01 Jun Investment Insights from the Lanchester “3X” Strategy
“Is there a “natural limit” or “stall point” in the size of the business by industry and country as the entrepreneur attempts to scale up before he or she faces the challenge of their corporate lives to overcome the start of a secular reversal in fortune?”
Many SME business owners whom we have interacted closely with over the years are blighted by a hidden fear and doubt which they loathe to share with others, even family members.
Despite attaining a certain level of success and personal wealth, their hearts are ever more unsettled as time passes because they have hit a stall point in their core business model and are unable to unlock the valuation potential of their business.
There is no terminal value in the business because time becomes an enemy of the business. Without terminal value, the discounted cash-flow valuation analysis would point towards a low PE multiples in the valuation of the business.
In other words, they failed the acid test that value investors employ to gain conviction in sizing up the investment bet. This test is a seemingly simple but profound question:
“Does the business get easier as it gets bigger?”
F.W. Lanchester (1868 – 1946)
Through our research and interaction with some of our Hidden Champions, we understood how they overcame stall point in their business model.
Their long-term business model and management strategy is guided by the Lanchester Strategy; named after the British aeronautical engineer F.W. Lanchester (1868 – 1946) who had made important contributions to automotive engineering, aerodynamics, and co-invented the topic of operations research.
He was also a pioneer British motor car builder, a hobby which resulted in his developing a successful car company, and is considered one of the “big three” English car engineers – the others being Harry Ricardo and Henry Royce.
Lanchester researched attrition in land, sea, and air combat, focusing in particular on aircraft in warfare and quantifying the ratio of aircraft to casualties. Based on these studies, he developed the Lanchester Laws and the importance of the scale of the fighting force in warfare.
Lanchester “3X” Strategy
One investment insights is that a company commanding a market leadership position that is over three times relative to its next rival will enjoy a profitability level that is proportionately far greater and with long-lasting durability. We dubbed this the “Lanchester 3X Leadership”. In other words, the business gets easier as it gets bigger.
Below are some extracts from Shinichi Yano’s insightful book Lanchester Strategy (Volume 1) that talks about how tyre maker Bridgestone leads with sales that are 2.4 times those of its number two local rival Yokohama Rubber, with Bridgestone’s profits not merely 2.4 times greater but over 10 times more.
We traced the data using S&P Capital IQ and found that Bridgestone is a long-term compounder that gets stronger as it grows bigger over time because of the “Lanchester 3X Leadership”.
Its sales in 1987 were 2.7 times larger than Yokohama, a lead that was extended to 6.1 times in FY2015, while its operating profit compounded substantially faster to grow 543%, resulting in profits being 8.8 times those of Yokohama.
Today, Bridgestone’s market value is US$30.9 billion, over 10 times larger than Yokohama’s US$2.9 billion; a powerful multiplier effect in translating the “Lanchester 3X Leadership” to sustain shareholder value creation when they pass the acid test with a resounding “Yes” to the question: “Does the business get easier as it gets bigger?”
Applications To Uncovering Hidden Champions
As an illustration of how we apply the “Lanchester 3X Leadership” in investments, one of our portfolio companies which is a global leader focused in writing instruments and other stationery products had a 3x market share lead over its next largest local rival in the key US and Europe markets.
Over the FY2011-15 period, its operating profit growth was indeed more robust at 294% compared to 85% for its local rival. This world-class innovator generated a 29.5% ROE (EBIT), defined as EBIT over Shareholders’ Equity and trades at EV/EBIT 9.6x and EV/EBITDA 8.5x.
We are confident of the long-term prospects of this Hidden Champion which is renowned for quality, performance, cutting-edge technology, and consumer satisfaction.
The roots of its success can be traced back to the founder who started as a humble engineer on merchant ships involved in international trade. His constant interaction with imports being transported on these ships inspired him to create something from his home country that the world would be proud to use.
When he moved on to become a professor in a school, he noted how the students struggled just to pen things down. This began his journey to create a writing instrument that feels incredibly smooth, has uninterrupted ink flow, and a dense ink colour.
Even after a few generations of leaders, the spirit and vision of the founder still resides in the company. For the past century, the company maintained the same level of sincerity, commitment and made continuous improvements and innovations.
They have since accumulated the know-how in precision equipment that includes precision lathes, the equipment used to manufacture luxury watches, with some requiring even a higher precision than watch-making.
This resulted in an extensive array of products of extremely high quality, varying thickness, and colours of every shade of the rainbow. Backed by a decade of creativity, innovation, and design, the business has positioned itself as the world leader in writing instrument technology and we are quietly confident that this Hidden Champion will continue to grow and be the best in the industry.