IFB174: Bottleneck Businesses and Secular Growth Trends with Braden Dennis

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Dave (00:33):

Welcome to the Investing for Beginners podcast. This is episode 174. Tonight, We have one of our favorite guests back for us—another show. We have Braden Dennis from Stratosphere Investing and the Canadian Investor, the top podcast investing podcast in Canada, I believe. And it is fantastic, by the way, a little side note. Suppose you’ve not checked it out easily to check it out. It’s great stuff. He and Simon are fantastic. So I’m going to go ahead and turn it over to Andrew and Braden. And we’ll go ahead and have our little conversation tonight. So Braden, welcome back to the show.

Braden (01:05):

Hey, thanks, Dave. And I appreciate the kind words I get to have you on again.

Andrew (01:11):

Braden, I figured we’d just get right to it. So you sent us a cool framework that you are describing some of the things you’d like to look for with stocks, and you call those Stratosphere Compounders, a lot of different, good elements in there.

Andrew (01:28):

Maybe you describe that for a high level, and there’s some good stuff in there that we can talk about.

Braden (01:35):

Yeah. So this framework that I made a couple of months ago was almost a stock checklist and all kind of notes I had put down on a document, but I wanted to make it into a graphic that was easy to understand, not only for interested people but for myself to wrap around what I think is a good longterm compounder and going back to basics. And sometimes you got to bring yourself back to basics. When it comes to investing, you are ultimately seeking to find companies that will be much stronger, more profitable, have a wider moat, and be more important in the future. And this is a framework to identify what those businesses are and the characteristics that they have.

Braden (02:31):

Just quickly, the elements that are consistent in a lot of these businesses are typically a leader or disruptor in a secular growth trend. And we can talk about what some of those growth trends are right now later; they have excellent re-investment opportunities. And this is typically quite easy to figure out by just looking at their ten median return on invested capital. And if it’s another type of business, like a bank, return on equity will do as well. I’d like to see some proven topline growth of both revenue and free cash. This is a consistent, proven topline that not only is potentially stable but accelerating from here. That’s what I like to see. I try to pay a fair price relative to those qualities of growth. Valuation does matter. The starting multiple you pay today does matter.

Braden (03:38):

I’m looking for strong, durable pricing power. So this business, I don’t want it to be commoditized. I get lots of questions about buying cheap oil and gas stocks all the time. And I just ask people, what would you rather have a business that gets to decide its prices or the market that they operate in gets to decide those prices for them. And then they have a conservative capital structure. So on their balance sheet, do they have a good amount of cash? Do they have a reasonable amount of debt? And can, can they use that debt for growth? So just looking at their balance sheet, nothing too, or has gone awry. These are some other qualities that I’m looking for that are kind of nice to have, but not necessary. So I like founder-led operated businesses. And if it’s not founder-led, I like to see that the CEO has been there for a while and has a proven track record.

Braden (04:39):

Capital light is nice, with high gross margins. If it’s capital-light, you’re going to find that revenue flows down to 40 cash better if they have network effects. And this is also really important, easily understood. If you can’t explain what the business is very, very easily, you either don’t have a good idea of what that business is or could be out of your circle of competence. And that’s okay. I don’t well, thoroughly understand every publicly traded company; no one does. So it’s okay that you don’t understand every business should operate with what you understand. And I think you’ll do well. Additionally, I like to buy companies that are what I consider a bottleneck business, which is a concept that I took from Chuck Akre. Who’s a chief investment officer and founder of acre capital management. He’s a smart guy, and you can, you can find them online, and he talks about bottleneck businesses. And it’s a concept that makes sense to me.

Andrew (05:45):

Let’s talk about that. I haven’t heard of a bottleneck business before; when I think of a bottleneck, I think of like those glass Coca Cola bottles. And so I don’t know what that refers to, but it sounds interesting. So break that down for us.

Braden (06:00):

Yeah, sure. People typically say when they run into a corporate world problem, they say, say, ‘ Oh, they’ve run into some bottleneck. Or it typically just means that things are funneled through it, but it’s, but it’s a pain point. You’re going from a wider diameter to a smaller diameter. And it feeds through there. So there are two things that Chuck Aker describes the Bob Mack business. I’m giving him credit because I am borrowing this concept from him. And once you hear it, I think you understand that it makes a lot of sense.

Braden (06:38):

So two things happen with a bottleneck business that demonstrates competitive advantages that might say competitive advantages. Some people call it a moat. All it means is that this company has characteristics that will let it succeed against competitors for a long period. So what is their edge is another way to say it. So bottleneck businesses are given opportunities because of their strong position in their secular trend. That they’re a part of. And I’m going to give an example of these two things, these two qualities in a second. And then the other thing about bottleneck businesses is in their value chain, their value chain. If they go away, it’s very, very difficult to replace the same. It’s very difficult to replace them and achieve the same result. So let’s give an example here. You guys know, I love the payments companies.

