Why Successful Microcaps Start out in a Niche Market

I've been reading a ton of books on the topic of entrepreneurship and many of the lessons apply directly to microcap investing. The most important lesson I took away from all my readings is for a small company to first dominate a niche market and then expand into other markets. The concept seems counter-intuitive when first hearing about it, but I'll explain why it makes perfect sense. Interestingly, the concept also explains why superior products or technology doesn't guarantee market acceptance.

By definition, small companies have less resources, be it number of employees, engineering talent, access to capital, or assets to name a few, than their larger counterparts. As a result of this constraint, it's wise for small companies to target a niche market with their product.

First, it will allow them to better service the accounts in the niche market as they will better understand their clients needs by focusing on them. By contrast, when they try to enter a large market, they will lack the necessary resources to understand all the different customers's needs and satisfy them. The proper servicing of accounts is imperative because these clients will serve as references when the company decides to branch out into new markets. It's no secret that executives or decision makers seek input from others who have already used the product before committing to a purchase. So the lack of high quality references could be easily the limiting factor to gaining market acceptance.

Second, by picking a niche market to target, competition will be limited or nonexistent. The advantage is twofold: larger competitors will dismiss the small companies and won't improve their own offerings to compete with the smaller companies's products, and marketing dollars will produce a higher ROI as the message won't get blocked out by all the other competitors and it's easier to get your message across to a specific audience over a vast audience spanning multiple industries. Therefore, much less capital is required when targeting a niche market since marketing spend (i.e. getting the message out) will be more efficient and less money/time will be spent scrambling to defend against competitors. The end result is that these small companies benefit from strong revenue growth and market share dominance as a result of not being hindered by competitors. It's ridiculous how many times I hear companies say that they only need to get 1% of a this multi-billion dollar market in order to be successful. It's like they believe the competition will just stand still and let their market share erode. As if! What they will do is pull out the heavy artillery and they will win 99.99% of the time.

The final reason for choosing a niche market is to attain "market leader" status and build credibility around the company. Customers, especially the larger ones, ONLY look for turnkey and well supported solutions because they already use a vast amount of other products and don't want to disrupt their operations. As a whole, they are risk averse. They don't want to purchase a product that is incomplete (e.g. lacks compatibility with other products, lacks proper documentation, lacks people to install the product, etc). That's why they have such sticky relationships with the product providers -- they count on them to support the product and solve the problems with the product so the customer won't need to take his focus off from the business operations. Imagine if the customer himself had to fix all the problems with the multitude of solutions they purchased. That would be a severe distraction from running the business. So how does this tie back to the importance of being the market leader? Well other companies will always build around the market leader's products, either adding extra functionally or providing further support. Furthermore, by being branded as a "market leader" it lends further credibility to the company, reducing the effort needed to penetrate new markets.

To drive the point home, let's list a few examples: Facebook started out targeting college students progressively expanding campus by campus, Tesla started in the luxury electric car segment and is now making it's way to the mainstream car market, and Paypal began by offering eBay power sellers a more convenient, safer and expeditious way of receiving funds before integrating with other merchants.

More relevant examples to publicly traded microcaps are: XPEL Technologies which dominated film pattern cutting software market (a huge part of their moat today) and then decided to create their own paint protection film, and Paladin Labs (similar business to BioSyent) which first started out sourcing and acquiring exclusive rights to patented and already approved pharmaceuticals products that had a peak addressable market of $2-15M. To anyone familiar with the Paladin Labs story, it should be enough proof that the niche-market-first-and-then-expand strategy works.

In conclusion, the evidence for small companies to dominate a niche first and then branch out into other market segments is overwhelming. To those looking for more insight into the subject, I recommend reading Peter Thiel's book titled "Zero to One" (it's in my top 5 favorite books).