Supersize returns II

While more time is needed to fully evaluate the merits of these stocks, thus far their performance has been encouraging. As of 19 February 2015, $1,000 (£651) invested in each of the 10 companies would today be worth $15,000 compared with $12,760 invested in the Russell 2000 Index, the US's main smaller companies index.

Supersize Portfolio I

Source: Yahoo! Finance, as of 19 February 2015; Russell 2000 Index measured by the iShares Russell 2000 ETF (IWN); *Pacer International was acquired by XPO Logistics in 2014

That's all well and good, but how can we begin to tell which companies - large or small - might have economic moats?

As you might expect, companies that possess true economic moats are a rare breed and, of course, they're much easier to recognise in hindsight.

But the markets price in what's to come, not what's already been, so our challenge as investors is to determine whether or not a company has the right business model and the right leadership to consistently and successfully defend its business from formidable competition.

One way to approach this task is to ask yourself with each company you research whether or not it's in possession of one of the following economic moat 'sources':

■ Intangible assets: This could be brands, patents, or regulatory licences that make it difficult for competitors to easily enter the market. The key here is to determine if the intangible asset in question provides the company with sustainable pricing power. For example, there are many clothing brands for consumers to consider, but a luxury brand such as Burberry is able to sell its clothing at a much higher price due to its image and reputation.

■ Network effect: A classic example of network effect is eBay's auction business - as more buyers and sellers join the service, the marketplace itself becomes more valuable. Other companies have tried to imitate eBay's auction business and take market share, but have by and large struggled to lure buyers and sellers away from eBay's more active marketplace.

■ Efficient scale: This is a dynamic in which a limited market is fully served by a few companies. If a new company entered the market, it would dramatically reduce the returns available to all market participants, which all but eliminates the incentive for new competitors.

■ Cost advantage: Companies that are able to produce the same goods as their competitors but at a substantially lower cost can either win business by offering lower prices or realise high profit margins by matching the prices of competitors.

■ Switching costs: If it's costly - whether in time or money - for a customer to take its business elsewhere, the provider of that service may have a switching cost advantage. Companies with 'razor-and-blade' business models that sell both the equipment and the consumables are excellent examples of this moat source.

If you can identify at least one of these sources in the company you're researching, you may have found a company with an economic moat.

Using this framework, I've chosen five more small-cap companies that I think possess one or more economic moat sources and, if bought at a good to fair price, could make for solid long-term investments. As always, it's critical to do your own research prior to investing in any share.

Monro Muffler Brake (MNRO)

Share price: $63

Market capitalisation: $2bn

Dividend yield: 0.8%

Trailing price-to-earnings ratio: 33.8 times

It's no secret that we Americans love our cars - according to the World Bank, there are 809 motor vehicles in the US for every 1,000 people, compared with 519 in the UK. Americans are also driving their cars longer than ever before. According to IHS Automotive, the average car on US roads is now over 11 years old (in the UK it's about 7.5 years) and climbing steadily higher. Since we're trying to get every last mile out of our cars, it stands to reason that the average American will spend more time and money in the shop for repairs and maintenance.

Despite this favourable tailwind, there are fewer service stations in the US than there were a decade ago due to a number of auto dealership closures during the financial crisis. There are also fewer gas (aka petrol) stations offering repair services. This presents an attractive opportunity for industry consolidation and Monro Muffler Brake has taken the lead in consolidating the 'do it for me' (DIFM) side of the market (eg, tyres, maintenance, brakes, etc). Having made 32 acquisitions in the past 13 years, Monro has built a strong presence in the eastern US and has plans to nearly triple store count in its existing geographic footprint.

The brilliance of Monro's acquisition strategy lies in its ability to lower system-wide costs with each deal. While most DIFM repair shops purchase parts from retailers, Monro sources directly from manufacturers and leverages its company-owned logistics system, thereby keeping supply chain costs down relative to its peers. Further, by adding stores in a focused geography, Monro improves its distribution network by minimising transportation costs between distribution points and spreading advertising costs across a larger store base.

This strategy, in turn, makes it more difficult for independent operators to keep up with Monro's low cost base and thus more likely to be acquired themselves. In this sense, Monro's acquisition strategy creates a virtuous cycle that supports its economic moat derived from low-cost production advantages.

