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Supersize Returns III

Todd Wenning turns his attention to this side of the Atlantic in his search for small companies with star potential
Supersize Returns III

In two previous articles ('Supersize Your Profits', 13 May 2013, and 'Supersize Returns II', 27 February 2015), I profiled 15 US small-cap shares that I considered to be in possession of "economic moats" - a phrase coined by Warren Buffett to describe companies with durable competitive advantages. In this article, I look at five UK small-cap shares which I consider also possess economic moats and worth further research.

Determining whether or not you think a company is in possession of an economic moat is, as with any forward-looking assumption, an exercise in managing uncertainty. Even Mr Buffett misjudges a company's moat now and again, so mastery of the subject is elusive. Moats are much easier to determine in hindsight, but investing while looking in the rear-view mirror is not a sound strategy. The key, then, is to have a method for evaluating a company's potential for generating sustainably high returns over the next decade and beyond.

Why is this important? In most cases, investors naturally and quite reasonably assume that a company's recent success will diminish and revert to the mean in the coming years as competition intensifies. If your moat evaluation is indeed correct, however, and the company's high returns persist over a decade or more, there's a pretty good chance that other investors will need to readjust their assumptions upward.

Economic moat evaluation is a particularly important exercise when investing in small-caps because they tend to come under attack from both larger and smaller companies. Larger companies generally have more resources at their disposal and are formidable competitors if they want to enter a certain market. Tinier, would-be competitors could see the small-cap company as a more achievable target than a larger company. Thus, a defensible competitive advantage can help a small-cap company survive and thrive across the business cycle.

When evaluating a company's economic moat potential, I look for at least one of the following criteria to be present:

1. Intangible assets: Does the company have valuable brands, patents, or regulatory licenses that provide it with sustainable pricing power? Often-cited examples of intangible asset advantages are Coca-Cola (brand) and GlaxoSmithKline (patents).

2. Network effect: Does the company's product or service become more valuable as more participants join it? eBay's auction market, Facebook, and Uber can be considered examples of the network effect.

3. Switching costs: Does the consumer pay a high price, in time or money, to stop using the company's product? Once installed at a business, Sage's mission-critical accounting and operations software, for example, would likely be costly to swap out in favour of a competitor's offering, as the business would need to retrain its staff and take downtime to incorporate the competing software.

4. Low-cost production: Can the company consistently produce goods or provide services at a lower cost than its competitors? Larger companies are more likely to possess this advantage as they generally have greater economies of scale than smaller companies. Wal-Mart (parent company of Asda), for example, can usually offer lower prices than its competitors due in part to its lean supply chain and still deliver attractive returns on invested capital.

Bearing this criteria in mind, here are five small-cap shares that may possess economic moats.


Walker Greenbank (WGB)

Share price: 212p

Market cap: £127m

Dividend yield: 1.9 per cent

Trailing PE ratio: 25.7 times

Luxury goods made by companies such as Hermes, Tiffany, and LVMH Moët Hennessy Louis Vuitton can yield durable competitive advantages supported by their extremely valuable brand equity. While it's not impossible to enter the clothing, jewellery, or accessories markets with a little capital, it is far more difficult to create an aspirational brand with global appeal and - here's the important element - be able to consistently charge customers healthy premiums for the privilege of wearing your products. This sort of brand value can take decades to build and even then a lot of luck is involved.

This high hurdle provides a huge advantage for luxury goods companies that have already established themselves. One such company may be Walker Greenbank, the maker of upmarket wall coverings and home furnishings through brands such as Sanderson, Morris & Co, and Zoffany. Gross margins at Walker Greenbank are consistently near 60 per cent, which implies considerable pricing power and is well within the range of what you'd expect from a luxury goods provider (ideally you want to see at least 50 per cent in this category) and are superior to those of its main competitors, Laura Ashley and Colefax. Operating margins are a little lighter than I'd like for a company in the luxury category, but Walker Greenbank appears to have significant operating leverage given the high fixed costs related to manufacturing wall coverings. Naturally, then, as sales have increased, operating profit has grown at a faster rate and margins have steadily improved. The company's also spent a decent amount on upgrading its technology and manufacturing capabilities in recent years and those expenses are expected to tail off.

Walker Greenbank is able to achieve these results through both its Brands division, which produces proprietary patterns and designs, and its Manufacturing division, which prints premium wall coverings and fabrics for both internal and external clients (including direct competitors).

