“Starting in day one requires you to experiment patiently, accept failures, plant seeds, protect sapling, and double down when you see customer delight”
Jeff Bezos
When researching what high quality investments we make for ourselves and our clients, we place them in several categories:
The focused business – these are the narrowly focused businesses, which are very good at what they do in a relatively narrow market, and have all the qualities we look for in a high - quality company (high barriers to entry – the monopoly/duopoly of the market, and high return on capital employed (ROCE)) – examples such as Costco, Home Depot, Stryker, etc;
Great capital allocators, which is what Warren Buffett did for so many years at Berkshire Hathaway
Uber cannibals – firms who do not have a high growth market anymore, but they buy their own shares at an extremely high rate – an example is Rightmove;
Spawners.
Spawners are companies which continually spawn related or unrelated businesses. These are companies which have a deep conviction of relentlessly adding and incubating new businesses that have the potential to be massive growth engines. They expect many failures, and they take failure in their stride.
They have a huge tax advantage; the investment cost of spawning is reported as Research and Development (R&D) expenses which are deducted from the net income before corporation tax is applied.
These spawners could be categorised into four main types:
Adjacent spawners – create related businesses. Examples - Nike, Starbucks, Pepsi;
Embryonic spawners – acquire and start small businesses and nurture them into much larger enterprises – example: Microsoft with PowerPoint (started as a small business Forethought), also the LinkedIn acquisition.
Clone spawners - these companies do not innovate; they copy successful products and sell them to their own clients. Microsoft is again a great example, it copied from other companies software that was successful (World, Excel, Explorer), but also laptops, and tablets etc.
Non-adjacent spawners create or buy new, unrelated business areas. A good example is Google with Waymo which is their autonomous car business, also Tesla with its solar and Powerwall home offering.
We tend to name the spawner company who can employ three or all four categories as the “Apex” spawner. A few examples below:
This is just a small list of Apex Spawners, there are a few others, some which we do not invest in now due to their valuation such as Tesla. We also have a small list of what we believe will become new Apex Spawners in a few years, companies like Illumina, Intuitive Surgical, or DocuSign.
All of these spawners tend to have a few things in common. They have a great CEO, most of the time someone who has an important ownership in the business. This person is very inspirational for the company, has a clear vision, and has very high targets (like going to Mars). Once the company could find a new product or service niche, they focus 100% on client satisfaction, introducing new standards (delivery next day, no quibble returns etc), taking advantage of competitors when they are reacting slowly. Their processes are improved all the time, and their Return on capital employed (ROCE) becomes remarkably high, following this the company goes back to its relentless work of finding and incubating new businesses using the cashflow created from the main businesses. These companies tend not to use leverage (borrow money) or they use leverage to a very low extent.
The result is a company which manages to defeat gravity, in this case “the company cycle”: start-up, growth stage, expansion, established, and decline, by avoiding the declining phase. In fact, the company has many businesses which could be in any of these stages (Amazon’s selling of printed books is in decline), but as a group the company remains in the growth stage for an exceedingly long period, ideally forever. Investors have great advantages as they can remain invested for a long period and earn great investment return, most of the time exceeding / beating the market return.
It is however important to differentiate the spawner company from a diversified conglomerate owning multiple businesses. Compared with a spawner, the conglomerate usually has very low ROCE and tends to be relatively highly leveraged – an example is AT&T. These companies tend to show what is named the “conglomerate discount” (a low price-earnings ratio), their stock price trading at low prices. Compared with the conglomerate, a spawner will carry a relatively high multiplier, investors having high expectation from them. There could be moments when a spawner could become a conglomerate, as it may have been the case for Berkshire Hathaway in the last 10 years, when most of the new investments were made in bad companies: Kraft Heinz, airlines, banks (Wells Fargo), Precision Castparts, etc.
Usually this would become the case when the spawner is so successful at generating free cashflow, as the company fails to re-invest it using the four methods for spawners I described above. Instead of having to make bad investments, it would be preferable for the company to return capital to investors in any of the following forms: dividends, special dividends, or to start a buyback strategy for the company. Some spawners like Microsoft, Nike, Apple are already paying a dividend every year.
Berkshire Hathaway which did not pay a dividend since 1967 has started buybacks from 2019. They have also reformulated their investment strategy making some interesting investments recently, most notable $1 billion investment in Snowflake.
Our high-quality investment process will remain focused on investing in spawners, Apex spawners, and focused companies, some of them which we believe will become spawners and Apex spawners in the future. To learn more about our high-quality investing process please read:
IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested
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