Business Model Optionality

Real options provide equity investors with hidden value — Quality businesses have real options embedded in all their assets — Capturing this value generates excess return.

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BUSINESS MODEL OPTIONALITY

Option holders have the potential to capture value when the unexpected occurs, as options become more valuable in volatile times. A high quality business model provides shareholders with, often unrecognized, optionality.

High quality businesses have real options embedded in their business models. These assets are unappreciated in good times, but pay off in times of market stress, allowing a business to strengthen its position in volatile environments.

Real Assets Options

Although equity investors have become enamored with capital-lite businesses with few physical assets, the ownership of these assets can often provide hidden value.

The Covid lockdowns highlighted the value of owning manufacturing facilities.

Companies that had aggressively outsourced, selling their physical assets to their suppliers, found their supply chains under pressure with suppliers often failing to deliver.

Boeing, as an example, struggled to source parts from around the world as their sprawling supply chain faced different restrictions depending on the geography. Sourcing over 600,000 unique parts per aircraft from a global supplier base proved to be overwhelming.

Contrast this performance with Snap-On, a manufacturer of tools for mechanics, and their vertically-integrated US manufacturing base. The company is able to purchase steel and plastic pellets and turn these inputs into thousands of products for their customers. The physical assets, as well as the manufacturing know-how, to accomplish this feat has been critical to the company’s success both during and after the Covid crisis.

Economic Moat Options

Businesses with strong economic moats not only compete successfully in existing markets, but also have the option to leverage these moats in the face of disruption. Regardless of the source of moat, be it platform value, network effects, etc., high quality businesses often surprise investors with their ability to adapt.

Microsoft’s Teams product, prior to the launch of ChatGPT, was one of the fastest-growing enterprise applications ever. Microsoft’s Office 365 platform and strategic bundling have, time and time again, proven to be an invaluable asset. The company’s incredible economic moat not only protects today’s profits but also serves as a springboard for entering new markets, with ChatGPT as the latest example.

Similarly, Wal-Mart’s scale, physical store base, and supplier relationships have allowed the business to morph into a capable competitor to Amazon, a feat accomplished by few legacy retailers. Although Wal-Mart was later to the e-commerce party than Amazon, its strong existing moat allowed for successful market entry.

High quality businesses should expect to face disruptive competitive threats, as this is a hallmark of capitalism. The value of economic moats though, are often unappreciated by competitors and investors alike, and routinely allows past winners to maintain and grow their earnings streams even in the face of industry revolutions.

 Relationship Options

Customer relationships have minimal balance sheet value but are increasingly recognized as critical assets. Being close to a customer allows for invaluable feedback on a product or service. This feedback is often the difference between launching new products that resonate with customers or fall flat, ultimately determining a business’s future market share.

Industrial businesses in particular have recognized the power of this feedback. Cummins, Eaton, and Parker Hannifin have all bought into their aftermarket distributor networks to become closer to their customers in the field. While this provides these businesses with a stable aftermarket revenue stream, the underlying strategy is to gain direct customer access and return feedback to their R&D teams.

By recognizing the power of customer relationships, we can view the entire distribution space in a new light. Distributors all have the hidden value of direct access to thousands of customers. These customer lists and historical purchasing data have the potential to create significant value as digital analytics (powered by AI) can increasingly extract value from these datasets.

The Hidden Benefits of Quality Business Models

All assets, whether physical, digital, or intangible, possess inherent optionality. High quality businesses, with strong business models and economic moats, stand to benefit from volatility by leveraging their assets in times of stress. Identifying this hidden value within a company’s business model can unlock rewards for equity investors.