If you run a multibillion-dollar mutual fund that’s constantly growing, you need many, many ways of finding prospective new investments. For Peter Lynch, the manager of Fidelity’s Magellan Fund between 1977 and 1990, one of those sources of ideas was identifying great companies in lousy industries.
Writing in chapter 11 of his 1993 book, “Beating the Street,” he argued that treasures could be found in junkyards. When industries are lousy, all but the strongest competitors are pushed out, and those that are strong end up with more market share. What’s more, he wrote:
“The greatest companies in lousy industries share certain characteristics. They are low-cost operators, and penny-pinchers in the executive suite. They avoid going into debt. They reject the corporate caste system that creates white-collar Brahmins and blue-collar untouchables. Their workers are well paid and have a stake in the companies’ future. They find niches, parts of the market that bigger companies have overlooked. They grow fast—faster than many companies in the fashionable fast-growth industries.”
He went on to say that classy boardrooms and expensive executive compensation go hand in hand with mediocre performance. He explained his thinking by profiling several of these gems.
Sun Television & Appliances
When Lynch picked up the phone and called the CEO of Sun, he got through right away, which meant that the company did not have a lot of hierarchy. The central Ohio-based chain operated stores that competed with companies like Circuit City; the location was important to him because about 50% of the U.S. population lived within 500 miles.
The company was growing its footprint quite vigorously while keeping its debt down (less than $10 million after establishing 22 stores). According to the author, it was growing at 25% to 30% per year, yet its price-earnings ratio was just 15. At the time the book was written, he was still thinking about making it one of his recommendations (for an annual Barron’s magazine feature).
Southwest Airlines
In the 1980s, wrote Lynch, there was no worse business than airlines. Several major carriers had gone bankrupt, while others were teetering. Yet one of his favorite stocks was Southwest Airlines (LUV, Financial), which had grown its share price from $2.40 to $24 in the decade of the '80s.
The key to its success was its successful implementation of a low-cost strategy, with prices that beat all its competitors. There were several reasons why it was able to keep costs down: It eschewed exotic destinations for high-frequency, short-distance hops, it served only peanuts and cocktails, employees were well paid while executive salaries were kept down and its first head office “resembled a barracks.”
Bandag
Lynch called Bandag the “earthy” equivalent of Southwest; in the early 1990s, it was retreading about 5 million truck and bus tires a year. Its earnings were growing, it had increased its dividend every year for 18 years and at the time of writing was expanding into foreign markets.
Despite its accomplishments, Bandag got little attention from the market. Lynch wrote, “Only three analysts have followed Bandag on its rise from $2 to $60 in 15 years.” He was also impressed because the stock price had seriously dipped a couple of times recently—the Great Correction and the Saddam Sell-Off—but had rebounded strongly both times.
Cooper Tire
Like Bandag, Cooper Tire (CTB, Financial) is in the tire business, but it was a low-cost producer with a niche. While the big companies in the industry were fighting a money-losing battle over tires for new cars, Cooper quietly went about its low-competition business of putting new tires on old cars. Lynch noted:
“The stock price tripled from the 1987 low to $10 a share before the Saddam Sell-off, when it lost much of those gains and fell to $6. Investors ignored the fundamentals to focus on the sad future for tires after the world came to an end. When that didn’t happen, the stock rose fivefold to $30.”
Green Tree Financial
This is a case where Lynch made something of an exception. He wrote, “Green Tree has tremendous debt and a CEO who is higher paid, even, than some second basemen, so it doesn’t qualify as one of our great companies in a lousy industry. I include it here to show that even an OK company in a lousy industry can do well.”
What was special about Green Tree was that it specialized in mortgage loans for mobile homes, sales of which had been declining since 1985. Aggravating that situation was high default rates. So where was the good news for Green Tree in all of this? Its major competitors all gave up, leaving it the dominant lender.
Markets gave up on the company, too, expecting it would follow its competitors; yet Green Tree survived even though its stock dipped to $8 at the end of 1990. And just nine months later, the stock had risen to $36 because of a big jump in its loan volume, and its ability to package its loans and sell them in the secondary market.
Dillard’s
While department stores, in general, might have been limping a bit in the early 1990s, Dillard’s (DDS, Financial) was not. Here’s part of the reason why Lynch liked the company, “With Scroogian intensity, they search the books looking for new ways to cut costs, but not at the expense of employees. Dillard employees are relatively well paid. One place where Dillard does scrimp is on debt. There’s little of that on the balance sheet.”
The company was also an early adopter of computers and computer technology to track its merchandise, giving it an edge over its competitors. It also picked its place carefully: It stayed away from “the glamour markets where the larger retail giants stumble over one another.”
Bottom line: A Dillard’s investment of $10,000 in 1980 was worth more than $600,000 in 1992.
Crown Cork & Seal
The executive suite at Crown Cork & Seal (now Crown Holdings (CCK, Financial)) is described as an open loft above the assembly lines. In other words, management is not spending on itself, a trait that Lynch liked very much. At that time, the company made soda and beer cans, jugs for antifreeze and other packaging. He added:
“I probably don’t need to tell you that can making is a lousy industry with a thin profit margin, or that Crown Cork & Seal is a low-cost producer. Its ratio of expenses to sales is 2.5 percent, which is more than a couple of notches below the industry average of 15 percent. This piddling level of expenditure, bordering on the monastic, was inspired by John Connelly, the CEO, who recently died. Connelly’s hostility to extravagance brings us to Peter’s Principle #17:
'All else being equal, invest in the company with the fewest color photographs in the annual report.'”
Nucor
At the time this book was being written in the early 1990s, American steel companies were trying to cope with competition from Japanese companies. Lynch wrote, “The big-name producers, U.S. Steel (alias USX) and Bethlehem Steel, once symbols of American prowess, have tested their shareholders’ patience for 12 years.”
On the other hand, a $6 share in Nucor (NUE, Financial) in 1981 would have been worth $75 just a decade later. Heading up this money-making enterprise was “a penurious maverick with a vision, F. Kenneth Iverson. Employees were well paid and shared profits along with the modestly paid management team. It had also developed innovative approaches to the steel business.
Shaw Industries
This company, also overlooked by almost all of the market, was in the carpet business, and, “There hasn’t been a worse business in contemporary America. In the 1960s, when the Shaw brothers got into it, so did everybody else who had $10,000 to invest in a carpet factory.”
But in the 1980s, consumers headed in a different direction, replacing carpet with wood flooring and, according to Lynch, half of the top 25 manufacturers had gone out of business by 1985. But Shaw Industries survived because it was the low-cost producer, picking up more market share each time a competitor expired.
It was financially rewarding for shareholders: “During the worst of times for carpets, Shaw has managed to keep up its 20 percent annual growth rate. The stock price has followed along dutifully, up 50-fold since 1980. It lagged a bit in 1990–91 and doubled again in 1992. Who would have believed we’d see a 50-bagger in carpets?”
Conclusion
Most of us stay away from lousy industries, concerned that any stocks we might hold in them might be infected by the viruses that killed others in that industry. Yet, Lynch made a strong case for looking at great companies in those industries.
And how do we know which are great companies and which are pretenders? By looking for companies that are low-cost producers and spend little on executive comforts. They minimize or avoid going into debt at all, while creating a workplace culture that values blue-collar and white-collar employees equally. And, they find fast-growing niches that their bigger competitors don’t know exist, or don’t want to enter.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Beating the Street: Mr. Lynch Got a Haircut
- Beating the Street: Smiling at Bad News
- Beating the Street: Insights Into Retail Stocks
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