Monro's balance sheet is healthy and consistently generates free cash flow. With a $250 million line of credit with a 1 per cent interest rate at its disposal, it should have no problem financing bolt-on acquisitions in the coming years. Finally, Monro insiders own about 4.6 per cent of outstanding shares, which should align their interests with those of shareholders.

Douglas Dynamics (PLOW)

Share price: $22

Market capitalisation: $493m

Dividend yield: 4 per cent

Trailing price-to-earnings ratio: 14.1 times

So far this winter, we've received about 60 inches of snow in Chicago, including a storm that dumped 20 inches in a day. As you might imagine, this area is a good one for snow plow* operators who clear parking lots, highways, and side roads to help people get on with their business. It's an even better market for Douglas Dynamics, which builds the plows that are fitted on the front of both light- and heavy-duty trucks.

One of the things I love to see in a small-cap company is that it's dominant in a niche market - and snow plows are about as niche as they come. When a municipality or business is counting on its roads and parking lots to be cleared quickly after a snowfall, there are no alternatives to a truck-mounted plow, so these are indeed mission-critical products.Even better, Douglas Dynamics has a robust 50-60 per cent share of its major markets, which also include hoppers and spreader attachments for turf maintenance equipment.

Traditionally focused on sales to independent plow operators driving light-duty trucks, late last year Douglas Dynamics further consolidated its position in the industry by acquiring Henderson Products, the largest seller of snow and ice removal equipment to the heavy-duty truck market that primarily deals with state and municipal government agencies. With a massive dealership network across North America, Douglas Dynamics provides customers with valuable support and aftermarket parts and services, which a would-be competitor would find difficult to match.

At this point, you might concede that while this is an attractive niche, demand is very lumpy. Snowfall varies by year, of course, as do replacement cycles for plows. All this is true and Douglas Dynamics' equipment orders can fluctuate substantially from year to year, but what's impressive is that the company's price per equipment unit has steadily increased each year. Even in down years, Douglas Dynamics knows that its customers will be back, so there's no point to slashing prices to drum up demand. This is the type of pricing power that is typically indicative of a company with an economic moat.

Income-focused investors will appreciate that Douglas Dynamics prefers to return cash to shareholders in the form of a generous dividend that's been increased each year since its 2010 initial public offering.

(*Ed: we know this should be spelled 'plough', but given the company's ticker we've decided not to correct this Americanised spelling.)

Natus Medical (BABY)

Share price: $37

Market capitalisation: $1.2bn

Dividend yield: na

Trailing price-to-earnings ratio: 38 times

When I first learned about Natus Medical in 2006, the company was focused on healthcare equipment designed for treating newborn babies - hence the clever ticker - with hearing impairments, epilepsy, and other conditions. The company came to dominate the newborn care market - and still maintains a 70 per cent share of the newborn hearing market - but growth opportunities were limited after Natus had already become a standard of care in many hospitals and birth rates remained stagnant in its major markets.

In response, Natus used the cash flows from its newborn care franchise to fund acquisitions in the niche neurology diagnostics market. Admittedly, I don't know much about the science behind electroencephalography, electromyography and transcranial Doppler technology, but I do appreciate that these devices are often employed in the operating room and in intensive care where they are far from discretionary, helping doctors and nurses monitor the patient's brain function. Today, neurology accounts for about two-thirds of Natus's annual revenue, with newborn care accounting for the rest.

Natus's competitive position is strengthened by a portfolio of patents, regulatory approvals, and strong relationships with healthcare providers that most upstart competitors would struggle to match. Further, because Natus has become a standard of care in many hospitals' paediatric care and neurology departments, it's less likely that busy doctors and nurses would want to switch to another equipment provider as they would need to spend valuable time learning a new system. This results in a switching cost advantage. Supporting this switching cost argument is Natus's valuable recurring revenue stream, which accounts for 35 per cent of annual sales and consists of consumable and disposable supplies. If hospitals were changing equipment providers on a whim, one would expect lower levels of recurring revenue.

While it's entirely possible that a larger medical device company will move into the newborn care and neurology markets, these markets remain relatively small in size and Natus's position in them is so dominant that the company would be far more likely to simply acquire Natus. Barring being acquired itself, I expect Natus will make another acquisition push into a new niche market in the coming years. If the past is prologue, Natus is a name to keep an eye on.

