What are spawner stocks?

The invention of spawner stocks

Meet Nick Sleep, founder of Nomad Investment Partnership. Nomad Investment Partnership tore through the investment world between its launch in 2001 and 2015 closure. Over the course of this period, the partnership put up an average return of 20.8% per annum. Keep in mind, this is a period that encompassed the middle of the early 2000s recession as well as the 2008 financial crisis. Accordingly, the S&P put up a paltry 6.5% in comparison.

Sleep developed a cult following amongst investment managers — especially those focused on fundamental, long-term investment. During its lifetime, materials from the Partnership have been rare to surface. But when the Partnership was rolled up, the founder decided to release all of their Partnership letters, allowing investors everywhere a peek into the mind of the great investor.

What they found was a unique framework that focused on what Nick Sleep called “spawner stocks.” This was the backbone of Nomad Partnership’s returns.

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What are spawner stocks?

Spawner stocks are in a number of different niches and sectors. However, a core part of their DNA revolves around incubating new businesses within their own corporations. Hence, these large entrenched businesses end up spawning off brand new ones. These “startups,” may eventually become standalone business segments or spin-offs.

These new businesses don’t have to be directly related to the business’s original product or service. In fact, some of the most successful spawner stocks (which we will delve into below), have spawned off businesses unrelated to their parent company's core business lines. A business that focuses on a specific product can spawn out a service-based segment, and vice versa.

Another important aspect of spawner businesses is that they are often growth businesses. This usually means that they begin their lives as money-losing endeavors. In the most successful cases, end up matching or even overtaking the core business in terms of profits.

Finally, spawning businesses can choose to incubate new businesses organically or inorganically. A company may buy a smaller start-up in an adjacent or unrelated sector, then scale up the company internally. There are examples of successful businesses employing both strategies, and some even mix and match them.

Another alternative some companies pursue is finding a smaller company. Instead of acquiring them, they create very similar products of their own to compete. These businesses will often leverage their size and economies of scale to then beat these smaller companies at their own game.

Characteristics of spawner stocks

A true spawner stock is part of a business's long-term DNA. The spawner framework isn’t something that the original business uses to save itself from a secular decline. It's something that management has been supporting and fostering for years, if not a decade.

A business that isn’t serious about following the spawner framework and is chasing an acquisition as a fad is one of the major risks to investing in these businesses. It’s important to make sure the company has been pursuing the spawner strategy over the long term.

Free cashflow

In order to successfully pursue the spawner framework long-term, businesses will usually share several key characteristics.

This includes businesses whose core business lines are already generating consistent free cash flow. Many of these new businesses may fail. A company pursuing this strategy cannot leverage itself with such a high risk of failure — sooner or later the debt will catch up with the company.

Using free cash flow, however, allows the company to be far more flexible in its acquisition policy. It can divert money into more research and development to create businesses internally. Simultaneously it can enable the acquisition of external businesses, with a clear way to pay off any debt interest they may incur. In a perfect situation, the company could even rely exclusively on its cashflows to acquire a new business to spawn.

Free cash flow is also a key component in being able to nurture the business while it scales. As mentioned before, many early-stage businesses will not generate profits (without counting those that will fail outright). Throughout this stage, these companies need to be financially supported. This again can be achieved through debt or equity offerings. However, this is clearly not a long-term solution to a strategy that requires surviving failures repeatedly.

Shareholder friendly management

The next characteristic that many of these companies share is a focus on shareholder returns. Traditionally, shareholder-friendly companies are those that consistently payout and raise dividends or a company that buys back shares at a rapid clip. Both of these corporate strategies have their proponents and critics, and their own pros and cons.

Another way to return value to shareholders is to reinvest profits into the business. Specifically into parts of the business that may yield huge returns down the line. From the business’ perspective, this is far more tax-efficient than paying out a dividend. And it provides a better path to long-term share price appreciation when compared to stock buybacks (which usually generate short-term stock appreciation).

For the investor, this strategy makes the business a far better buy-and-hold long term opportunity. It shows that management is focused on the future rather than short-term stock price appreciation. Still, other investors always prefer cash reinvested rather than paid out in dividends.

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Why does the spawner strategy beat the market?

If a business happens to employ the spawner strategy, that doesn’t guarantee that the stock will be a long-term success. However, when pursued effectively, the spawner framework presents plenty of benefits for a company’s long-term success.

The reality is that the largest and oldest companies we all know today such as Ford, General Electric and even IBM distort the reality: running a company successfully for decades is hard. Looking at the S&P 500 or the Dow Jones, you may be fooled into thinking that large companies have a much easier time surviving, but that is just survivorship bias.

The fact of the matter is that in 2016, the average lifespan of a company listed on the S&P 500 was just 18 years. Why? Because managing a large company and growing it through different macroeconomic regimes is incredibly difficult.

Corporations, especially large ones, often act as large ambling giants that are slow to change. The spawner framework is one way to adapt fast enough to our rapidly changing world.

