πͺπ Big Caps: A Winning Investment Strategy?
Note: This is not financial advice, and any investment commentary is strictly opinion only. This is analysis for educational purposes only. Consult with a licensed professional before investing.
The Rich Get Richer: Megacaps Win BIG In Economic Hardship
When owning a small business, the cards are stacked against you from the start. Finding suppliers who can supply small orders relative to the volume of Walmart are difficult. Adding to the challenge is getting your name out into the community to generate new and repeat customers. Insert a pandemic into this dynamic and all of a sudden suppliers are focusing on servicing their largest and most important clients, and customers lean toward a one-stop shop as opposed to wandering a dozen stores.
While much of the focus in recent memory has been on who will be the next big tech company to completely disrupt an aging industry (such as with Uber and the traditional taxicab), weβre seeing the gap widening between larger and smaller companies. This week, we do a deep dive into why weβre seeing this trend and how it can shape your decisions as an investor. At the end of the article, we also provide insight into the kinds of industries this trend is likely to affect the most.
Intro to Economies of Scale
Economies of scale are the cost advantages that businesses can achieve when they increase their production or scale up operations. In simple terms, it means that as a company produces more goods or provides more services, the cost per unit decreases.
The Bakery Example
To understand this concept, let's consider an example of a bakery. When the bakery produces a small number of loaves of bread, the cost to make each loaf is high because the cost of labor, rent, and the oven are all attributed to those loaves. However, as the bakery increases its production and makes more loaves, it can spread its costs over a larger number of units.
As a result, the average cost per loaf decreases because the fixed costs, such as rent for the bakery space and the salaries of the employees, are being divided among a larger number of loaves. Additionally, the bakery can benefit from bulk purchasing, negotiating better deals with suppliers, and improving its production processes, which can further reduce costs ($0.20 for flour vs $0.25).
These cost savings can be passed on to customers through lower prices, which can make the bakery more competitive in the market. It can also lead to increased profitability for the business as the profit margin per unit increases with lower production costs. Consumers are drawn to these places because they are generally able to offer the same products at cheaper prices due to these economies of scale and purchasing scale. While the above is an oversimplified example, it showcases that even having larger fixed costs is not a problem so long as the volume is sufficient to cover that.
Walmart Case Study
Walmart is quite possibly the prime example of economies of scale. The model behind Walmart is to negotiate with suppliers down to the lowest price possible, to keep prices lower than competitors and drive in customers. Walmart has this kind of negotiating power for a number of reasons.
Walmartβs order quantities are so large that suppliers are likely not going to be able to sell the same volume to other retailers.
Walmart is far more important to any supplier than the supplier is to Walmart. If a supplier is unwilling to negotiate downward, Walmart can simply choose to go elsewhere.
Walmart leveraged its online marketplace during the pandemic which allowed suppliers to continue to move products during shutdowns.
Walmart then gets the product into their centralized warehouses and into their stores at a fraction of the cost per unit that small-scale operations experience, leading to drastically lower prices for similar products on the shelves of Walmart than small businesses. As a result, small businesses are forced to compete on things other than price such as convenience, niche selection, or ambiance.
This dynamic isnβt new, and the pandemic didnβt create this (apart from accelerating the shift toward online shopping). But the unique circumstances of lockdowns and economic hardship drove consumers towards shopping at single locations and being more focused on finding the cheapest price. The winners? Walmart, Target, and other big retailers. The losers? Mom-and-pop small businesses across the nation.
Small Business Decline Over 2 Decades
βIn 2000, 15% to 20% of small companies became medium or large companies every yearβ, business professorsΒ Vijay Govindarajan and Anup Srivastava reported in Harvard Business Review.Β By 2017, that figure had been slashed by half.Β
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