The Magic Attribute of a World-Class Business By Austin Root, portfolio manager, Stansberry Portfolio Solutions
What's the best business in the world? Take a moment to think about that. Think about your own portfolio. Out of all the companies you own, which has the best business model? More specifically, what attributes make that business one-of-a-kind? Some common answers might include having a uniquely strong brand, superior pricing power, a talented management team, and perhaps even the ability to sell something addictive like nicotine, chocolate, or caffeine. (This last type of company is among Porter Stansberry's favorites because it generates such attractive and predictable returns year in and year out.) These are all great and highly desirable business attributes. And they're all among the traits we routinely look for when adding a new name to our Stansberry Portfolio Solutions. But there's one more attribute that might just be the most valuable to a business. You see, nearly all the businesses that I consider to be "the world's best" share this one attribute. And perhaps even more telling, I can't think of a single company with this trait that I don't consider to be world-class. Let's dive into the details... I call this magic business attribute "the network effect." Others (like Porter) call it an example of Metcalfe's Law... a virtuous circle... or a flywheel business. Whatever you choose to call it, this key trait creates a business that gets better as it gets bigger. To be clear, I'm not talking about the simple economies of scale that occur as a business grows – things like increased purchasing power, lower borrowing costs, or the leveraging of static fixed costs over more and more revenues. Those types of benefits are great, but they're fairly easy to come by in good companies. No, I'm talking about core businesses that actually improve – and become more desirable to their customer bases – the larger the company gets. The perfect example of a network-effects business is Stansberry Portfolio Solutions holding Facebook (FB)... because it's actually a social network. Think about Facebook's business model and, if you're a member of its site, how you may have gotten started with it... People want to be connected. We don't want to miss out. That's why the more people you knew who used Facebook, the more likely you were to join. Then the more you actively posted about your life, the more your friends and family wanted to join the site as well. And so on and so forth until, suddenly, there weren't just thousands or millions of people on Facebook, but billions of people sharing and liking posts every day and watching tens of billions of paid advertisements every month. That's just how a network-effects business operates. Growth begets more growth. Momentum increases. And the business gets better and more profitable along the way. These types of businesses are often hard to get started. And they don't always take. Just look at failed competitors of Facebook, such as Myspace or Friendster. But once they get rolling and build up some momentum, they're like a snowball rolling downhill, growing larger and more powerful with each rotation. The biggest snowball generally takes all (or most) of the market share. Now for a word of caution... Many companies in this category look expensive. For that reason, we often recommend that you own these companies for the longer term, rather than trade them over the short term. Do not buy these stocks if you're looking to make a quick buck. Network-effect companies trade at such seemingly rich valuations for a reason – or in fact, for three reasons... One is that they're growing much faster than most companies out there. In the current market environment, outsized growth is scarce. So the demand for these types of businesses is high and pushes up the share price. More importantly, at their core, network-effect businesses are stickier and more predictable than the competition. They tend to have extremely loyal customer bases that spend more every year and rarely leave. So these companies can safely project a big growth in revenues even before they bring on a single new customer. (And we can be confident that they're signing up more new customers all the time, as well.) Finally, for high-growth, forward-thinking companies like these, looking at their whole-business financials only tells half the story. So at Stansberry Portfolio Solutions, we also analyze their "unit economics." (That means we look at their financials on a per-customer basis.) By this measure, we've identified a few network-effect businesses that are so profitable and cash-generating, that they're among the best unit economics we've ever seen. And as they continue to add customers to their capital-efficient operations, more profits from each relationship will drop to the bottom line and improve overall margins. The combined effect of this customer stickiness, predictability, and attractive unit economics allows us to confidently project further into the future than we could with a typical business. And so while these businesses might seem expensive on current earnings, if we "look over the horizon," they're incredibly attractive based on future earnings power. Still, once you find network-effect opportunities worth investing in, you may have to let these positions "stew" for a bit in your portfolio. They're generally not short-term holdings. We recently recommended two network-effect businesses – one in The Total Portfolio, and one in The Capital Portfolio. One is a hypergrowth software company that is disrupting one of the fundamental elements of business – the contract. The other takes huge amounts of proprietary data and analyzes them, in order to help its clients – mainly insurance companies – make better informed, more profitable decisions. If I were forced to come up with a list of the best stocks to own over the next three to six months, neither of these companies would make the cut. These are long-term investments. I'd count them among my best stocks to own over the next 10 years. And that's really what we're aiming for with our Portfolio Solutions. We want to recommend companies that will outperform over the long term. If the market corrected sharply downward tomorrow, would these shares get hurt? Sure. But given the quality of their businesses, they may not drop as much as the rest of the market. Their business prospects might actually improve in a downturn. While other companies are reeling, these leading businesses will likely take more market share and come out stronger on the other side. So in today's environment – where investors are skittish, markets are hitting all-time highs, and online stock trades are now free – it's important for you to stay focused on the long term for most of your portfolio. Seek to own more world-class companies with enduring franchises, capital-efficient business models, and superior growth prospects. These are the types of companies you can hold with confidence while the rest of the world gets nervous. And if more than a few of these companies have fast-spinning flywheels attached to their businesses, all the better. Good investing, Austin Root Editor's note: Last night, Austin joined our top three "gurus" at Stansberry Research for a live chat. They revealed their favorite moneymaking ideas for 2020... And they shared a crucial step that can help you set up your portfolio for long-term success – even if the markets get bumpy. If you missed it, click here to watch a free replay. | Further Reading "The race to get big is a matter of survival for a lot of these companies," Dr. David Eifrig says. "Many of these markets will be winner-take-all." The network effect goes beyond tech stocks. Soon, it could even be a driving force in health care... Get the details here. "A lot of people trade stocks like they're renting them," Austin writes. "But now is the time to start buying stocks like you're planning to commit to them." If you're looking to invest in long-term winners, learn the three questions you must ask yourself right here. |
INSIDE TODAY'S
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