Everyone knows no human can possibly dunk a basketball after taking off from the free throw line. This feat defies the basic law of universal gravitation. Yet some athletes make it seem effortless.
The same can be said of exceptional companies. While they are few and far between, companies do exist that break the basic rules of economics and capitalism. They are industry outliers that defy the standard metrics used to measure companies within a given industry.
Although not as well known as the law of gravitation, the economic law of "Long-Run Equilibrium" is no less important for businesses and investors. In capitalistic systems, it's difficult to maintain a competitive advantage over the long term. If, for example, a company is earning an above average profit, other companies will enter the market and compete for that excess economic profit. Once that happens, completive pressures will cause the economic profit to disappear until it's completely gone. In the "long-run competitive equilibrium", firms will only earn a normal profit and, over time, all economic profit is ultimately eliminated. I define economic profit as a profit over and above the "cost of capital," where the cost of capital is the return that equity investors and the interest that debt holders expect.
For example, airlines routinely compete for highly profitable routes. During airline industry deregulation in the 1980s, routes that had been highly profitable like the New York to Miami route, became unprofitable because competition became unfettered and every airline began flying those desirable routes. It wasn't until some of the new competitors dropped the route that the remaining airlines once again began earning a meager profit. The same dynamic occurs in every industry where one company earns a higher than average profit.
However, I've found five company essentially prove that capitalism doesn't necessarily work as it's supposed to and that basic economic rules don't apply to everyone. The following companies compete in some of the most cutthroat and efficient industries in the world, yet they have been able to earn above average returns for long periods of time.
Broad market corrections, as we're currently experiencing, are excellent opportunities to buy stock in these exceptional companies. That's because these stocks are fully valued most of the time. The market understands that these companies are the creme of the crop and assigns a high earnings multiple to the shares. As a stock investor, it's hard to earn a good return on these great companies because the shares are already priced for perfection. However, as the market correction takes hold, investors might have the opportunity to buy these shares at more reasonable valuations. Investors should therefore take the opportunity to upgrade their portfolio holdings, selling weaker companies and adding stronger ones.
With that, here are five exceptional companies that are breaking the economic laws in their generally dreadful industries.
Few other industries have been as marred by overcapacity and economic losses as the automotive parts industry. Fortune magazine recently described the complexity of making money in autoparts. "There is a huge imbalance between suppliers - 10,000 in North America alone - and their customers - a couple of dozen giant automakers. Guess who holds the upper hand? Automakers can and do demand annual price reductions for the life of a contract. Combine that with burdensome debt, soaring commodity prices, and fragile production schedules, and you the potential for a major catastrophe." From powerful end market customers who don't always pay their bills, to high fixed and variable costs, the auto parts industry always seems to enter a blood-letting stage every five years during which numerous companies go bankrupt. In this fiercely competitive, fragmented and global market, it's difficult to imagine any company earning an above average economic profit for any period of time. Yet Gentex (GNTX) has been able to do just that for over ten years.
Gentex makes automatic-dimming rearview mirrors for the automotive industry. The company's products include the cool auto-dimming headlamp control mirror that automatically turns your car headlights on at dusk. Gentex also makes fire safety products for the home. It's not the kind of stuff that would guarantee higher than average profits. However, that's just what Gentex has delivered consistently.
Just looking at Gentex's net profit margins makes the company seem like it's in the Internet search business, not the automotive parts business. The following table shows how Gentex compares to its rivals in profitability and other operating metrics. While growth has been slowed during the recent downturn in the industry, the company has maintained its record margins. GNTX reported a EBITDA margin of 31.5% and a net income margin of 19%. That compares with an average of 11% and 3% for the rest of the comparable companies. Gentex only generates an ROE of 16.6% but that's because the company has no debt compared to some staggering levels for other companies in the industry.
Gentex maintains its competitive advantage by continuously innovating its product. That allows the company to maintain some pricing power in the face of stiff competition and powerful customers. The company's newest technology - SmartBeam - automatically senses and turns on your high-beam lights. Who would have thought ten years ago, that rear-view mirrors would become one of the most complex and technologically advanced parts of a car? Certainly not Magna International, who is Gentex's main competitor. Otherwise Gentex would never have had the success it has achieved.
