As enterprising investors, we aim to own ONLY high-quality businesses. You may wonder, do these have to come from an attractive industry? Most of them do, but that's not the case with all of them.
As every cloud has a silver lining, we do land on outliers in some poor-quality domains from time to time thanks to our genuinely bottom-up process. Some of these companies are pretty exceptional; we have followed them diligently and often had the good fortune to buy them at attractive prices. Let’s go through some examples.
The restaurant industry is a typical space filled with challenges we attempt to avoid, i.e., suffering from a thin profit margin, high employee turnover and lack of scalability. However, Snack Empire (HKSE:01843, Financial), the Taiwanese street-food brand operator, has a brilliant franchise model, making it an economically appealing story. With low CapEx needs, cash-rich operations, superior returns on total/incremental capital and a highly liquid balance sheet, it has all the usual characteristics we find in a high-quality business. Despite its scale disadvantage (i.e., the micro-cap status), we love the fact Snack Empire’s downside risk is well shared, particularly in geographic expansion. According to the founders, the company did minimal franchise marketing, yet many of its overseas franchisees are operated by loyal customers of the brand.
Oil and gas
Another (perhaps predictable) example of a poor industry, oil and gas companies form another cohort we tend to shy away from. As price takers instead of price setters (think Hermes (XPAR:RMS, Financial) here as a counterexample), fossil fuel producers often find themselves in the situation of having to invest heavily upfront for unknown future results. We should state that not all oil and gas-related businesses are created equal. Texas Pacific Land Corp (TPL, Financial) is one darling showing the exact opposite effect. Thanks to its royalty-driven model, on the top of approximately 900,000 acres of land in West Texas, the company requires little CapEx or OpEx to sustain operations, grow and produce persistently high returns on capital. Its land provides drillers with some of the most profitable sources of oil in the United States. This creates a sort of natural hedge for the business (in case of a decline in oil usage and price).
Lastly, the automotive industry earns another spot on our caution list. As the adage goes, never invest in any company making things out of metal. The rule of thumb is that if the product is too durable, sales will be susceptible to the economic cycle. One silver lining we have noticed across the entire industry exists in the aftermarket segment. Two companies dominate here: auto-parts retailer O'Reilly Automotive (ORLY, Financial) and collision repair center operator Boyd Group (TSX:BYD, Financial). Both generate decent returns on capital with high consistency no matter how the economy goes. This is because O’Reilly would benefit from more wear and tear on vehicles already on the road when consumers are not spending on new cars (during a recession). In Boyd’s case, insurance companies (not the consumers) usually take care of the payment for auto repair.
As we can see, good companies do exist in “poor” industries. This is why we are huge fans of bottom-up stock picking. Given that high-quality businesses are an ultra-rare species, alpha-seeking investors (those whose goal is to outperform a comparative index) should certainly not give up any chance of finding one.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. I/We have position(s) in any of the securities referenced in this article.
This article was written by the author and first appeared in Hillside Wealth Management's monthly newsletter.