The koi pond analogy of investing

We have often explained the foundation of the growth stock theory of investing using the quotation from Thomas Rowe Price in which he advises investors to search for "dynamic, capable management operating in a fertile field of future growth."

We have previously explained that one way of defining "fertile fields of future growth" is through the concept of paradigm shifts (closely related to Clayton Christensen's concept of "disruptive innovation" or Joseph Schumpeter's concept of "creative destruction").

We believe it is very important that investors devote some time to actually assessing the potential "fields of growth" for every single company in which they invest capital, or in which they are considering investment of capital.

In practice, this is actually much easier said than done. Determining the monetary value of an addressable market is not at all an exact science, and depends significantly on whether the market will change in the future by growing larger or becoming smaller. Nevertheless, without falling into the error of believing they can precisely assess the size of the total addressable market to the penny year by year, investors should still devote some mental energy to assessing the total addressable market and evaluating factors that could cause it to grow or shrink over time.

An analogy for this assessment might be to think of the company's total addressable market as a "koi pond," in which the pond is the addressable market and the koi (Japanese carp) is the company. The key point of the analogy is the relationship between the two -- the size of the fish to the size of the pond. If you want to grow larger koi, you need to provide the fish with a larger and deeper pond. The same is true for a business enterprise.

Using the koi pond analogy can help the investor envision the size of the company in relation to the size of the market it is addressing. If the market is small, then even if the company eliminates all competition, that company's growth is limited by the small size of the pond. As growth investors, we are not looking for fish that have limited room to grow (small fish in small ponds, or large fish in large ponds that do not support further growth).

A better scenario is one in which the pond is large and contains small fish with plenty of room to grow (particularly if you can identify the fish that you think will be able to outswim and outgrow the others). Even better is to identify a pond that is getting ready to burst out of its boundaries because of some paradigm shift, or one that has already begun to burst out and turn into a lake of enormous size!

A company that has come to dominate a market, with no indication that the market will grow in the future, does not meet our definition of a growth company. This is the case whether it is alone in that market or shares it with a few others. That company might be a source of ongoing dividends, but it will not likely be a source of future growth. We discussed an example of this in "The importance of a proper sell discipline."

Investors should definitely be looking for "koi ponds" that are either very large in relationship to the existing market participants, or that are currently expanding rapidly due to "paradigm shifts" or "disruptive innovations" discussed earlier. Using current representative revenues, and some expected rate of growth in those markets, investors can approximate how large that market may ultimately become.

This type of projection of a market is definitely an art and not a science, and it bears repeating the caution that exactitude is not achievable and that continued monitoring to see what actually develops will be necessary. However, if you have done some preliminary estimating, you may be better equipped to identify early signs of changes.

Also, it is important to realize that companies that are successful in filling up one market will often expand into a different market, if there is little likelihood of their core market expanding further. This scenario is different than the "bursting out" situation described earlier, because it does not involve the growth of the existing business but rather a recognition that the existing pond will not grow further, and so other completely different business lines must be found. Investors should always maintain healthy skepticism of such forays into new "koi ponds," because the environment may well be different in those new markets and present challenges to management.

In any case, the koi pond analogy can help investors to understand the critical concept of "fertile fields of growth," and serve as a mental image to help assess the growth potential of the businesses in which they invest capital.

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For later posts dealing with the same subject, see also:

• "Panning for gold during unfriendly business climates" 09/30/2009.

• "Would you sell your successful local restaurant because of a debt hiccup in Dubai?" 11/30/2009.

• "What battles of the tech titans tell us about investment theory" 09/08/2010.

• "Another wake-up call" 11/29/2010.