Learn to Love Scale, Part 2

 | Aug 12, 2014 | 1:00 PM EDT
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In yesterday's column, I wrote about the magic sauce to long-term, market-beating investment gains: looking for businesses with the ability to scale. I used the following example to illustrate my point:

In 2004, [this] company had revenues of $8.2 units. Ten years later revenue was coming in at more than $170 units. During those 10 years, the stock rose by more than 4,000%. This was not some tiny grain-in-the-sand small-cap. These numbers belong to Apple (AAPL) and revenue grew to $170 billion from $8.2 billion. Profit, on the other hand, grew to $38 billion from $276 million. That is scalability.

If you study any business that has scaled, you will find the same result.

Consider Intuitive Surgical (ISRG), which makes robotic surgical equipment. During the past 10 years, its revenue has grown from $139 million to over $2 billion. Net profit has grown from $23 million to nearly $700 million. The stock has moved up more than 2,000% during that time.

Consider Google (GOOG), the search engine giant. The company's revenue has grown from $3 billion to over $60 billion in 10 years. Its net income has grown from $400 million to over $12 billion. Interestingly enough, Google went public on August 19, 2004, nearly 10 years ago to the day. The company was then valued at a seemingly ridiculous $23 billion. Today, its value is $384 billion.  

In thinking about businesses that have the ability to scale, investors need to understand the difference between scale and growth. A lot of companies can grow; fewer can scale. On way to scale is for a business to have the ability to create a new market or create new demand. The iPhone did just that -- just consider everything that can be done via a smartphone today and what that has done for the economy on a global scale. Google did that by basically creating the Internet search business.  

Another way to scale is to understand that there are certain industries where scale is nearly impossible. For example, you wouldn't invest in a newspaper company in hopes of scaling. Scaling requires finding companies in industries that are conducive to abnormal growth. Such was the case with Coca-Cola (KO) back in the 1980s, Microsoft (MSFT) in the 1990s, and Google 10 years ago.

Finally -- and this will the focus of the examples I give in the subsequent columns this week -- you then need to find the companies that are conducive to scaling. These are generally smallish companies that are doing great things in big industries. It's easier to go from $100 million to $1 billion and, even now, from $1 billion to $10 billion. But it gets tougher as a company grows bigger. Apple's next 10 years of growth will be nothing at all like that of the past 10 years.

Using that basic framework is a better way to identify scalable ideas. I will attempt to do just that in my next few columns.

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