When big is definitely better

In a business with low profit margins, the long-established incumbents have an advantage.

The year has started with something of a bang. A couple of them, actually. And not all bad. Inflation has come down further and faster than many of us dared hope. But not in time to save one of Australia’s most recognisable retailer names: vacuum cleaner purveyor Godfreys.

To be fair, Godfreys isn’t just a victim of inflation; though that’s part of it, along with interest rates. But so are changing consumer tastes. We’re visiting different stores and increasingly shopping online. And while most of us need a vacuum cleaner to keep the place clean, if yours works already, upgrading the Hoover (ask your parents, kids) is something you can put off when there are other, more urgent calls on your cash. That’s why – and when – many investors look for a little more certainty, at least in terms of the underlying business (protection from share price volatility can never be assumed). In retail, that means moving away from so-called discretionary outfits and towards those selling staples. Groceries are an easy example. But, according to the ASX, so are wine making, spirits distilling and liquor retailing, plus chicken pluckers, the (blessed, obviously) cheese makers, fruit and vegetable harvesters and beef growers.

The list of smaller companies in this space is broader again, including pharmaceutical companies, skincare outfits and even a meal delivery business. You can decide which of those companies most – or least – fit the label.

When it comes to investing in these sorts of businesses – particularly the large, dominant mature companies – you need to understand their operations, risks and opportunities, but also how much growth is left. And while this column is focused on quality, rather than price, valuation must be an important consideration. If there’s not much upside left, paying too much can really dent your potential returns.

It may not be surprising, then, that some of the companies in this sector have very long histories. Woolworths and Coles have been around for generations. Metcash, which may not be a household name, and its forerunner, Davids, have been supplying independent supermarkets for decades. One of the primary industry businesses – the plainly, if accurately, named Australian Agricultural Company (AACo) – began in 1824.

Scale and execution matter; these types of businesses are rarely (though not never) price setters, often with (very) low profit margins and similar margins for error.

That doesn’t mean brands don’t count for anything, but they tend to be opportunities to aggregate volume, rather than to charge more. And that creates opportunities – once you’re big enough to advertise nationally, for example, you can use that capacity to out-promote and out-sell your rivals.

Plus, once you’re there, good luck to anyone who wants to unseat you. Yes, Costco and Aldi have taken it up to our supermarket incumbents, but would-be entrant Kaufland took its bat and ball and went home without firing a shot in anger.

That said, AACo is trying to build a brand for itself, so it can charge premium prices. And Treasury Wine Estates is pushing upmarket as fast as it can, trying to improve margins and offset the capital-intensive nature of winemaking and maturation.

Scott Phillips is The Motley Fool’s chief investment officer. He owns shares in Treasury Wine Estates. You can reach him on Twitter @TMFScottP, Facebook scottphillipsmoney and via email ScottTheFool@gmail.com. This article contains general investment advice only (under AFSL 400691).