Just because something cannot scale does not mean it cannot earn outsized returns
We recently came across an investment opportunity that reminds us of the proverbial bait and tackle shop. While the company will never grow to be size of a unicorn, its geographic positioning allows for extraction of abnormal returns over the long-term despite seeming innocuous to the casual bystander. In discussing the opportunity, we were reminded of an article we wrote in 2015 about the bait and tackle concept which has since become a central talking point in our investment discussions. From the article:
We stumbled upon an older article on the Oddball Stocks blog which focused on the source of abnormal returns for value oriented investors. The author notes that in the absence of net nets (companies trading below net working capital, the pursuit of which made Ben Graham famous), most modern investors look to acquire all or a portion of quality businesses at reasonable prices with the hope that the business will leverage its competitive moat to compound at high rates over the long term.
However, the author then notes that there are many ordinary businesses that are able to generate high returns on capital despite their plain vanilla nature. From the article:
“There are plenty of ordinary businesses that earn abnormal returns as well. Why aren’t there competitors reducing the abnormal return down to an economic return? Consider an example, a bait and tackle shop on the only access road to a state park with a nice lake. The shop has no pricing power over suppliers, has a low barrier to entry, and doesn’t even require specialized skills. Yet the location of the shop, being the only one on a specific road allows it to charge a bit more and earn above average returns. The bait shop has a small niche, serving fishermen at the local state park, yet they don’t have any classic competitive advantages; there are many businesses like this.”
The main differentiator between a lake-side tackle business and a serious competitive moat business (think Coke, Gieco, or any other long-time Berkshire Hathaway holding) is scalability. The chance that the tackle shop finds quality growth investment opportunities is extremely low. This means it has limited ability to expand its franchise over time and thus, viewed in isolation, it has limited appeal to a traditional investor base.
Our perspective is different. A business in an overlooked niche that generates consistent cash flow above reinvestment requirements looks to us more like a valuable source of investment capital, so long as we are willing to take a portfolio perspective and pursue reinvestment opportunities outside the original company’s scope of business. The fact that such opportunities seem to be available at a discount to market multiples is simply an additional bonus.
As the author mentioned in the article, “you’ll never wow anyone at a party announcing you own shares of a tiny plastics manufacturer, or a family held leather boot company,” but we believe a portfolio of such businesses, prudent management, and patience could combine over time to be something worth talking about.