Braden (07:37):

So let’s look at Visa or MasterCard here. They’re given opportunities because of the secular trend of digital payments. As a new business emerges and they take digital payments, which is part of a very large global secular trend. Or if a company is innovating within financial technology, they ultimately visa and MasterCard are being given growth opportunities and maybe even have to invest in it. So that’s why you see the ten-year median on MasterCard’s free cash flow margin is 40%, which is, by the way, insane. And you won’t find that number anywhere else in the stock market. So there you’re getting opportunities without even having to invest in them. So that’s important. And then in their value chain, if these payments companies were to go away, it would be very, very difficult for most of the world to do business these days. So they’re a bottleneck because you can’t achieve the same result of accepting payments or doing business between a merchant and a consumer; that value chain is broken without them. And that’s, that’s why they have such a competitive advantage. So that’s, that’s kind of a lowdown on, on what a bottleneck businesses

Andrew (09:02):

That, that does make a lot of sense. Do you find that most of the companies that are like a bottleneck characteristic tend to be in the B to B space, and you know, I’m just saying this without putting much thought, but I just thought I’d throw it out there. You know, I think of consumers as kind of being maybe more particular about how they spend money, you know, they’ll, they’ll spend money based on interests or pleasures or, you know, things that they prefer where maybe businesses will spend money to solve a pain point. And so do you see that or mind just not thinking of customer pain points that would work as bottleneck business?

Braden (09:45):

No, that’s a very good point. A lot of them are B to B, whether directly known as a business to business model. Still, typically yeah, in, in, in these examples, it would be very, very difficult, or have massive switching costs for a company to switch providers. In this case, where the example used was, were payments. It’d be very, very difficult for them to switch that.

But additionally, a company like Google, which I think is a bottleneck business, is the relationship between consumers and businesses of finding them on Google. Like they say, if you, if you’re not on the first page of Google, your business is dead, right. Or they hide the third, the bodies on the third page of Google. That’s an interaction between, you know, B to C, even though Google does a lot of B2B business as well. So, but that is a good example. There are high, high switching costs and bottleneck businesses. And typically that is B2B,

Andrew (10:57):

I guess, on the flip side too, I think of a company like Nike, where if you play basketball, even like pickup basketball, and you’re looking for some basketball shoes, I feel like Nike would be hard to replace. So that would be a pain point if they went away. And so maybe those types of businesses that are the bottleneck to the consumer would have that feature and make them, you know, into this category. Like you said, with the other good examples, like Google and Visa and some of those other ones.

Braden (11:28):

Yeah, totally. And people who are sneakerheads would think that the world just collapsed and exploded if Nike was to go away. So that speaks to the brand power. I don’t see a consumer goods business like that. Having true, very high switching costs because the consumer does have so much optionality, but again, Nike’s brand power has shown that it’s a very compelling business for a long time to come.

Dave (12:02):

What about Apple? How do they, how do they fit into that?

Braden (12:08):

Yeah, Apple’s an interesting business because I wasn’t that long ago that it traded at about 12 times earnings. It was 90 bucks. This is pre-split. And I was looking at it one day, and I just thought, this is, this is just way too cheap. Right. And what happened was is the market recognized that they had made a massive pivot to not only being a dominant player in the smartphone business, which is tech hardware, which by the way, the more, the multiples applied to tech hardware much smaller. So that’s why it traded in the realm of about 12 times earnings. The market recognized that, wow, this is a tech services business, and the app store taking on such a low revenue share of every single business that operates within their ecosystem. Suddenly, you see this huge multiple expansion. In what seems like a few months, Apple went from 1 trillion to 2 trillion in market cap because of that multiple expansion and the obscene amounts of cash flow that they spend off.

Braden (13:26):

And if you don’t play within the sandbox of Apple, you’re not going to have a very good time. You see, Epic games have this dispute with the margins that they take on revenue for their games. And a whole laundry list of companies is not too fond of, of Apple doing that. I mean, Spotify, he loses money to Apple, and you know, what did Apple do for them while they provided the ecosystem for them? And they have those network effects where if you don’t want to play in their sandbox well, as you’re going to have a bad time. So Apple is, you know, if by definition, perhaps a bottleneck business, that was a good example, Dave, thanks.

