From The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns:
The truly exceptional business can operate with little capital. When U.S. securities markets function normally, most healthy businesses have no trouble securing needed capital. This means that great business opportunities whose only competitive hurdle is access to capital are likely to be exploited, and the economic profitability of industry participants inevitably suffer as a result. Exceptional businesses enjoy competitive positions that are more nuanced. Their competitive protections enable pricing power over their customers and control over their input costs from suppliers. This means that they can maintain and increase profitability without having to spend excessively to protect their turf.
Companies that have sound competitive positions but operate in industries where expensive machinery is needed for production expose themselves to inflationary pressures. Current capital outlays that are needed to maintain equipment may end up costing a fraction of what is spent on similar outlays in the future. Analysts should be aware of this hidden cost when entering periods of anticipated high inflation.
An analyst can become adept at qualitatively assessing the capital needs of a business and the follow-on effects that inflation would have on future capital outlays by studying the growth patterns of similar businesses. It is often the case that businesses require little capital to grow while maintaining their competitive position because the industry itself allows it. In industries like information services, software, and precision instruments, companies stake out competitive territory with products that may become universally adopted. Other companies in the industry often cede this territory willingly rather than spend enormous amounts of capital in a futile attempt to gain meaningful market share. The winners are left with the enviable position of dictating pricing terms to their customers without fear of a competitive response.
A company that has a unique competitive position that allows high returns on investment and has plenty of opportunity to reinvest back within the business at similarly high rates is especially compelling for the buy-and-hold investor. The internal growth prospects create a natural allocation mechanism for capital within the business, and management’s task is relegated to protecting and expanding the company’s competitive turf. These situations are the ones qualitative analysts seek.