Both divisions appear to possess intangible asset advantages. In the Brands segment, many of Walker Greenbank's designs make timeless cultural reference to traditional British luxury, which would be difficult for an upstart to genuinely replicate since the Sanderson and Morris & Co brands can be traced back more than 150 years, with the former granted a Royal Warrant in 1927. There's also relatively low fashion risk with wallpaper since consumers are less likely than, say in apparel, to swap out wall coverings on a yearly basis to keep up with the latest fashions. In Manufacturing, the fact that competitors and other luxury consumer brands commission Walker Greenbank to print their designs indicates that it has 'know-how' in manufacturing premium products that others don't.

Writing this from the other side of the Atlantic, I can say that wallpaper has been out of favour with the previous generation or two of US homeowners, but I get the sense that this trend is changing. Having just purchased a house, my wife and I have spent a good amount of time (more than I'd care to admit) researching design and we've noticed more wallpaper recommendations when it was rarely recommended in years past. Because of this potentially developing trend, Walker Greenbank's recent investment in its New York showroom may pay off quite well. Although the US accounted for just 29 per cent of 2014 brands revenue and 10 per cent of total revenue, in the latest annual report management called the US an "extremely important opportunity" for the company. Anecdotally, as I was researching this article, my wife had a look through the Sanderson wallpaper catalogue and was disappointed to find out they only shipped to the UK and Ireland, so when they build out their US business they can be assured of a customer at the Wenning residence.


FW Thorpe (TFW)

Share price: 195p

Market cap: £223m

Dividend yield: 1.9 per cent

Trailing PE ratio: 19.3 times

In addition to economic moats, one of the things I look for in a promising small-cap share is meaningful insider ownership. At small companies, I prefer to see executives and directors of the company own at least 5 per cent of the shares outstanding as this shows management has some 'skin in the game' and might be more inclined to think like long-term owners. This is likely the case at lighting company FW Thorpe, where two of the founder's grandsons, Andrew (chairman and co-CEO) and Ian (non-executive director) together own more than 40 per cent of the company.

Another benefit of insiders owning a large equity stake is it gives them the ability to think long term and not get wrapped up in short-term City projections. A potential drawback of high insider ownership is that, in the event of prolonged poor performance, it can be hard to unseat management. With small companies that have high insider ownership, it's therefore important to determine whether or not management is widening the moat and if they are motivated to grow the company rather than milk it for short-term cash flow.

I don't have those concerns about FW Thorpe. While management could be criticised for being too conservative with its balance sheet, it operates in a cyclical industry with changing technology (ie, the shift from traditional fluorescent lighting to LED lighting), so a cash-heavy balance sheet seems logical. Management has also been kind to the broader pool of shareholders by steadily increasing its dividend over the last decade and paying out special dividends in particularly good years. On the growth side, net assets per share grew nearly 55 per cent from 2010 to 2014.

Management also deserves a lot of credit for investing heavily in LED technology rather than ignoring it in favour of the highly profitable traditional lighting approach that helped build the company to where it is today. As of June, 58 per cent of the company's revenue came from LED products. And while these LED investments have weighed on FW Thorpe's returns on capital and margins, its ownership structure affords management the time to focus on driving long-term profitability. Competitors in the LED space likely lack such a favourable ownership structure.

Admittedly, FW Thorpe's moat source isn't as clear as some of the others, but its historical results suggest the company's been able to successfully defend its competitive position for many years. FW Thorpe's success is likely due to a combination of intangible asset advantages rooted partly in employee 'know-how' in the manufacturing and servicing of complex lighting systems that would serve as a steep learning curve for upstart competitors, as well as sticky customer relationships due to FW Thorpe's strong reputation. The company has a large installed base of customers, who - since lighting purchasing decisions are infrequent but important - may be more inclined to stick with the company they've used in the past.

While the technology shift from traditional fluorescent lighting to LED lighting should be of some concern to potential investors, management's track record and ability to endure short-term performance mis-steps in a cyclical market are reasons for optimism.


Diploma (DPLM)

Share price: 639p

Market cap: £724m

Dividend yield: 2.7 per cent

Trailing PE ratio: 19.5 times

Any company that consistently generates operating margins and returns on equity above 15 per cent is likely to possess some durable competitive advantage, so I would be remiss not to include Diploma on this list. The technical products and services company's business model is to provide "essential products, essential services, and essential values" to its customers through its three main business lines - life sciences (medical devices and related consumables), seals (hydraulic seals, gaskets, etc), and controls (wiring components and fluid controls), which account for 30 per cent, 40 per cent, and 30 per cent of the company's total revenue, respectively.