Andrew (14:11):

To pivot off of this, I thought what you said was also interesting about one of the desirable qualities was an opportunity for both organic and acquisition-driven growth. And so, you know, I’m interested in the acquisition strategy. Is there something that you look for in a business that tells you that they have a good strategy in place, and are there any consolidators or anything like that in certain secular trends that you’re seeing? Like, are their industries working towards that because some industries, you know, might grow without consolidation and without these bigger companies eating the smaller companies where some won’t. I think it would be interesting to get your take on if you see any markets like that and what you would look for that would tell you that, okay, I like this situation.

Braden (15:08):

Yeah. Good point. And I realized that I skipped over that bullet point when I was talking about some of the desired qualities, but yes, I will. I’m looking for businesses that can grow the top line organically and through acquisitions if they make sense. But it’s not always treated equally. I am not an exclusive technology investor. I like to try to find value wherever it may present itself. However, when it comes to consolidators, I almost exclusively like software as a service consolidator. And the reason for that is that there’s a whole massive ecosystem of very niche software as a service business to private business companies that are ripe for an opportunity where entrepreneurs are looking to make exits they’re very profitable, have very nice margins. And they are very sticky when we were talking before, as business to business software, as a service is very bottleneck in nature, high switching costs, and competitive advantages.

Braden (16:26):

It’s niche enough that the big tech won’t go for it. So some consolidators have been tremendous performers inside of this inside of tech, because not only for those reasons that I’m mentioning, but they have integrations with each other that make sense. Many companies that are growing by these companies’ acquisitions have huge, huge costs to integrate them and put them into the system. But with tech, that’s just usually not the case. There can be instant benefits from day one of the acquisition being part of the broader, broader offering. For instance, the big tech giants Microsoft has had made tons of tactical acquisitions along the way that grow their offering. For instance, Skype was an acquisition way back when, and although Skype blew a ten-year lead to zoom, the Microsoft team’s application is very compelling.

Braden (17:30):

So many big tech companies have made acquisitions and instantly brought it into their offering and created value. So there is very, very compelling software as a service consolidator, especially in the niche area. I can give you two examples. So Constellation Software, which only trades on the Toronto stock exchange for Canadian investors. However, it is probably the only business that I would actually buy in Canadian dollars on the TSX if I were an American. It has been an 80 bagger since IPO. I didn’t; I didn’t misspell that 80 baggers since IPO, an unbelievable compounder, a very smart management team headed up by Mark Leonard here in Toronto. And they’ve done this; they own over a hundred companies of the niche software business, the business all over the world that generate cash flow and then rinse and repeat. So you have to study the management team with these businesses and do a little bit of extra work, but they can reward shareholders.

Braden (18:42):

A very, very similar business model in NYC is called Roper technologies. It’s about 45 billion in market cap. So it’s not a small business at all. And they do a very similar thing. You know, they own about 45 software businesses. It’s a roll-up strategy, but they look for businesses that are achieving organic growth inside their system. And then they’re making acquisition growth on the top line as well. So I’m not opposed to a roll-up strategy. Some people are on a more case-by-case scenario, but they’ve done exceptional for shareholders real quickly. What’s whether you what’s a roll-up strategy, just a consolidator it’s, it’s a company that’s looking through different vertical markets like those two, two, I just mentioned like Roper technology. They’re just rolling up the industry. They’re consolidating it. It’s, it’s a synonym.

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Andrew (19:51):

Yeah. And I guess, you know, to bring it into the non-tech world, an example of this would be a company like Coca Cola, who would acquire any drink brand. I don’t know if it was Pepsi or Coca Cola who acquired the energy drinks. But you know, bringing that into the portfolio and then using Coca-Cola’s massive distribution system to plug in another product that already has a strong brand that’s already doing well. And because Coca-Cola is built this distribution, the effects of combining those two gray things can create a lot of revenues, profits, free cashflow, and all the things that investors like to see. That can apply to tech, and that can apply to things outside of tech. And I think it’s; it’s worth looking around for that.

Braden (20:43):

I like you brought that up because that’s an amazing example. And you’re right. It’s because distribution is King that’s Coca Cola is competitive. The advantage is their distribution is unlike any other company on the planet for a physical product. So tech can do this very nicely because they have that distribution like a Microsoft people are already on that subscription to distribute it and serve it up to their customers immediately Coca Cola with when it comes to physical products like their drinks distribution is King. So that brand that they’re purchasing might be worth a lot more in Coca Cola is portfolio than whoever they are held privately with before because of that distribution channel. So that’s where they can generate a lot of value.

Andrew (21:35):

Yeah. I love it. Are there any other secular trends that we should be aware of? I guess, yeah, we didn’t intend to do this, but we’ve been talking pretty much tack all day. So might as well throw in any other tech trends That we should be thinking of.

