Which company would you rather invest in? One that will continue to make a million dollars in profit, or one that is only just breaking even, but has the chance of making billions?
The right answer depends on what you’re trying to achieve with your investment. But there’s a factor which many people overlook when trying to pick the companies that have a bundle of potential. How quickly, easily and cheaply could they get to that billion dollar mark?
BHP didn’t just go from being a small cap stock to making tens of billions in profit overnight. It took vast amounts of capital investment, costly acquisitions, painstaking exploration and more to get at each ton of iron ore. The more iron ore they wanted, the more they had to spend, explore and dig.
That meant BHP’s owners got rich the hard way. There’s nothing wrong with that. It just takes time and money to do it.
Other companies can do things differently. Take Microsoft as an example. It also has great initial expense when it designs its software. But from that point on the company can sell the software an infinite number of times at very little cost…especially now that you can download the software over the internet instead of buying a disk.
What separates Microsoft from BHP is something called scalability. It’s the ability to scale up sales without adding significantly to costs or effort. And that’s what allows scalable businesses to grow profits remarkably quickly. So the next time you pick a stock for its potential to make you rich, you’ll want to keep scalability in mind…
Companies that are set to take advantage of scalability aren’t necessarily good investments though. They tend to come with unique risks. For example, it’s easy for an up and coming competitor to take over quickly.
Social networking websites are the ultimate scalable businesses. They design their websites at a cost and then have an infinite number of members join at almost no additional cost. But the war between the social networking companies showed how quickly a business empire can disappear in scalable industries. MySpace was outpaced by Facebook and now Google Plus is on the move.
If you invest in a scalable business, keep in mind that competitors can very suddenly and quickly rise.
Of course, scalable businesses are inherently risky and speculative. They will either take off, or fail. That’s different to investing in a company like BHP with a proven track record.
Given these risks and the potential for enormous profits, you should at least be conscious of scalability, whether you want to avoid it or make the most of it.
Scalable companies can make good investments during tough economic times. Their success depends less on the wider economy than for unscaleable companies. At least, they still have the potential to grow dramatically during those times. Facebook probably did just fine as a company during the financial crisis (when it was still privately owned).
So what are some examples of budding Aussie scalable businesses? The best place to start looking is for companies that operate online. The internet is the scalable business’ best friend because it allows vast volume at low cost.
Carsales.com (ASX:CRZ), the hotel booking website Wotif.com (ASX:WTF) and Flight Centre (ASX:FLT) are great examples of this…they are scalable businesses. (Please note, these aren’t recommendations, just examples of scalable businesses.) The number of people that use their sites doesn’t affect their cost base significantly compared to other companies. They could double their business without increasing their costs nearly as much.
If you enjoy punting on small-cap companies for big gains, perhaps think about using scalability to your advantage. Far too many investors see the potential revenue stream a company has and they forget that generating that revenue comes at a cost. The secret to a scalable business’s success is that these future costs are very low…
And that means more profit at the end of the day.
Editor, Money for Life Letter