At the risk of belaboring a point, one of the more fascinating business models is that of the humble middleman. Middlemen usually operate quietly, out of sight of consumers and the media, so they often go unnoticed by investors. And they can be tricky to analyze because often it’s not obvious why a business that appears to simply buy something in one place only to sell it somewhere else should exist in the first place. And yet—thousands of years after it first occurred to someone to ask “why don’t they just cut out the middleman?”—middlemen continue to exist and even thrive. Therein lies the opportunity, for if we can learn to appreciate what others dismiss or misunderstand, we might then have an investing green field all to ourselves.
The best way to do this, it seems to me, is to train our intuition to recognize successful middlemen in the field, while at the same time groping towards some kind of general theory. And the best way to do that is to start small, by observing and analyzing simple examples. Which brings me to a recent article in the New York Times about Mr. Hajji Ramazan, a Kabul, Afghanistan-based importer and wholesaler of used clothing—a middleman par excellence if there ever was one. Mr. Ramazan’s business is simple: twice a year he makes the 870-mile trip from Kabul to Karachi, Pakistan, the main port city in the region, where he spends two to three weeks buying used clothing in bulk, which he then imports to Afghanistan and sells on to a group of retailers and “commission workers” (which appear to be more or less what we would call peddlers). Simple, and yet he does well, according to the article, possessing a status-symbol car, a son in Australia, and a “modest empire.”
Our task, then, is to figure out why Mr. Ramazan succeeds, and in particular why his customers don’t “cut out the middleman” and buy directly from Karachi themselves, where clothing presumably costs less. I don’t pretend to have any definitive answers from just one article, and perhaps things work differently in a frontier market like Afghanistan. But we can make some intelligent guesses:
- It may well be that the fixed costs of buying in Karachi—everything from travel costs, to the opportunity cost of all the time away, to the time and effort required to acquire the necessary knowhow to navigate customs, logistics, transportation, and the innumerable other details of international trade that most of us quietly leave to others—are high enough that it is more efficient for the retailers, on a per-garment basis, to have one person—the middleman—assume them on behalf of everyone, and then pay him a “commission” in the form of the middleman’s customary markup. It’s the same reason hedge fund managers “rent” their knowledge of hedge fund law from hedge fund lawyers rather than earning law degrees themselves.
- Perhaps as part of his business, our middleman is also engaged in the distribution of goods to retailers within Afghanistan, which might involve things like storage and transportation. The same rules apply to this part of the value chain too—it’s more efficient to have one player assume the fixed costs of this activity at scale, and then amortize those costs over as broad a customer base as possible, rather than have each customer assume those costs itself. One big warehouse, and one big fleet of trucks that always operates near 100 percent capacity, is ultimately cheaper than a bunch of mini-warehouses behind each shop and a bunch of trucks in the shopkeeper’s driveway that are idle much of the time.
- I like my first two guesses well enough, but something tells me there is another, more subtle factor involved in the success of Mr. Ramazan. The clue was his description of the first buying trip he took to Karachi, where the traders there were willing to sell him 40 bales—all on credit. “You will not steal our money, we are confident,” they told him. Trust is an elusive and intangible quality, so those of us in the more contemplative, analytical corners of the business world tend to underestimate how important it is to people transacting day to day. But trust is eventually made concrete and even quantified in the form of a business’s terms of credit, which in turn determine its working capital needs. Where trust exists, a trader can finance purchases with accounts payables, and at prices that reflects a lower risk of default. But where trust is absent, the trader must usually finance purchases with cash on hand, which is to say working capital—and this carries an implicit cost that is every bit as real as the explicit cost of a warehouse or a trip to Karachi, even though it doesn’t show up on the income statement.
My guess is that the presence of Mr. Ramazan as middleman increases overall trust in the system. His sellers in Karachi trust him, having met him in person and built up a history, and he in turn is in a better position to trust his customers locally in Afghanistan, more than the men in Karachi would trust the far-off retail customers in Afghanistan if the latter bought direct. So overall prices, credit terms, and working capital needs are lower—which acts as a negative tax for the system that more than mitigates the middleman’s markup.
Ultimately, then, this middleman is an intermediary of trust, which is to say credit. He looks like a merchant, but some sense he acts more like a banker—another classic middleman business in which savings become investment through a trusted—and trusting—intermediary.* With just a slight nudge to his business model you could even call him a “merchant banker“—and indeed, if you climb high enough up the family tree of even the most prestigious banking families, you’ll usually find a humble dry goods merchant or clothing trader just like our Mr. Ramazan, whose business may not be so humble after all.
It’s a modest example and a modest exercise, I admit. But sometimes the things you learn by looking at small businesses apply surprisingly well to the big ones too—including, perhaps, to some misunderstood middleman businesses trading quietly in public markets today…
*The difference is that the banker takes actual money on deposit and lends it, while the clothing importer takes goods “on deposit” and then “lends” them. But they both earn a “spread”, and if you looked at the balance sheets of a banker and an importer side-by-side, and switched the names for things while keeping the numbers the same, you could probably convince yourself that the banker is the importer and vice versa.