I spend about nine weeks a year in a rental car looking for companies all over the world, discovering their products, operations and customers. Here's what I'm looking for.
The blue bottle, red screw cap and yellow logo of WD-40 are ubiquitous in the United States. Eight in 10 US households have the lubricant spray in their homes. So indestructible is its brand name that the WD-40 company has a “graveyard” cabinet at its San Diego headquarters dedicated to all the rivals that have tried unsuccessfully to snatch market share.
There is nothing unique or patent-protected about WD-40, apart from the smell. Even so, the brand name translates into a 20% profit margin1, which makes the lubricant an outstanding long-term investment.
I spend about nine weeks a year in a rental car looking for companies like this all over the world, discovering their products, operations and customers. At a time when everyone is fixated by Nvidia and Big Tech, smaller companies of up to $10 billion in market capitalisation are commonly ignored and offer an opportunity to generate investment returns above the market average. Often these companies focus on one profitable niche and are hardly followed by analysts. That makes it easier to find a hidden gem than with, for instance, Microsoft, which is closely monitored by 70 analysts.
Valuation discounts and investors’ mistaken assumptions
It has rarely been as interesting as it is now to invest in smaller companies. The valuation discount against big companies has rarely been this big. While small caps have historically traded at a circa 10%-15% premium to large caps, this has now reversed and small caps trade at a 15% discount to large caps.2 Meanwhile, I believe that the Fama-French Three Factor Model studies showing the “small cap effect” that smaller companies perform better over time still stands.
The small cap universe is very large, around 6,000 stocks. And typically we only invest in 70-90 of them. I look for companies with what Warren Buffett, the legendary US investor, calls an economic moat around the business model that provides a competitive advantage. Time and again, investors underestimate the long-term benefit of a competitive advantage. A competitive advantage translates into a high return on invested capital. Investors wrongly assume that this high return quickly shrinks back to an average return. We want to exploit this market inefficiency, as we have through owning WD-40.
But WD-40 is not the most profitable stock in our portfolio. Remarkably, that’s a UK maker of miniature wargames headquartered in Nottingham: Games Workshop.3 Thanks to a growing group of hobbyists buying its Warhammer wargame figures and paints, the company has an outstanding profit margin of more than 40%.4 Originally, the hobbyists were mainly British, but there are increasing numbers in the United States. What’s more, an Amazon TV program is being made starring British Superman actor Henry Cavill, which could strengthen the brand name even more.
From Belgian chemicals to a Munich beer hall oven
Turning to Europe, we have a Belgian holding that also shows the kind of quality smaller companies we buy. We have owned Azelis for a couple of years. The speciality chemicals supplier is the kind of company we are looking for: it has pricing power thanks to a fragmented supplier and customer base and makes a difference with the formulas it uses to put together its own products.
Valuation matters and we always seek to buy at an attractive price. For instance, for years we were interested in Rational, the German world market leader in ovens for commercial kitchens. But we only got a chance to invest in 2022 when the share price dropped because of general disinterest in industrial companies. Rational makes ovens for customers from Kentucky Fried Chicken to Buckingham Palace and Michelin restaurants. The ovens not only save energy but also staff: since the pandemic my local Italian restaurant in the UK has been operating with one chef and a Rational oven instead of two chefs. With the labour market tight, this is important.
On my recent travels through Germany, I saw the one millionth Rational oven with a golden rotary wheel. It’s in the famous Hofbräuhaus beer hall in Munich, dating back to the 16th century. Unsurprisingly, I had to take a look.
The mention of any specific shares should not be taken as a recommendation to deal.
Past performance does not predict future returns. All intellectual property rights in the brands and logos set out in this article are reserved by respective owners.
