Morgan Stanley IM: Niches – Searching for roads less travelled

While many of the companies we own are large businesses with well established, familiar brands, in our experience, excellent companies and investment opportunities can also be found by looking at players focused on specialised niches — particularly those that play a critical role within a market and enjoy close customer relationships. Undeservedly – but perhaps not surprisingly – these companies often sit outside the market limelight, and can fall between the cracks of sell-side coverage.

The strengths of niche operators
By niche we mean a specialist market that is served by a modest number (preferably a handful!) of competitors. For a company, there are some clear benefits to successfully implementing a focused niche strategy. By virtue of a concentrated market structure, a niche operator should be able to enjoy excellent margins and therefore likely superior long-term returns. The fact that the markets they focus on tend to be fairly modest in absolute size can also reduce the risk of significant competition, as larger and seemingly juicer opportunities are to be found elsewhere. A further benefit of modest size is that there tends to be fewer anti-trust issues.

Arguably most important, however, is that a successful niche operator is likely to have a culture focused on profits and returns, and not on sales. It will often have a more focused investment strategy, crucially also for mergers and acquisitions (M&A). By their very nature, M&A deals will tend to be smaller and “bolt on”, rather than higher-risk jumbo or “transformational” acquisitions. Deal rationales will often be more focused on important questions such as “why is this an attractive market to operate in for the long term?” rather than the toxic “what is the EPS-accretion that a spreadsheet spits out?”

A criticism levied at niche operators is that they simply lack ways to grow, especially if they already dominate a market segment. However, the reality we typically observe is more nuanced. Niche operators often successfully outcompete less focused peers who are also busy operating in far larger but structurally less attractive end markets. Well-run companies can also be in a position to grow the overall market they operate in. They operate from a position of strength, with the management resources to innovate in new areas and expand the range of products available or the potential customer base.

Successful niche operators
Niches can form high quality pockets within larger, more mature and competitive sectors. From the perspective of an investment prospector, the securities exchanges form a rich vein of excellence within the financial industry. They operate essential and difficult to displace market infrastructure, typically enjoying very deep moats from a combination of branding and network effects. As a result, securities exchanges can deliver very attractive profitability and high returns – financial plumbing may not be particularly glamorous but it can be lucrative.

For a company, an appreciation of the benefits of being a niche operator can result in a deep-rooted culture of continuous improvement, even as the underlying business increases in size. A U.S. tech company we own has industrial roots, but today its revenues are split approximately 75% vertical software and 25% medical & water products.¹ The company is focused on operating “market-leading business in defensible niches” and has consistently become a higher quality business, as measured by returns on operating capital, profitability, cash generation and markedly reduced cyclicality.

By their very nature, niche operators can often play a vital but less visible role. One U.S. business services company we own plays a key position as the dominant proxy infrastructure provider. The company is deeply embedded in the U.S. financial markets, as can be seen by its very high and consistent recurring revenue retention rate, which has averaged 98% over the last 15 years.² We think this is a company that probably is “under-researched” by Wall Street, something almost certainly not helped by the fact that while it considers itself a fintech, and largely serves financial customers, it is classified as an industrial!

Recipe for compounding
Our investment philosophy focuses on high quality companies with a strong and resilient compounding outlook. By focusing on attractive niches, well-managed companies can carve out consistently profitable, high return businesses. In our experience, management teams with an appreciation for niches are often good custodians of shareholder capital. In any given year, the results are unlikely to blow the lights out, but a taste for niches is a good recipe for strong, consistent, long-term compounding.

¹ Source: Company reports and FactSet.
² Source: Company reports and FactSet.

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