Back to basics - Always hold increasing returns to scale businesses

What should drive your equity choices for the rest of 2020? The classic factor style approach focuses on value, quality, size, momentum, or volatility which may often seem abstract from the underlying businesses. For example, value or quality is a factor which is sorted and not a strategy or a review of the business and the environment it works in. 

Simply put, successful long-term businesses that produce high returns should be those that have increasing returns to scale that can be exploited, serve as a tailwind, and can stop competitors. 

Most good firm will have at least constant returns to  scale. If a 10% increase in resource usage of labor and capital leads to a 10% increase in production, there is constant return to scale. If the output increases by more than 10%, there is increasing returns to scale. We can look at the classic Cobb-Douglas production function Q = K^a*L^b and work through the math to find conditions for increasing or decreasing returns to scale. Increasing returns to scale will lead to economies of scale or decreasing long-run average costs which support higher profits.

Increasing returns to scale is not the same as just getting large. Many firms think they should merge or acquire others to get scale by sharing supplies, management, or platform costs, but that is not the same as increasing return to scale nor will it create economies of scale with the underlying activities of the firm.

There are number of businesses that will have increasing returns to scale, those with high upfront costs or R&D, network effects, customer learning curves, branding for quality and location. Meaningful increasing returns to scale exist for businesses that create barriers to entry from their scale. For example, look for network scale. The attractiveness of a network product grows through the use by more customers, and more network users create value for all so that even moving to a cheaper product that does not have network is expensive. Firms that set an industry standard and gain a network are especially attractive and will have increasing returns to scale that will be hard to overcome.

However, these increasing return to scale business have issues of winner-take-all competition. There is a degree of gambling with finding these firms especially during their early life stage. Hence, there should be desire for those that have broken-out ahead of other competitors. Investors may be late to early gains, but they have the opportunity for sustained returns. 

The result of an increasing returns to scale business is high industry concentration which leads to demands for some regulatory control. We are seeing this now with the network tech companies. Government has to be large to monitor this concentration. There are political issues if the economy is dominated by large firms and large government for oversight. Small businesses may suffer because they cannot compete or be subject to a single service provider. There are spill-over effects beyond profit and loss but as an investment strategy it will always have merit.