Sunday, September 2, 2012

"How an average business can be a great investment"

In my post about decomposing the Conrad Industries return on equity, I mention an Oddball Stocks post about the difference between a moat and a niche.

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...

[T]he difference between a niche and an economic moat is the ability to scale. The bait and tackle shop can earn abnormal returns at their original location it's unlikely they will be able to replicate it unless they find a second location with the exact same characteristics as the first one. [T]hey don't have additional reinvestment opportunities and will most likely remain the same size forever.
I thought this was insightful in thinking about small companies. You can't go putting up Conrad shipyards like See's Candy stores.

You would need to match the accumulated knowledge [1,2] that Conrad has acquired about running a shipyard, but all that would allow you to do is invest about a hundred million dollars in building your own.

If you cared to learn the oil and gas industry in as much detail, you could deploy orders of magnitude more capital.

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