Braden (21:48):

Yeah. There’s a, there’s a couple, I’ll spin it off here and say that a direct to consumer is a very, very interesting secular trend, but I’m going to talk about two names that are not direct to the consumer that you’re thinking of people think of D to C as you know, this e-commerce explosion, the Shopify and Amazon’s of the world. But another company like Teladoc health is bringing healthcare direct to consumer online Teladoc; ticker T doc is a very interesting business. The cohost of my podcast, the Canadian investor, has been a long-term shareholder of this, and it has been a ten-bagger, probably twice already forum. And it is bringing health rights to the consumer directly. And they just made an impressive $18 billion acquisition for chronic care and these other kinds of offerings that they can put into their suite of offerings.

Braden (22:55):

Another company like we talked about before Nike directly to consumers their eCommerce sales saw double growth in two quarters in a row. So not only was the COVID pandemic bringing forward some of that acceleration, but if you go onto the Nike site and you go on the direct to consumer experience, it’s nice. And this is not a new thing. They were investing in this, you know, many, many years back. One of the trends I’m seeing is that companies who invested in this new economy or thriving because of this pandemic, all it did was bring forward a massive acceleration of about five or six years expert. Think in many of these digital trends that were already happening; they just over an, in two months, six years went by in terms of the consumer’s readiness to adopt some of these new technologies, digital payments.

Braden (24:03):

I mean, is there a secular trend? I like more than digital payments, probably not. So visa, MasterCard, square, PayPal, Aiden, a European traded stock, very similar to a company like Stripe, which is still private that I, I tweet them all the time asking them to go public. They probably don’t read it. That’s okay. I’m a strong trend. Digital payments are, is the future cash is dead that was already happening, but now it’s being forced upon us, and you know, shareholders of those companies will do well. There’s no doubt about it. Now, what I did want to talk about one thing, which is very interesting for listeners who might not be familiar with these names because they are international businesses, is there are three names, Mercado Libris ticker, M E L I 10 cent, the Chinese massive $700 billion company, ticker T C H Y with trades over the Crowner and then C little ticker, S E they do gaming payments cloud and social ads in a Mercado Libras in South America, 10 cents in China and Southeast, and see limited as the rest of Southeast Asia. And they’re leaders in all three of those secular trends in their respective geography and check a chart of any of them. Oh God, it’s been nice to be a shareholder of them. I have been sitting on the sidelines and kicking myself for it.

Andrew (25:48):

And, you know, you wonder if, because they’re in those developing countries, if they have less to fear about say like antitrust regulations like a company might run across in more Western countries. So, in theory, maybe they could grow a lot more than, you know, who knows what other businesses they could. They could start to swallow too, as, as they just continue to Shroom in size.

Braden (26:19):

Yeah. Tencent is a very interesting business, and many people don’t want to invest because it’s a Chinese company, and it is very tied to the Chinese state. Let’s not get ourselves, but, interestingly, they have a payments business that rivals the size of PayPal. They have subscriptions to video and music that rivals the size of Netflix. Their gaming business is bigger than a lot of the big gaming companies combined. It’s about double the size of Nintendo. They have a cloud business. That’s about 10% of the size of Amazon web services. They have social ads; that’s about 10% of Facebook. They operate the largest app store by daily active users in the world. They have we chat the number one used app in the world, or that’s definitely in China, maybe not in the world, but given how many people there are, you know, there’s a chance they’re operating in all these spaces.

Braden (27:32):

And it’s just, you look at, you, look at a company like this, and you just go, there’s no way that it’s not bigger, much bigger than it already is in 10 years. So, I mean, these growth rates are very hard to assume. And to guess yesterday, the company Fastly, which does a lot of data, I’m not going to get into the business, cause I don’t want to bore you, but they were trading at 35 times sales. They dropped 20% yesterday because they missed revenue a little bit; even though revenue is still up insanely from the previous quarter, these super prices, the highest price to sales ratios, are through the roof. Now 35 times sales are becoming the norm for these high-tech growth companies.