Granted, these three businesses don't have much in common, but a lot of credit is due to Diploma's management team, which has allocated capital very effectively through value-enhancing acquisitions. The common thread these businesses share is that they provide mission-critical products for end-uses where the cost of failure is very high, such as in the operating room, on a construction site, or on an aeroplane. More importantly, the cost of the products Diploma provides to these industries is relatively small, making it more unlikely that the customer will shop around based on price alone. As such, it appears Diploma could have established a durable switching cost advantage.

One of the other things that I like about Diploma is its decentralised business structure that puts more decision-making power in the hands of front-line employees who directly deal with customers. In many of the markets that Diploma serves, time is of the essence, and heavy bureaucracies can considerably slow the company's approval process.

All has not been rosy for Diploma in recent months, however, with a 25 per cent share price fall between July and September. The dramatic drop in oil and gas prices, adverse currency effects, and ongoing sluggishness in the mining and construction industries have weighed on results. With two-thirds of Diploma's business facing considerable headwinds, the market re-evaluated its prospects. The big question to consider is whether or not these headwinds are cyclical or secular in nature.


Portmeirion (PMP)

Share price: 915p

Market cap: £98m

Dividend yield: 3 per cent

Trailing PE ratio: 15 times

While it's unlikely that a tableware and cookware company will be the most exciting share in your portfolio, the Portmeirion, Spode, Royal Worcester and Pimpernel brands have helped Portmeirion deliver consistently strong results for shareholders. The company acquired Spode, Royal Worcester, and Pimpernel in 2009 in the midst of the financial crisis and has since been on a roll, generating an average return on equity near 19 per cent from 2009 to 2014.

Behind Portmeirion's success likely lies an intangible asset advantage rooted in its well-regarded brand names and its intellectual property - primarily proprietary patterns used on its products, such as the popular Botanic Garden patterns. Even if a would-be competitor wanted to enter this market today, it would likely take some time to approach Portmeirion's reputation for producing quality upscale china, particularly since those competitors can't use the company's patterns without licensing them.

Beyond the moat, Portmeirion has a sturdy balance sheet with a net cash position of £3.4m and grew its half-year dividend payout by 11 per cent.


Emis (EMIS)

Share price: 1,018p

Market cap: £655m

Dividend yield: 1.9 per cent

Trailing PE ratio: 27.8 times

Software that makes professionals' work days run more efficiently are worth their weight in gold. This is particularly true in higher intensity jobs where even the slightest hiccup in the software can cause stress for its users. Moreover, the longer you use the software in your day-to-day operations, the more dependent you become on it. In most cases, it takes a series of massive problems with the software to spur the user to consider other options.

The aforementioned Sage's accounting software, for example, is deeply ingrained in many companies' back-office operations and a switch to a competitor's platform would come at a considerable cost in time and money. As such, companies with effective software programs can potentially realise a large switching cost advantage over competitors and generate high margins for well over a decade.

Emis's mission-critical healthcare software programmes might similarly afford the group its own durable switching cost advantage. Used in 53 per cent of GP practices and approximately 70 per cent of the independent pharmacies in the UK, Emis's electronic health records system gives healthcare professionals instant access to a patient's files and aims to make the healthcare system more efficient by reducing costs and treatment errors.

What I like about entrenched products and services within the healthcare sector specifically is that, because doctors' and nurses' time is so valuable, it becomes expensive in time and money to retrain them on new platforms. This makes it difficult for potential competitors to steal market share from the incumbent provider (in this case, Emis's software) unless the competitor can make a very compelling quality argument or can offer a similar platform for a fraction of the cost.

Supporting evidence of Emis's durable switching cost advantage can be found in its high recurring revenue stream (about 75 per cent of total revenue), as well as in the data point that 78 per cent of English GPs who use Emis's platform have been using it for more than 10 years.


Bottom line

Economic moat analysis is an important step in the research process - along with valuation considerations, management analysis, etc - as it can help you decide whether or not you think the company can generate returns above its cost of capital over the next decade and beyond. The five companies listed above exhibit promising signs of having established a moat and are worth further consideration.

Todd Wenning, CFA is an equity analyst based in the US