Good spawner businesses hold this strategy as a core part of their DNA.

The spawner strategy for corporations provides an attractive hedge for a business’ future. If senior management is worried about the survivability of their main product a decade from now, the smart thing is to research and invest in alternative products that could reach fruition when the original products lose their luster.

Spawner stocks are diverse

The spawner strategy brings diversification to a company. This is more relevant for businesses that have one core successful offering, but in general business theory, any product/service niche that commands high margins will invite relentless competition, leading to a steady erosion of the high margins.

Companies that get caught with tunnel vision risk being part of a sinking ship. Meanwhile, companies that are continually experimenting will likely have a more diverse product line, which will enable them to survive demand shocks much easier.

Finally, these companies, at least in their early stages, are often unfairly punished by Wall Street analysts for taking profits and throwing them at risky experiments, rather than giving that excess money back to shareholders. This may lead to these companies being undervalued relative to their true growth potential, and offer investors higher risk/reward ratios. When these experiments scale up into completely new businesses, the underlying stock can be revalued at sky-high valuations as a result.

An example of a spawner stock: Amazon

Amazon shows the extreme end of how successful the spawner framework can be for a business, and how long it may take for a big success to come to fruition, but when it does — it may completely change the company’s future.

Most people think Amazon runs the biggest e-retailer in the world. While that's true, what is actually driving Amazon’s profits?

Well, that's easy: Amazon Web Services (AWS). AWS is a profit-making machine. The B2B cloud software segment has nothing to do with Amazon’s core retail business. To put things into perspective, in 2018, AWS made up a whopping 73% of Amazon’s total operating profit for the year.

This may sound strange as AWS only makes up about 10% of Amazon’s total revenues. While there is no doubt that Amazon is a behemoth of retail, the margins in the business itself are incredibly narrow. In fact, for many years Amazon’s stock price languished as analysts complained of the lack of profitability in its core business.

The rise of AWS

That all changed when  Amazon created an internal IT architecture to help with surging web traffic and demand from customers. Eventually, Jeff Bezos understood that every corporation must be facing the same issue. He began packaging it as a software product for large businesses. The rest is history, and today AWS commands 33% of the cloud market.

Did Jeff Bezos catch lightning in a bottle? Well, it's unlikely that he knew at the time that AWS would essentially become a money-printing machine. However, experimenting and scaling up businesses with the risk of failure was nothing new at Amazon. In fact, Amazon has a history of branching out into related and unrelated businesses with mixed success. One major success is the Amazon Kindle, which brought ebooks into the mainstream. Likewise, Amazon Alexa is attempting to tap into the growing Internet of Things trend.

That's not to say that there haven't been missteps; Amazon eventually closed its Amazon Fire mobile phone project with a $170 million write off. But that's the beautiful thing about the spawner framework: that $170 million sounds like a steep cost for a failure, but it's pennies compared to the $7.3 billion in profits that AWS produces annually.

Today, Amazon is the second best performing stock in the entire market since its IPO in 1997. Other high profile spawner stocks are Tencent, Alibaba, Facebook and Google.

The risks of spawner stocks

There isn’t a single stock investing strategy out there that is foolproof. The spawner stock strategy, like others, also presents some risks. With proper research, investors can weed out the bad apples from any future stock selection based on this framework.

For one, you need to make sure that this is a true spawner stock, and isn’t throwing money at new ideas as a lifeline while the company itself is in secular decline. This strategy hardly, if ever, works out and you’re best investing your money elsewhere. That means avoiding companies whose main business is in an industry facing secular decline. Make sure that the company has a solid track record of reinvesting its earnings into new projects, research and development.

Next, the company should have a profitable (or at least successful) core business that can support the company’s experiments and scale up phase. A business without this runs the risk of having to cut its incubation short and exit with a write off, instead of letting the project grow into a possibly stand-alone, successful business. Additionally, not having that cash buffer may push some companies into using debt, which comes with a range of issues.

Should you invest in spawner stocks?

In the end, you can research all you want, but the future is never certain. That is why personally, I would construct a portfolio of eight to 12 spawner stocks that show the positive characteristics, but happen to be diversified by either geography or industry focus. This will significantly reduce the risk that some of these companies end up being fake spawners.

Following that, all you have to do is hold on for the long term, dollar cost average and keep an eye on any companies that may be entering a stage of secular decline. If you do find a company like that, your best bet is to sell out of your position and reinvest it into the remaining stocks you find.

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Spawner stocks: a modern value investing framework

Traditional value investing may be dead as we know it, as the proportion of assets of companies on the S&P 500 that are intangible skyrocket while tangible assets dwindle. Whether we like it or not, technology is a game-changer.  We may need to update how we approach value investing.

The spawner stock framework is one such way, where we can reconcile future growth potential that may be undervalued. Investors such as Nick Sleep and Mohnish Pabrai, two self-proclaimed value investors, have both used this strategy to great success — and it is a strategy open to just about everyone.