Braden (28:23):

And if you miss just a little bit, the market beats you up for it. So having these secular trends behind you on your back is even if they miss just a little bit, as I said, what the bottleneck business is, they’re being given an unproportionate amount of opportunities because of the businesses that they’re in and the sectors that they’re pursuing and the talent that they’ve retained, that that is built into your assumption into your growth assumption is that margin of safety that even if the business doesn’t execute, as I expect the total addressable market, that they’re in that big pie that they’re looking to take market share from is growing at such a significant rate, that there’s a margin of safety built into them by, you know, by being in the spaces that they’re in. So this is a thing that I think about all the time, these days,

Andrew (29:26):

I’m glad you brought that up, and maybe it’d be a good way to close. I’m wondering, you know, you talked about a lot of great businesses. Is there a price is a price? Is there a price that is too high for any of them? You know, you mentioned price to sales. You mentioned margin of safety when you’re at the business that you believe is a bottleneck. It’s, it’s just got all these great secular trends behind it. And it’s just businesses like you you’ll never see, is there ever too expensive a price for them?

Braden (29:56):

Yeah, there there is. And it’s hard to determine what that upper limit is. And that’s why I say in my framework it is trying to pay a reasonable price. Wasn’t until Warren Buffett met Charlie Munger that he changed his investment framework at Berkshire Hathaway. When he started working with Charlie Munger, you don’t have to buy cheap businesses. You have to buy the highest quality of businesses, and you got to pay up a little bit for the quality. Now that doesn’t mean run and buy 50 times sales businesses, and you can find them everywhere. So you don’t have to look very hard. You don’t have to run and buy those businesses. You should consider paying a premium for quality because that’s the kind of companies you want to own in the long term. So what I will say to people is try to pay a reasonable price, do your best, you know, pay a fair price, but don’t ever buy a crappy crummy quality business because it’s cheap that hasn’t worked. It has never worked. And to end, it only works. If you are timing a trade by exiting at the correct time, I’m looking to buy and hold these businesses and compound themselves for me. And that’s basically what, what I do is I find these good businesses. I try to pay a reasonable price, and then I do absolutely nothing.

Andrew (31:38):

Yeah. That’s, that’s the goal. I believe it’s let the earnings compound, let the dividends compound, and let your returns compound. So, you know you’re all over the place on the web. You mentioned Twitter. We know you have a podcast. Where can people find out more about what you’re doing? What you got going on. Maybe if they’re interested in this framework that you presented, give us a scoop here.

Braden (32:02):

Yeah, sure thing. So I recently launched a new software offering that people can search for any business in the world. There’s a stock screener inside that; looking up any business in the world, you can find financials ten on a tenure basis. You can graph them. You can export them to Excel. You can see what insiders are doing, buying, or selling stock. You can see analyst reports; you can see their dividend history. You can see how they compare to other competitors in their industry. And that’s all, available @stratosphereinvesting.com. But if you don’t know how to spell that, I can’t blame you. The URL getstockmarket.com will bring you to my site. And it is a; there’s a free trial. You don’t have to bring a credit card or anything. You can; you can try it all the software. And I also post my research on there as well. So get stock market.com. You can, you can find me. And then I am on a weekly podcast called the Canadian investor. Can investors typically like it? But if you feed it, if it’s not for you, we’re talking about a lot of Canadian stocks. Sometimes I get that.

Andrew (33:11):

So you mentioned, you know, that’s a software offering, so why don’t you just make it software as a service? And maybe you go public.

Braden (33:21):

If I go public, I’ll say it’s cloud software as a service. They’re going to slap on a nice 35 times sales multiple on me. And I will be a very rich man. I like that idea. That’s a good idea. It’s a great idea. But seriously, it’s been really fun to build out that software and build the, build the product that I want when I’m looking to research a certain company, I put everything in there that I would care about and look for in a product. And so that’s, that’s what it is. Yeah. I did sign up for your trial, and I like the aesthetics of it are nice. You know, you put some good work into the visuals and the graphs and everything, and it looks nice. Yeah. Thanks for saying, so, Dave, have you tried it out yet?

Dave (34:17):

I did. I actually, I tried it out today. Andrew and I were talking about it the other day, and he sent me a Lincoln. So I checked it out, and I have to echo Andrew’s comments. It was, it was cool. It was; there was a lot of cool stuff on there. I’m going to go back and dig on it some more after we get off the podcast tonight. So feedback later, but yeah, I liked it. Yeah.

Braden (34:42):

So you can find me there at those places. I am on Twitter Brandocapital on Twitter. I have about 36 followers. So whoever wants to be at the 37th, that’d be much appreciated.

Dave (34:56):

All right, folks. Well, that is going to wrap up our conversation for this evening with Brayden Brayden. Thank you again for taking the time out of your busy day to come to talk to us. And it was a very interesting conversation. I learned quite a bit today. So I appreciate you sharing your knowledge and your wealth and continuing all the great stuff you’re doing. So without further ado, we’re going to go ahead and sign this off, go out there and invest with a margin of safety emphasis on safety, have a great week, and we’ll talk to you all next week.

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