Weekly Thoughts

Here are some items that caught our eye this week. This week we focus on value creation both for our future customers, and for our investors as well.
 

The Math of Compounding

We came across an interesting article concerning ROIC and the math of compounding. The crux of the author’s argument is that an ability to re-invest a large portion of earnings at high returns will create prodigious amounts of intrinsic value over time and that this compounding effect is considerably more important than the original multiple paid for the investment. Consider two companies (A and B) that reinvest 100% and 50% of earnings respectively at 20%. Clearly company A will create more intrinsic value over time but how much? From the article:

The tables compare purchase price P/E’s for Co A and B (the top row) and compares that to various sale P/E’s 15 years later (the left hand column). As you can see, at a certain valuation, Company B is a better investment, but I noticed that you could roughly pay twice the valuation for Company A and still come out ahead over time. And I used 15 years, but the longer you own Company A, the wider the gap gets between Company A’s and Company B’s investment result.

Our vision relies on this math but with a twist. In the small business space we are exploring we have found several business that produce compelling cash flow but with limited opportunities for high return reinvestment. However, if those cash flows are instead used for the acquisition of other highly cash generative businesses, the compounding effect described above can be re-created. We spend most of our day working on executing the minutia of business searches and developing our management company but occasionally it is important to reflect on the math behind the longer term vision. In a world of largely overvalued assets, we see a compelling opportunity for value creation.

Full blog post here
 

Startup Guidance

Stanford is offering an interesting course this semester titled “How to Start a Startup” taught by the founders at Y Combinator, the well-known incubator. The exciting part of this is that the MOOC (massive open online course) format allows us to follow along with the lectures and pick up some important lessons. Despite the focus on technology based startups, the course provides great insights that we think will be very useful as we acquire, operate, and try to grow businesses. For instance, Paul Graham gave an interesting lecture earlier this week in which he emphasized the importance of delivering value to the users/ consumers of your product. From the lecture notes:

The second counterintuitive point, this might come as a little bit of a disappointment, but what you need to succeed in a startup is not expertise in startups. That makes this class different from most other classes you take. You take a French class, at the end of it you’ve learned how to speak French. You do the work, you may not sound exactly like a French person, but pretty close, right? This class can teach you about startups, but that is not what you need to know. What you need to know to succeed in a startup is not expertise in startups, what you need is expertise in your own users
…
In fact, I worry it’s not merely unnecessary for people to learn in detail about the mechanics of starting a startup, but possibly somewhat dangerous because another characteristic mistake of young founders starting startups is to go through the motions of starting a startup. They come up with some plausible sounding idea, they raise funding to get a nice valuation, then the next step is they rent a nice office in SoMa and hire a bunch of their friends, until they gradually realize how completely f****d they are because while imitating all the outward forms of starting a startup, they have neglected the one thing that is actually essential, which is to make something people want.

This is an invaluable point that we will keep front and center as we continue our search process. It is important to create a good platform and to find a business that makes sense from a financial perspective, but ultimately our success or failure will be determined by our ability to understand what our customers want, and to deliver that product or service in a high quality manner.

You can follow along with all the Stanford course lectures here
 

Value-Add Technology

One thing we have discussed at length internally is how, as non-industry players, we will be able to add our own value to a company that we purchase. One strategy is to stay current on the many ways the marketplace for small businesses services is evolving due to technology. A recent post on the Small Business Labs blog has highlighted the boom in the creation of small business marketplaces. Websites like pro.comand thumbtack.com are revolutionizing how customers and small businesses interact with one another. Moreover, the rise of social media means that the nature of marketing is changing rapidly. Small business blogs are now offering advice on how to optimize your firm’s presence on Facebook among other sites. Figuring out how to best compete in the new game of Internet based small business customer acquisition is an area where we feel we can add significant value once we get to work on a company we acquire.

Have a great week,

Your Chenmark Capital Team