While Gentex is defying the typical fate of autoparts manufacturers, it's difficult to call it an outstanding investment opportunity. While its margins are second to none in the industry, so is its multiple. GNTX trades at 11x EBITDA and 4x Sales vs industry averages of 8x EBITDA and 1x Sales. So most of the company's excellence is already recognized and priced in by the market. An acceleration in earnings and revenue growth could keep the stock moving higher, but it's doubtful that the multiple can expand much from this point. Therefore, I would wait for a bigger correction before buying GNTX.
Forward Air (FWRD)
The transportation industry is one of the most efficient sectors of the economy because it's a "perfectly competitive" market. By that I mean that 1) there are numerous buyers and sellers, 2) price information is readily available 3) switching costs from one provider to another are negligible.
In this difficult industry, Forward Air has been able to exploit a very profitable niche in the freight forwarding market. Freight forwarders essentially pre-buy large blocks of "empty space" on airplanes, trucks and trains, then chop-up and re-sell that empty space to companies that need to transport goods from one place to another. They act like travel agents for goods instead of people. Unlike trucking, railroad and airline companies, freight forwarders don't have tremendous fixed costs and high capital expenditures. However, those characteristics also make it difficult to gain operating leverage and generate a large economic profit. But Forward Air has been able to achieve both.
In addition to its freight forwarding operations, Forward Air has been able to carve a niche in the lucrative airport to airport transportation market. In this capacity, Forward also operates its own fleet of trucks, which is what gives the company the ability to earn higher margins than traditional freight forwarders such as CH Robinson (CHRW) and Expeditors International (EXPD). Through its hybrid model, FWRD has been able to generate much higher operating and net margins than either its freight forwarder peers or its trucking counterparts. And the company's Returns On Equity (ROE) are higher than most all its competitors except for CHRW.
Transporting goods from one airport to another should not be a business with "high barriers to entry" and exceptional returns on equity. However, FWRD has been doing it so long and so successfully that it has created a barrier to other competitors. Smaller companies such as Kitty Hawk have tried to enter this market unsuccessfully. And Forward continues to crank out the high returns while it grows the other parts of its business. 
FWRD is currently trading in the middle of its historical valuation range. The stock has come down because the slowing economy and because the company has reached the saturation point of its airport/airport growth. Management is actively looking for new areas of expansion. Trading at 17x earnings and 11x EBITDA, the stock looks attractive relative to its competitors. However, the slowing growth rate could weigh on the shares and keep it from reaching previous highs. Given management's track record of finding new avenues of profitable growth, FWRD looks like a very interesting stock.
Ethan Allen (ETH)
Aside from airlines, no industry has endured more bankruptcies in the past decade than the furniture industry. In the past ten years, almost every furniture company has had to announce significant layoffs, plant closings and/or permanent shutdowns. And the remaining companies haven't earned an economic profit in years. Furniture Brands (FBN), La-Z-Boy (LZB) and Bassett (BSET) have all had declining or negative returns over the past decade.
Except for one.
Ethan Allen manufactures and sells high-quality furniture through its own and franchised retail stores. It's one of the few companies in the industry that has an integrated supply chain -meaning that they design, build and sell all their own products.
The company took some difficult steps in the economic downturn in 2001-2002. It transitioned to an "every-day fair price" strategy, eliminating the constant need to put everything on sale when inventories build up. The company also trimmed its manufacturing plants from 27 to 11 and began sourcing many more goods from Asia. In addition, the company closed and relocated about 50 stores. Finally, it introduced interior design services which added additional value to its product offering. While this has and will continue to lower operating profits in the near term, it will allow the company to continue to differentiate itself in the long term.
Other furniture retailers and manufactures have tried to duplicate Ethan Allen's success in building a vertically integrated company. However, none has done so with anywhere near the success of ETH. The company is now so far ahead on the value chain, adding interior design and every day pricing that I think it will be impossible to catch. The margins and returns bear out my analysis. The company has consistently posted industry leading operating margins and earned a 17% average return on equity over the past decade.
