“ Growth is life”- Dhirubhai Ambani
In our first post on “Moats and Competitive Advantages” we discussed four attributes that we consider while evaluating investment opportunities. This post covers the first point we laid down in our framework – the size of the available market for the product/service.
Imagine if you will that you’re a venture capitalist in the early 2000s - a young Harvard dropout shows up one day and pitches a website where Harvard (and other elite university) graduates build profiles with information like age, sex, relationship status etc; after building profiles users can post updates about their day to day life and follow updates posted by other users they follow. The dropout claims the website is addictive and has excellent user engagement numbers. At this point, what do you do? Do you chose to invest in a website that is arguably just a social media platform for kids from elite universities with no clear route to monetization or do you pass?
If you thought passing was wise - you’re no Peter Thiel. You just missed out on being an early investor in Facebook.
Much imaginary scenarios. Much regret.
So, what did Thiel see in Facebook? Why did he part with $0.5 million and invest in a company started by a couple of kids or a few hundred kids? Thiel’s investment thesis at the time was simple – he had seen the internet economy boom and was looking to invest in businesses that could at scale converge the physical and digital world. This thesis fit exactly with Facebook’s functionality.
It wasn’t a stretch for Thiel to see a website that was then restricted to a few universities expand its target demographic by changing a few lines of code and opening up to everyone. Thiel accurately gauged that the total available market for the website was gigantic. Identifying this market and being an early investor in Facebook resulted in Thiel netting a cool $750.0 million from his initial investment of $0.5 million.
The power and potentially mind boggling returns that can be made from identifying a growing market in its infancy isn’t restricted to venture capital investments. It spills over to all forms of equity investing regardless of whether these are in private or public markets.
So now that you understand the power of successfully sizing markets, the next question that props up is how do you size a market? Most of us aren’t as smart as the best venture capitalists in the world, these people have seen the evolution of multiple companies and therefore intuitively grasp the size of markets. How does an ordinary investor size a market?
We have utilized a combination of the following steps for market sizing -
Back of the envelope calculations
First things first, sizing a market is more of an art than a science, there is absolutely no way anybody can definitely arrive at a number that can be declared as “the” size of a market. A typical back of the envelope calculation while estimating the market size for an industry would look something like this –
Step 1 - Identify major players in the industry
Step 2 - Sum the revenues earned by these players in the latest and prior financial year
Step 3 - Observe the historical growth in revenues for the industry
Step 4 - Read analyst and management commentary on the future of the industry and expected growth rates.
Step 5 - Consider the historical growth rates (estimated in Step 3), analyst and management expectations for future growth (observed in Step 4) and select a number of growth rates that lies between the optimistic and pessimistic outlook for the industry.
Step 6 - Grow the revenues for the latest financial year (estimated in Step 2) by the selected growth rates to estimate a range of industry sizes.
Step 7 - Select the median industry size as your final market size estimate.
Observe analyst estimates
Industries like FMCG, automobiles, steel and other conventional industries are extensively covered by brokerage houses, these brokerages publish frequent reports that provide estimates of the market size. One should ideally run a sanity check on their back of the envelope calculation to see if the estimated market size is in the same ballpark as analyst estimates.
An important point to note here is that blindly relying on analyst estimates without conducting due diligence on how this number was estimated would not be wise. One can never know the analyst’s motives and biases and therefore all third party research must always be viewed with healthy skepticism.
Exercise your imagination
Like we mentioned before, estimating the market size is more of an art than science. Market sizing often ends being the primary reason for divergent opinion on a stock. One investor might be extremely bullish on the size of an opportunity and the market share that a company will come to capture while another might be bearish on the same. This will drive differences in valuation and contradictory buy and sell calls on the same stock.
This divergence in opinion and why exercising imagination is a must is best captured by this blog post by Bill Gurley (an early investor in Uber) which captures differences in opinion between Gurley and Aswath Damodran (Damodran is to valuation what Amitabh Bachan is to Bollywood) on the total available market for Uber. The short of the disagreement is that Gurley believed Uber is an urban logistics company that will come to earn revenues via a share of all last mile logistics (such as food delivery, dunzo like on demand services and cabs) while Damodran believed Uber is a modern day cab hailing service.
Now whether you agree with Gurley or Damodran on Uber’s market and growth potential is not the point, the point is this estimating market size requires a certain degree of imagination and pragmatism at the same time and such dilemmas will manifest themselves regardless of the company being valued.
We feel equity investing is all about growth and economic profits. Companies showing a) promising growth runway and b) returns higher than cost of capital tend are always rewarded by the market with higher valuations (the market can test your patience and not reward you with the returns you expect immediately, however, if the above two points hold - over a long period of time you will be rewarded for your patience). Consequently, fragile businesses with low or no growth are valued poorly by the markets.
While most investors understand that returns are earned by holding fast growing companies with large available markets, the following factors are often not considered –
It is important to understand the longevity and ceiling for growth in the long run.
Regardless of however strong a company’s competitive advantages, management team and industry tailwinds it is simply not possible for a company to keep growing at double digit growth rates forever. If such a situation where to arise, the total available market would at some point reach global GDP or some other such astronomical number. As we discussed above, imagination that couples pragmatism with optimism is a necessity.
The market size is not a static number.
