The blue bottle, red screw cap, and yellow WD-40 logo are ubiquitous in the United States. This spray lubricant is found in eight out of 10 American homes. Its brand is so indestructible that WD-40 Company has a “buried closet” at its San Diego headquarters dedicated to all the rivals who have tried in vain to take market share. Aside from the smell, there is nothing unique or proprietary about WD-40. Still, the brand translates into a 20%1 profit margin, making the lubricant an excellent long-term investment.
I spend about nine weeks a year in a rental car searching for companies like this around the world, discovering their products, their customers, and how they operate. At a time when everyone is obsessed with Nvidia and big tech stocks, smaller companies, up to $10 billion in market cap, are often overlooked and offer the opportunity to generate above-average investment returns. of the market. These companies usually focus on a profitable niche and are hardly followed by analysts. That makes the task of finding a “hidden gem” easier than, for example, with Microsoft, which is followed by about 70 analysts.
Valuation discounts and investors’ erroneous assumptions
It has almost never been as interesting as now to invest in the smallest companies. The valuation discount to the majors has rarely been this wide. While small caps have historically traded at a 10-15% premium to large caps, this situation has reversed and small caps are currently trading at a 15% discount to large caps. capitalization. At the same time, I believe that Fama and French’s Three-Factor Model studies demonstrating the “small-cap effect,” where smaller companies outperform over the long term, are still valid.
The small cap universe is very broad, with around 6,000 stocks. And we typically only invest in 70-90 of them. I look for companies that have what Warren Buffett, the legendary American investor, calls an “economic moat” around the business model that provides a competitive advantage. This generates long-term benefits that investors constantly underestimate. A competitive advantage translates into a high return on invested capital. Investors mistakenly assume that this high profitability will soon recede back towards average profitability. We want to exploit this market inefficiency, as we have done by investing in WD-40.
From Belgian chemicals to the oven of a Munich brewery
Turning to Europe, we have a position in a Belgian stock that also shows the type of quality small companies we buy. We have invested in Azelis for two years. This specialty chemicals supplier is the type of company we are looking for: it has pricing power thanks to a fragmented base of suppliers and customers and makes a difference with the formulas it uses to make its own products.
Valuation is of some importance and we always try to buy at an attractive price. For example, for years we have been interested in Rational, the German market leader in commercial kitchen ovens. But we did not have the opportunity to invest in this value until 2022, when its price fell due to the general disinterest in industrial companies. Rational makes ovens for customers ranging from Kentucky Fried Chicken to Buckingham Palace to Michelin restaurants. Ovens not only save energy, but also staff: since the pandemic, my local Italian restaurant in the UK operates with one chef and a Rational oven instead of two chefs. Given the tensions in the labor market, this is important.
On my recent travels through Germany, I saw the millionth Rational oven with a gold rotating wheel. It is located in the famous Hofbräuhaus brewery in Munich, which dates back to the 16th century. Of course, I stopped to look at it.
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