Evenlode Investment View - July 2011

Hidden Champions

I recently came across an excellent book - Hidden Champions Of The 21st Century - by business consultant Hermann Simon. In the 1980s, Simon identified a group of businesses that occupy very large market shares in tightly defined, specialist markets, but have limited public profile. He has spent much of his subsequent career analysing these ‘hidden champions’ and over the years has built up a database of more than 2,000 companies around the world that fit this mould. Here are a few examples:

Jungbunzllauer: An Austrian-Swiss global leader that supplies the citric acid for every drink of Coca-Cola produced and sold.
Petzl: French-based world leader in harnesses, rope-blocking snap links and front lamps used for safety equipment, rock climbing and caving
McIlhenny: Founded in 1896, a private, family business producing Tabasco sauce, ‘the most preferred pepper sauce in the world’.
Gallagher: New Zealand based, global market leader in electric fences.

Simon first got interested in hidden champions because he had a question: why do some countries such as Germany, Switzerland and Sweden so consistently punch above their weight in the export sector of their economies? He argues that one of the main reasons for this success is the vast number of specialist small and midsize companies – often private or family owned – that populate these economies (known collectively as the Mittlestand in the German-speaking world).These businesses tend to pick a niche market and focus on it relentlessly, growing mainly by globalisation over the years rather than product diversification– applying their proven business model into new geographies, and only broadening their product range within a tightly defined niche.

It is remarkable how impressive the performance of these tightly focused businesses has been over the years. Simon’s hidden champions have, on aggregate, grown sales at nearly 9% per year over the last decade and their return on equity and pre-tax margins have averaged 24% and 10% respectively – far higher than the average business achieves. And as he puts it, for hidden champions, ‘self-financing is and remains the most important source of finance… This gives rise to a virtuous circle of profit creation’. So here is a group of growing, profitable, cash generators – exactly the type of business we like. They possess the fundamental economics required to compound returns for their investors over the years.

The Importance of Focus

So why do these hidden champions succeed where others businesses don’t? Simon concludes that management focus and consistency is one of the most important characteristics that the hidden champions share.

The average CEO tenure at Simon’s 2,000 hidden champions is 20 years. For comparison, a recent Wall Street Journal study found that the average CEO tenure at S&P 500 companies is just over 6 years. Even more important than the exact length of management tenure, however, seems to be the consistent application of a focused and disciplined strategy over time. Simon suggests that for most hidden champions this approach has, over the years, been hardwired into the attitude and culture of the workforce. Halma, Diploma and Domino Printing, all Evenlode holdings, exemplify the benefits of this approach. All are hidden champions in the sense that they are largely unknown to the public, but dominate the niche sectors they have chosen to specialise in. All have drawn a clear circle around the markets they want to be involved in, and just as importantly have consistently focused on return on investment as a key management principle over the long-term. It is as refreshing as it is rare to find management teams that care more about sensible capital allocation than sales and profit growth. This discipline has allowed them to keep on the straight and narrow – retaining their focus when other management teams might be tempted to boost growth by channelling excess cash-flows into low return areas, outside their circles of competence.

It’s Not About Price

Another interesting takeaway from Simon’s research is that the typical product price premium for hidden champions is 10-15% versus their peers. Hidden champions, it seems, focus on getting the details of service and product quality right, rather than being the cheapest supplier in their markets. They achieve market leadership through customer satisfaction, not by economies of scale. As an example, Evenlode hidden champion WS Atkins recently suggested that they would have a high chance of winning engineering consultancy contracts ‘even if we are 9th out of 10 on price’. This pricing dynamic, found in many niche markets, goes against the body of conventional management theory that has dominated the business world since the 1970s. For years business executives have been told that market share is the key – and should be obtained almost at any cost; the bigger a company’s market share – goes the argument - the bigger its economies of scale, the lower its prices can be. This results in higher sales and a virtuous circle of market share growth. However, as Simon points out, it’s not quite that simple:

“The relevant issue is whether the market share and market leadership are ‘good’ or ‘bad’. ‘Good’ market shares are earned by innovation, superior performance, excellent service and so forth. ‘Bad’ market shares are achieved through price reductions and aggressive promotions to drive up volume without correspondingly low costs. ‘Bad’ market shares are not earned in the long-term but obtained quickly in the short term by unsustainable price concessions.”

Driving prices relentlessly lower in tandem with an ever declining cost base has only been achieved successfully by a handful of companies – the Tescos and the Wal-marts of this world. In most markets, however, price wars driven by an attempt to boost market share lead to unprofitable and failing businesses. The US automotive market exemplifies this - the large market shares of General Motors, Chrysler and Ford have been of no benefit to the investor in these stocks over the last decade. The same goes for many other industries such as airlines, general retail, consumer electronics and tourism. From our perspective, we would always rather own a company whose customers are happy to pay a little more each year than a little less.

Although, for valuation reasons, our current bias is to blue chip stocks – a group that could hardly be described as ‘hidden’ - we think there are a good number of hidden champions in the UK market. Some we own, such as the examples mentioned above. Some we’d like to buy at more attractive valuations (our current ‘subs bench’ for Evenlode includes more than 50 stocks, several of which fall into the hidden champion category). Over the years, we expect these tightly focused specialists to be an important engine-house for the fund’s returns.

Hugh Yarrow
July 2011

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 12th July 2011 and does not constitute investment advice

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