Culp (CFI)

Share price: $21.80

Market capitalisation: $266m

Dividend yield: 1.2 per cent

Trailing price-to-earnings: 15 times

Whenever I come across a well-run small-cap company that operates in a decidedly boring or sleepy industry, I become even more interested in it because it's less likely to attract investor attention. And it doesn't get much sleepier than what Culp specialises in: mattress fabrics. In fiscal year 2014, Culp's mattress fabric segment accounted for 56 per cent of company sales and 69 per cent of income from operations, with 10.9 per cent operating margins and an impressive 29.3 per cent return on capital employed. The remaining 44 per cent of Culp's annual revenue comes from its upholstery fabrics division, the vast majority of which is based in China and operates on a lean manufacturing system that yielded returns on capital employed of over 40 per cent in 2013 and 2014.

Over the past 15 years, Culp management has done a remarkable job of turning around the business and the balance sheet by shifting the business's focus from US-based upholstery manufacturing, which was always dealing with competition from low-cost imports, to the more attractive mattress fabrics market and shifting its upholstery manufacturing to China. Even more remarkable was that during this transition the company rapidly deleveraged its balance sheet. In fiscal year 2000, Culp had $136m in net debt - and in the most recent quarter it had a $33m net cash position.

At first glance, mattress fabrics may not seem like a very attractive business, but what makes it so is twofold. First, mattress production isn't labour intensive, which greatly reduces the labour cost advantages offered by importers. Second, shipping costs are quite high and domestic manufacturers have short lead times, making it difficult for importers to match domestic producers ability to quickly deliver quality fabrics. As the largest mattress fabrics manufacturer in North America, it's likely that Culp possesses a durable low-cost production advantage.

Sleepy industries: Culp specialises in mattress fabrics

While I remain a little more sceptical about the sustainable advantages Culp may have in its China-based upholstery operations, I believe management has a solid capital allocation strategy that will support the overall business in the long run. It's rare for companies to outline their capital allocation strategies in detail, but Culp does just that with a five-page presentation on its investor website that explains how it thinks about dividends, share repurchases, acquisitions, etc. Further, management specifically states in its annual report that it "strives to strengthen its economic moat" and is putting its money where its mouth is by linking executives' annual bonuses to the Economic Value Added (EVA) metric that only rewards management for generating returns above the company's cost of capital.

Exponent (EXPO)

Share price: $89

Market capitalisation: $1.2bn

Dividend yield: 1.4 per cent

Trailing price-to-earnings: 30.4 times

One of Harvard Business School professor Michael Porter's famous "Five Forces" to determine competitive intensity is whether or not the company or industry has bargaining power over its customers. If you've ever locked yourself out of your car or house, for example, and had to pay the locksmith a princely sum to let you back in, you've been on the other end of this phenomenon. When you need something done right away and the cost of not having it done is substantial, you're less willing to shop around for the best price.

It's precisely this force that has driven much of Exponent's success since the company was founded in 1967 by a Stanford University professor. Formerly known as Failure Analysis Associates, Exponent is staffed by hundreds of PhDs from wide-ranging disciplines from biomechanics to civil engineering and helps customers research and respond to crisis situations such as complex insurance claims, litigation, and product recalls. As you learned from dealing with the locksmith, Exponent's customers are understandably less price sensitive in these types of scenarios where tens or hundreds of millions of dollars could be at stake.

Approximately 60 per cent of Exponent's business comes from this type of 'reactive' business, with the remaining 40 per cent coming from 'proactive' demand where customers are seeking help with product design, developing risk management programs, or addressing regulatory compliance. Customers in the proactive group tend to be more price sensitive than the reactive group as their business tends to be more discretionary, but Exponent's strong reputation in the industry still helps it command pricing power.

Even if someone were to put together $1bn and try to replicate Exponent's business by hiring a bunch of PhDs and having them respond to problems, the new company would lack Exponent's track record and reputation. If given the choice between two companies, it stands to reason that a customer with a big problem on their hands would be far more likely to pay up for the company with a proven record of execution.

What's more, because Exponent procures a steady stream of new and challenging projects, it's able to keep its staff constantly engaged. A company that's unable to keep its expensive payroll occupied would struggle to realise Exponent's profit margins. Even in downtimes, Exponent is financially strong enough to retain valuable employees and has them work on high-profile research and speaking engagements so that when the market does turn around, they'll be able to charge higher prices for that person's work.

Exponent provided engineering services to evaluate the cause of the Buncefield Fuel Depot explosion in Hemel Hempstead in 2005