Avoiding the group of death
In our third podcast episode, Moneyball and automation: introducing “The Lab,” Justin Anderson gave us two keys to winning at poker:
- You have to play fundamentally sound poker—i.e., pre-flop, you shouldn’t be folding aces or going all-in with deuce-seven.
- You need to know who is playing at your table.
While the first key is fairly obvious, the second is often underappreciated. The strength of your competition has an important bearing on your own odds of success. If the other players at your table are all amateurs, you are more likely to win than if you’re sitting with a bunch of sharks.
This idea doesn’t just apply to poker. In 2015, England crashed out of the Rugby World Cup in the pool stages, failing to qualify for the quarter-finals. As they were ranked 4th in the world coming into the tournament—not to mention the host nation—it was a national disaster.
Many reasons have been attributed to England’s failure and their coach resigned in the aftermath. But perhaps the most important explanation had nothing to do with the English team: England had been drawn into the “Group of Death” alongside Australia (ranked #2 in the world at the time) and Wales (#5), where only two of the three could qualify for the quarter-finals. No matter which two teams had advanced to the knock-out stages, somebody’s fan-base was always going to be bitterly disappointed due to the competitive dynamics within that pool.
Competitive dynamics in investing
The concept of knowing who is at your table or the strength of your pool is important to us as investors when analyzing companies. Our investment approach starts with a scrutiny of business models and their sustainable competitive advantages where much of the analysis is intrinsic to the companies themselves. In other words, what is it about a particular company that should allow it to earn a return on capital greater than its cost of capital over time? The answer could be a unique product, a strong brand, a technological advantage, or exclusive access to a scarce resource.
But competitive dynamics also matter, and this includes an understanding of the industry—or the pool of players—in which a company competes.
Consider banks in Europe. They inhabit a notably crowded space without a clear market leader where the persistently low interest rate environment has put pressure on their lending margins. In an effort to drive profitability and exacerbated by fierce competition, they have been forced to make increasingly aggressive loans. These competitive dynamics don’t tend to support sustainable wealth-creation and are key reasons we’ve generally shied away.
But the flip side is also true. We own a number of businesses in industries or niches where our holdings are the clear market leaders against a fragmented set of competitors. One notable example is Couche-Tard, which owns and operates over 16 thousand convenience stores and fueling locations globally, often competing against much smaller operators including “mom & pop” locations.
The advantages stemming from such competitive dynamics are numerous. For one, having a professional management team as opposed to single mom & pop operators can create a clear edge. Not to mention the benefits of scale which often allow organizations to enjoy:
- a lower cost of capital
- lower procurement costs given better bargaining power over suppliers
- the ability to spread out other costs (administrative, marketing etc.) across a multitude of customers or locations, and
- better brand awareness, often a virtuous circle.
In addition, if management can allocate capital effectively, there could be a large runway for potential acquisitions. And, if the roll-up strategy targets smaller operators (single store, smaller chains), these acquisitions can often be done at more appealing multiples as opposed to acquiring a larger competitor, which can result in more attractive returns on capital deployed. This is because smaller operators aren’t usually as profitable, generally carry more risk given their concentration, and don’t tend to attract as much attention from other acquirers given their small size.
Another prime example of this is Compass Group, the largest on-premise catering company in the world. Compass services hospitals, retirement homes, stadiums, educational and military facilities, offshore rigs…to names a few. All told, they serve 5.5 billion meals every year.
Compass is an example of a “defensive growth” company. The nature of its business is less economically sensitive—people need to eat!—which brings recurrence to their revenues. Their management team has also continued to allocate capital effectively through a roll-up strategy while delivering higher margins and returns on invested capital than their main competitors. We believe the incredibly fragmented nature of the industry—despite being the market leader, Compass only has a 10% market share globally—provides a long runway to continue making such acquisitions…think of the number of independent catering companies in the world.
In the end, if we deem a company’s management team able and honest, and if the business model shows evidence of being wealth-creating, the added benefit of finding a leader in a highly fragmented industry can make for an excellent long-term investment.
On a related note (and one dear to this writer), the next Rugby World Cup kicks off later this month in Japan. It’s shaping up to be one of the most competitive World Cups ever given the number of genuine contenders for the Webb Ellis Cup. Yet despite what appears to be a strong and confident team, English rugby fans are in for another nail-biter: their team has once again landed in a Group of Death alongside France and Argentina.