How concentrated is an investment in a single business?
For investors looking to build a portfolio of companies, diversity across industries and geographies is widely desired. The imbedded assumption being diversity lowers risk and is accomplished at the portfolio level. The investor diversifies their capital owning multiple companies in different industries and geographies. Owning just one company is viewed as a concentrated position. But how concentrated is one private company and can most of the risk diversification aims to reduce be achieved within one company?
Take a landscape maintenance company serving both commercial and residential customers across Portland, Oregon. (my hometown) The owner has their investment, representing 90% of their net worth, tied to the landscaping industry and it’s natural cycles and seasonalities. Common investing sense says this owner is highly concentrated in their investment strategy. But taking the example further, say this company’s customers consist of local vineyards, solar farms, hotels, apartment buildings, government offices, retail stores, individual residential homes, and the local municipal airport. Looking at the company from the customer level, this is a very diverse investment. In fact, the owner may very well view their net worth highly diversified since the source of their revenue within the company is highly diverse. Losing a few customers in any downward trending industry is unlikely to significantly impair the company.
So the question is, as investors in small private companies, which level of diversity should we be optimizing for first? The portfolio level or the company level?
The key variable in answering this question is control. Since public investors by and large don’t have control over their investments, it makes sense to focus on diversifying at the portfolio level. Public investors can’t order companies in their portfolio to diversify their customer base or go after different market segments. They can ask management teams nicely, but I don’t have faith in that approach consistently making a real impact. Thus, one should diversify where they do have control which is at the portfolio level.
In majority owned private companies you can change strategy, organize new sales teams, and build a more robust customers base. Even if you acquire a company with substantial customer concentration, making your investment very concentrated, you can market to a wider range of customers and diversify your investment without acquiring a second company to lower your risk. Risk can be reduced in-house. We can achieve many of the same goals of diversity at the company level.
Finally, what’s the real goal in diversification? To not permanently lose an investment. In my brokerage account I can achieve this by investing in companies with diverse customer bases in various industries, but I can’t make decisions for revenue diversity at the company level if they haven’t already done so. With this option available for small private companies however, I can reduce my risk of permanent loss without needing a second or third portfolio company. With a more diversified single business, I can play offense when acquiring other companies rather than defense.
Thank you to Traction Capital Partners for supporting the podcast and making it easier than ever to create new episodes. Traction acquires companies in the Pacific Northwest with between $1-5m in EBITDA and has acquired two companies to date. Visit their website or contact one of the partners, Justin Turner, directly to learn more.
A.J. Wasserstein at Yale has written some fascinating case studies about search funds and small company investing, including what is perhaps the greatest study on Chenmark Capital ever written. You can find more studies on this page if you scroll below A.J.’s profile. Shoutout to Justin Vogt for the recommendation.
Post-Close is a new blog with anonymous case studies of small company acquisitions and I really enjoyed reading through the four currently posted ones and have subscribed to future studies. I highly encourage you to subscribe along with me.
This Macro Ops article on the Chandler Brothers who grew a small fortune into a large one through global investments and bets was a fun read.
As someone getting married in a little over a month, this article about advice for a happy marriage was a great read.
If you found an interesting article, podcast, or interview that I missed, please let me know, I’m always looking for interesting stuff.