Market size is a constantly evolving number. Let’s take the newspaper industry as an example, majority of news industry revenues were via advertising. However, the advent of social media platforms like Facebook resulted in advertiser revenues switching to displaying adverts on these platforms as opposed to in newspapers. Who among us can confidently say we would’ve factored this in our calculation while sizing the market for the newspaper industry back in 2008? Staying on top of market sizing requires being widely read and seeing second order effects of what might appear to be unrelated trends.
So now that we understand what total available market is, why it’s important to engage in a market sizing exercise and how available market is estimated, we finally delve into our framework for categorizing companies into distinct categories based on two factors: a) the size of the company and b) the size of the market.
Large player with large available market
Companies that fall in this category are established leaders in large markets, these companies have a proven track record of dominating the market and roam to grow. Such companies can leverage their position of strength to grow disproportionately large over time. Some examples that fall in this category that we see around us today are tech behemoths in the United States (Facebook, Apple, Amazon, Netflix and Google) and China (Baidu, Alibaba and Tencent), these companies have tapped large markets in their infancy and today represent more than 8.0 percent of global market capitalization. We’d be remiss in our analysis if we only stated obvious examples like the FAANGs and moved on. Let’s look at a few companies that do not hog the limelight but still fall in this category.
Mercado Libre is the largest online commerce and payments ecosystem in Latin America. The company started as an online marketplace and over time has expanded to adjacent categories like providing payments solutions to both buyers and sellers, targeting both the merchant and acquirer side of digital transactions has resulted in creation of an ecosystem that grows larger by the day due to network effects.
What makes us believe that Mercado Libre a large player?
With $14.0 billion gross merchandise value in 2019, Mercado Libre was solely responsible for 20.0 percent of the total Latin America e-commerce market.
What makes us believe that Mercado Libre is targeting a large market?
Latin America has population of over 650.0 million. Increasing internet penetration has resulted in the population slowly moving to online commerce.
In 2019, e-commerce accounted for only 4.4 percent of total retail sales in Latin America. The penetration of e-commerce as a percentage of total retail sales in developed counties like the Unites States stands close to 16.1 percent. The United States had 4.0 percent e-commerce penetration a decade back, that’s where Latin America stands today.
The Latin American e-commerce market is expected to reach ~$84 billion in 2020 and ~$116 billion by 2023. This shift to online commerce will create amazing opportunities for e-commerce players in the region.
An example in the Indian context is Relaxo Footwear. Relaxo is the largest mass market footwear manufacturer in India. However, despite being the largest player in the country, Relaxo sells only 18 crore pair of footwear out of the 220 crore pairs sold annually (a market share of only ~5.0 percent). The company is cognizant of this statistic and has spent INR 90.0 crore to set up a new manufacturing facility that can produce 1.0 lakh slippers per day. Management hopes to utilize its existent distribution network, brand image and additional manufacturing capacity to capture more market share.
Small player with large available market
Companies that fall in this category are second best placed, these companies while smaller in size than incumbents benefit from a larger pie that is available for distribution amidst market participants. A large addressable market implies huge runway for the company to grow if the management has a growth mind set and efficiently allocates capital.
A few example from the Indian market that fall in this category are AU Small Finance Bank like MAS Financial. These are strong mid and small cap banks with decent asset liability profile, strong current account/savings account deposit base and strong recovery mechanism which are focused on the retail segment. These companies benefit from factors such as the growth in total retail loan book (expected to grow from INR 48 trillion in 2019 to ~96 trillion by 2024) and migration of loan book from inefficient public sector banks to strong private players.
Large player with small available market
Companies in this category have established a strong foothold in a market that where growth is constrained. If such companies are run efficiently, they prove to be cash cows which either provide shareholders with huge dividends or provide management with the dry powder required to expand into unrelated markets.
Marico via its marquee Parachute brand, is a dominant player in the coconut oil segment. Other brands such as Saffola are also leaders in the edible oil segment, Saffola has more than 75.0 percent market share in edible oils. However, despite this dominance the company has in recent times seen low to mid-single digit growth in revenue. This anemic growth rate has largely been driven by increasing awareness amidst consumers about the perils of oil consumption which has resulted in reduced per capita consumption of oil and a slowdown in the industry in its entirety.
Small player with small available market
This is the worst situation a company can possibly find itself in, being a puny player with no room to grow is a recipe for mediocrity and no returns for investors.
Let’s consider an offbeat example here, consider a Pao Bhaji stall on Juhu beach. Assume this stall whips up the best pao bhaji in the country, their pao is fresh and bhaji spicy and tangy in the right proportions. Assume the chef at the stall requires capital to buy new equipment and reaches out to you seeking investment. Having read this post, you start thinking about the market size.
What does the market size look like? Small. Your target market is people who visit the beach. Meanwhile franchises like Shiv Sagar serve all of Mumbai and the uncle from MDH is selling pao bhaji masala to the entire country. The opportunities to scale the business are limited.
That's about it from our end on market sizing. We believe the best businesses address pain points and deliver services/products to millions - not a few hundreds or thousands. Successful businesses that create wealth for shareholders address large markets. This becomes glaringly obvious once one starts analyzing a common pattern in successful businesses - HDFC Bank, Nestle, FAANGs all served the needs of the many not the few.
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Please note that the above article is for informational purposes only and none of the companies mentioned above can be considered as investment advice.