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Niche companies are Peter Lynch’s preferred type of value investments. He requires a number of factors to be in his favour before committing: (a) strong economic franchise, (b) owner-oriented managers, (c) a low price, and (d) financial strength.
Strong economic franchise
Lynch is firmly of the belief that a company is better able to exploit its superior competitive position sustainably in a slow growing industry, ideally a no growth industry, such as funeral services.
High-growth industries have a tendency of letting you down.
For example, over the last twenty years personal computer and flat TVs demand has grown well, but shares in these sectors have struggled. Every time a company comes out with an innovation rival manufacturers, whether in China, the US or Finland, put thousands of engineers on the task of figuring out how to make it cheaper and better; and a new product will be on the market in six months.
This doesn’t happen in industries with more mundane growth, say bottle caps, coupon-clipping services, oil-drum retrieval, or motel chains.
If the industry is not growing at all (especially if it is one that is boring and upsets people) you generally find less of a problem with new competition allowing the best firm in that industry to gain market share.
Niche companies are generally successful in one geographic area, and are then able to duplicate their winning strategy over and over again, and take it further afield.
This can lead to extremely rapid expansion and profits, largely ignored by professional analysts and newspapers, who are too busy following the struggle for superiority between the well-known ‘industries of tomorrow’ (e.g. bio-technology, social media, internet).
Meanwhile the highly competent niche companies continue on their way and get to dominate their particular area. The imaginary pot of gold at the end of the exciting fast-growing sector’s rainbow is a magnet to many ‘wannabe’ rivals, but in the unexciting humdrum sector competitors drop out, leaving the competent companies to dominate their market.
Lynch thinks it preferable to hold shares in companies that are able to capture an increasingly large part of a stagnant market than to have shares in companies that are fighting to protect a dwindling portion of a seemingly exciting market. Total domination in business is always more healthy for shareholders than competition.
It is apparent that some investors confuse two concepts of growth. The first is growth in sales for the industry. This will lead to growth in the more important form – growth of earnings and shareholder value for a particular firm in that industry – only if certain conditions are present, the most important of which is that high profits are not competed away.
Indeed, in most high growth industries there is great uncertainty as to the potential for translating the growth of sales into earnings growth. This uncertainty alone should put off investors, especially when they consider that there are simpler, more predictable industries where the competitive threats are easier to assess.
There are a number of clues to the strength of the economic franchise, e.g. if the company is able to raise prices year after year without losing customers; earnings per share have risen steadily; the company has duplicated its success in city after city; it is not selling a high proportion of its output to one customer; the firm has a clear local monopoly.
It is difficult to overstate the importance to companies of an exclusive product or franchise. Possession of this exclusivity puts them in a strong economic position, enabling them to raise prices year on year yet retaining their customers. Often the cost to would-be rivals of entering this exclusive market is prohibitive, as in the case of quarries.
Lynch is a fan of quarries: he says that he would far rather own a quarry than a jewellery business. The jewellery business is vulnerable to competitors, both those that have already set up and potential new entrants. These days high street jewellers even have to compete with online operators. The result of all this competition is that the customer is free to shop at dozens of alternative places.
A quarry near a big city, on the other hand, can find itself the only one for a hundred miles giving it a virtual monopoly. On top of that you are unlikely to find new entrants setting up in the near future because quarries are so unpopular with local residents that gaining planning permission is fraught.
Drug companies and chemical companies are also good examples of straightforward niche businesses that are protected from rivals by high cost of entry and cost of competing, but have plenty of room for expansion.
The ideal niche company would be engaged in a simple business. It is much easier to understand the ‘story’ of the simple business and draw conclusions on the strengths of the firms. Also, the management are less likely to make mistakes.
Owner-oriented Management
For investors it is vitally important that the management is interested in the progression of the company for the benefit of shareholders and not their own personal aggrandisement.
Lynch favours companies that do not squander company resources on plush offices finding an inverse relation between rewards to shareholders and the extravagance displayed at head office.
He was suitably impressed when he visited company headquarters that were shabby and unimposing, such as those of Taco Bell or Crown, Cork & Seal (a 280-bagger over 30 years). Taco Bell’s headquarters was a ‘grim little bunker’ stuck behind a bowling alley. At Crown, Cork and Seal the president’s office had faded linoleum and shabby furniture. The office did not overlook areas of green lawn, but the production lines.
As an investor look for the combination of rich earnings and a cheap headquarters. Far more important than an imposing executive suite is the capability of the management to run their business efficiently and engage in good labour relations, thereby increasing profitability.
Staff should be treated with respect and fairness; no corporate class system with white-collar Brahmins and blue-collar untouchables. Workers should be well paid and have a stake in the future prosperity of the company.
He disapproves of companies that use surplus cash flow to diversify unnecessarily (and often disastrously). He calls this process ‘diworseification’, and gives the example of Gillette, a company which had a spectacularly profitable razor business but diworseified into cosmetics, toiletries, ballpoint pens, cigarette lighters, curlers, blenders, office products, toothbrushes and digital watches – to name but a few! – before realizing the error of its ways and emphasising its niche business, shaving.
‘It’s the only time in my memory that a major company explained how it got out of a losing business before anybody realized it had gotten into the business in the first place.’ (Lynch)
A sure sign of a healthy company is when those on the inside are buying their own company’s shares. If employees are putting their own money into it then you should regard that as a useful tip-off to the probable success of the share.
This insider buying is reassuring, especially when lower-ranking managers use their salaries to increase their holding on the company. If people earning a normal executive salary are spending a fair chunk of that on the company’s shares then you can take it as a meaningful vote of confidence.
So factory managers and vice presidents buying 1,000 shares is to be read as being highly significant – more so than when the CEO buys. Owning shares encourages managers to reward shareholders (themselves) rather than pay increases in salaries or use the spare cash on pointless or ineffective expansion.
However, insiders selling shares should not necessarily be seen as a negative sign; there could be many reasons for selling – purchasing a house, school fees etc. – which are totally unrelated to the performance of the company.
Low Price
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