On frameworks for finding compounders
Hamilton Helmer distills the variables from which business value is derived
One book that we love at Sophon is Hamilton Helmer’s “7 Powers: The Foundations for Business Strategy.” Helmer is accomplished and clearly an intelligent individual: he began his career earning a PhD in economics from Yale and then worked as a consultant for years at Bain & Company.
After leaving the consulting world he founded his own long-only public equity fund called Strategy Capital, which has grown to ~$1B in AUM. Helmer used his experiences as a strategy consultant and investor to write this book, which was particularly well-received by the Silicon Valley crowd. Peter Thiel and Reed Hoffman are big fans, and Daniel Ek says the framework is a foundational part of the analysis done at Spotify to discuss new initiatives.
Part of the reason we like Helmer’s “7-powers” is because they are highly practical, and the framework is less abstract than other methods touted by strategy gurus (read: Michael Porter). Helmer is less theoretical than your typical career consultant (he did spend the bulk of his career in the investing world) and gives a list of attributes that not only serve to guide decision makers but are also a handy toolkit for investors trying to assess the inherent value of a business model.
A research piece by Morgan Stanley defined “compounders” as “high quality, franchise businesses, ideally with recurring revenues, built on dominant and durable intangible assets, which possess pricing power and low capital intensity.”
At Sophon, we seek to find businesses that fall into the “compounder” category. I think the 7-powers give a useful framework for business analysis and help determine whether a company qualifies as one. Helmer provides a fresh new formula for “value” (which he still considers to be shareholder value, the present value obtained by discounting future free cash flow generated by the business). His new equation is qualitative rather than quantitative:
Value = [Market Size] * [Power]
The “Power” variable in the equation above represents the degree to which a company collectively possesses the characteristics listed below:
Scale Economics - does the business possess economies of scale? Does the marginal cost of producing one incremental unit decrease as the company produces more units? Financial analysts often speak of operating leverage when evaluating companies - the proportion of fixed costs in a company’s overall cost structure. Companies with a high degree of operating leverage see greater economies of scale — as more units are produced, a greater portion of the company’s overall costs are spread across the total volume of output
Network Economics - does the value of a service increase as more users join the network? Take the example of Netflix…as more users join, Netflix gains a ton of data on users’ tastes and preferences and their algorithm gets better at recommending content to each new user.
Counter-positioning - this is the trickiest to articulate, but Helmer describes the following scenario: “A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.”
Does the company have a business model that allows it to gain share in the market it plays in, because other established companies (the “incumbents”) cannot copy it?
One market all of us are highly interested in is the hearing aid industry in the United States. Up until the present, hearing aids had to be prescribed by an audiologist, and the incumbent players (e.g. Starkey, GN, etc.) put down significant cap ex outlays to build physical audiology clinics. There has been the emergence of direct-to-consumer hearing aid companies (Eargo is perhaps the best known one) that enable patients to order hearing aids from the comfort of their own home. What would happen to the incumbents if they were to copy Eargo’s business model? They would cannibalize sales in their existing channels (i.e. the physical audiology centers). While there are far more dynamics we are not touching (which we perhaps will explore in a later article), in this sense you could say that Eargo and similar DTC hearing aid companies are favorably counter-positioned relative to the incumbents.
Switching costs - this is the degree of value lost by a customer when they switch from their existing service to one offered by a competitor. This is a crucial element to consider when evaluating how “sticky” - or recurring - a company’s existing revenue base is.
Branding - this one is the most self-explanatory…what is the company’s brand value? Companies with a higher brand value can charge more than a competitor offering an identical product. Compare Coca-Cola with generic cola. If unless you are incredibly cheap - and fortunate to belong to the middle class or higher - you are more than willing to pay an extra $1 for brand name Coke.
Cornered resource - Helmer describes this as “preferential access at attractive terms to a coveted asset that can independently enhance value.” One company with a business model that is fascinating is CoStar Group. CoStar has its own proprietary database for commercial real estate info that they built from the ground-up. One way CoStar gets data is directly from CRE brokerages - who upload their repository to gain access to the database (talk about a business with superior network economics!). CoStar has access to a proprietary database (coveted asset) at highly attractive terms (no other competitor can gain access to their database).
Process Power - Helmer describes this as “embedded company organisation and activity sets which enable lower costs and/or superior product.” One of our favorite words at Sophon is Kaizen - a Japanese term used to describe a company philosophy of “continuous improvement.” Many researchers attribute the success of Japan’s post-World War II economic boom to the proliferation of this corporate mentality. The best firms in the world are constantly getting better at producing output and serving their customers because they systematically learn from their mistakes. As an investor, when you consider a company’s culture, you should always try to identify the degree to which a firm adheres to elements of Kaizen.
This is the framework in a nutshell…however we still strongly suggest you go out and buy Helmer’s book.
We hope you appreciate our work thus far.