet engines. It expects to churn out more than 45,000 of the same design a year, so one might assume that conventional manufacturing methods would be more suitable. But printing technology allows a nozzle that used to be assembled from 20 separately cast parts to be fabricated in one piece. GE says this will cut the cost of manufacturing by 75%.“

It is also important to note that the pace of innovation in 3D printing is only continuing to accelerate. Globally, the number of patents relating to additive manufacturing materials, software, and equipment has skyrocketed to 600 in 2013, up from only 80 in 2005. In addition, as the production technology improves, the potential for supply chain re-design also expands. Whereas historically parts suppliers focused on the development of one specific unit, deploying additive technology unlocks the ability to use the same equipment to make engine parts, sunglasses, and toys on successive days all by simply switching the design specs and base input materials. It is not hard to imagine (and some firms are already putting into place) “printer farms” that can commoditize the making of products on demand.

Much like the internet circa 1995, it is difficult to anticipate exactly how 3D printing will evolve. However, the HBR article did predict that, “Within the next five years we will have fully automated, high-speed, large-quantity additive manufacturing systems that are economical even for standardized parts. Owing to the flexibility of those systems, customization or fragmentation in many product categories will then take off, further reducing conventional mass production’s market share.” We plan to keep a keen eye on the development of this trend, and hope to take advantage of this new technology where we are able.

Harvard Business Review, Small Business Labs
 

BDC’s

When we entered the world of small business investing, we had never heard of Business Development Companies (“BDC’s”). Since then, we have had the opportunity to better understand this unique vehicle. As background, BDC’s are closed-end funds that provide financing to small and mid-sized businesses. They were created in 1980 by an Amendment to the Investment Company Act of 1940 (known colloquially as the ’40 Act) that allowed BDC’s special exemptions, such as enabling these funds to invest the majority of their assets in private companies (rather than publicly traded companies), the ability to conduct shareholder reporting like traditional operating companies (quarterly filings and annual reports rather than daily or monthly reporting), and the requirement to make significant managerial assistance available to their investment companies.

BDC’s also enjoy certain tax advantages. Similar to a Real Estate Investment Trust (“REIT”), as long as BDC’s meet certain income, diversity, and distribution requirements, they pay virtually no corporate income tax. Instead, they act as a pass-through tax structure, distributing at least 90% of taxable income to shareholders every year in the form of dividends.

So, why should you care? From an investment standpoint, they provide investors with diversified exposure to private companies, meaning that they essentially offer venture capital and private equity like exposures with greater liquidity. Additionally, unlike VC and PE funds, which are only open to institutional or high net worth investors, these vehicles are open to all investors, regardless of income level. In addition to better access and liquidity, BDC’s have historically offered investors attractive yields. The chart below, sourced from a recent P&I webcast, shows how aggregate BDC yields have outperformed comparable asset classes:

As a result of these attractive characteristics, the BDC market has grown substantially, from $13 billion of assets under management in 2005 to $33 billion today. Despite the recent growth, many think the BDC market still has significant growth prospects. For instance, REITS and MLPs, which have similar structures and regulations, currently manage $907 billion and $355 billion respectively, despite being relatively small 20 years ago. P&I elaborates:

“Business development companies, or BDCs, are a growing and institutionally oriented asset class that provides investors a liquid alternative to invest in middle market loan assets. Notably, BDCs offer attractive diversification opportunities within fixed income as middle market loan products generally provide superior risk adjusted returns relative to the broadly syndicated loan and high yield markets. The drivers of this superior performance include less competition for transactions, lower leverage and higher spreads on investment. What’s more, those credit managers who are adept at sourcing and managing middle market collateral often hold distinct competitive advantages over their broader peer set. The BDC market is expected to grow from investor demand for yield, the growth of nonbank middle market financing and the general trend toward securitization of private assets.”

From a credit standpoint, BDC’s offer an alternative to bank lending and seller financing. While rates may be high, they do provide the market with additional financing sources, which is always welcome in the small business market. We look forward to watching the evolution of this market, both as investors and potential borrowers.

Bloomberg, Wikipedia, Forbes, PI Online
 

Swim Coaches

We have previously written at some length about our interest in health and wellness issues, so it should come as no surprise that we have been closely following the ongoing scrutiny of Dr. Mehmet Oz, the noted cardiothoracic surgeon at Columbia and media personality who is perhaps the best known proponent of alternative medicine in the country. With an audience of 3-4 million daily viewers, Oz is uniquely capable of delivering health advice to a large portion of the population, many of whom may not have access to quality information elsewhere.

While some of the information he provides is well known in the scientific record, Oz has come under fire for his promotion of supplements and other lifestyle adjustments which lack such evidentiary support. Oz has testified before Congress about misleading statements made on his show, and most recently he has been the subject of a letter sent to Columbia’s Dean of Medicine calling for his ouster from the medical school. The group of doctors who all co-signed the letter noted that:

“Dr. Oz has repeatedly shown disdain for science and for evidence-based medicine, as well as baseless and relentless opposition to the genetic engineering of food crops. Worst of all, he has manifested an egregious lack of integrity by promoting quack treatments and cures in the interest of personal financial gain.”

We confess to never having watched Dr. Oz’s show, and we have no idea what financial arrangements he may or may not have with his guests. However, we very much agree with the foundational premise of Dr. Oz’s effort. His website encourages people “to take control of their own health through simple lifestyle changes,” a mission that grew out of his own frustration as a medical practitioner. A 2010 New York times profile noted:

“Too often, he told me, he would sit in his office and be ‘telling you stuff too little, too late — that if you’d been able to lose a little weight or if your diabetes had been managed more aggressively, then it would have dramatically changed your destiny, which is now to go downstairs and have open heart surgery.’ With his TV show, he can exhort Americans to tend to all aspects of their health, head to toe, before they reach a point of no return.”

The problem that lies at the heart of the controversy behind Dr. Oz is that many in America believe health advice should come from two sources: medical experts supported by mountains of scientific evidence, and entertainers who casually trade health tips and should not be taken seriously. We believe there can and should be a middle ground where patients are encouraged to take an empirical approach to their own health and wellness, and are guided in that journey by competent professionals.

Here we find it’s best to think of classically trained doctors as lifeguards and wellness experts as swim coaches. It’s clear that if you are drowning (i.e. you need bypass surgery), you really need a lifeguard (i.e. a well-trained doctor). However, it is also true that if you need a lifeguard, you probably needed a swim coach and you didn’t get one. The point is that the health of the nation would dramatically improve if people received better guidance on ways to improve their wellness. The world needs more swim coaches, and Dr. Oz is trying to fill that role. His approach may veer off course at times, but we applaud his attempt, just as we applaud all enterprising individuals who take bold action to identify and address gaps in the marketplace.

Washington Post, Washington Post 2, New York Times, Vox, Dr. Oz, Glassman
 
Have a great week,

Your Chenmark Capital Team