The stock remains attractively valued at 13x 2007 earnings and 1.2x sales. While both multiples are at the higher end of the industry, both are at the lower end of the company's historical trading range. The slowdown in the economy and the housing market has no doubt weighed on the stock. However, investors should take a close look at this industry leader in the mid-$30s.
You know you've hit a home run as a marketer when customers are willing to pay a premium just for your packaging. I don't claim to understand it, but most women love getting jewelry in a little blue Tiffany's box. No matter that the jewelry isn't of the highest quality, the box (and the name) is what counts. I don't put the quality of the company's products in the same league as Gucci, Louis Vuitton and Rolex, but many consumers do. And that's a recipe for high returns and margins for investors.
In the intensely competitive jewelry business, Tiffany's has been able to develop a brand that's rivaled by very few other corporations. The company has built an international image in a fragmented industry that's still dominated by local operators. And this strong brand has allowed the company post consistent earnings even during recessions that have affected most other retailers. The stock is essentially both a cyclical and a countercyclical play - it does great when the economy is strong as consumers are more willing to spend on higher priced items and it does well when the economy is weak because the majority of its customers are very affluent and are unaffected by economic swings.
Tiffany's strength comes from it's world-wide reach. The company has seen great growth in Japan, where the brand is even more popular than in the US. TIF is a great play on the rebounding economy of that country. And the company's strength in Japan should translate to strong growth in China as well, although revenues from that country are still paltry compared to the whole. In addition, Tiffany's is enjoying strong growth in Europe.
The company's brand has also allowed TIF to earn above average margins and returns on equity. TIF has the leading EBITDA and net margins of all the major public jewelry companies.
The stock is currently trading in the middle of it's historical valuation range. TIF's forward earnings multiple has averaged about 21.2x over the past 15 years and currently the stock is trading at 20.2x. While it's not that compelling an investment right now, a couple of points lower would make it very attractive.
Right along with furniture, no industry has seen its manufacturing base move offshore faster than clothing and textiles. In a highly efficient, global marketplace, no company should be able to make an economic profit manufacturing something as mundane as t-shirts. That's why Gildan Activewear is so remarkable. It manufactures a commodity product and yet has been able to earn an above average return on investment for the past 10 years.
Gildan Activewear is a vertically integrated manufacturer and marketer of branded basic activewear, principally in the wholesale segment of the apparel industry. Essentially, all the company does is manufacture cotton and fleece t-shirts and sweatshirts on which other companies can imprint their logos.
By aggressively managing its manufacturing base, Gildan has been able to keep costs falling faster than the prices of its t-shirts. The company employs more than 7,400 employees and owns manufacturing facilities in Canada, the US, Mexico, Honduras, Haiti and the Dominican Republic. In addition to moving its production off shore, GIL focuses on continuous innovative improvements to maintain its technology and manufacturing lead.
Instead of spending money on building a brand, GIL focuses on lowering costs. It has consistently lowered prices faster than its competitors. In fact, Hansbrands (HAN), the recent spin off from Sara Lee, mentioned on it's first conference call that competitive pressures in the wholesale channel have kept it from improving its profit margins. In addition to driving production improvements, GIL only focuses on a limited number of very high volume, low-fashion-risk items that allows it to continuously improve efficiencies.
This has lead the company to be able to generate returns far in excess of its peers. In fact, most of the company's competitors have followed a much more "traditional" route to earning an economic profit. They've developed a brand, strong distribution channels and well defined niches. Yet few other clothing companies have even come close to approaching the operating margins and return on equity of Gildan Activewear. GILD has generated a five year ROE of 25% vs. the mid teens for most of its competitors. And its margins rival even those of strong brands such as GUESS and Polo Ralph Lauren.
The company is now moving into the retail channel. Instead of simply selling its t-shirts into the wholesale channel where other companies place their logos on the shirts, Gildan will now market t-shirts under its own brand name. Whether GIL will be able to create a brand along the lines of Hanes or Fruit of the Loom remains to be seen. However, the company's manufacturing excellence and low cost producer status should give it enough leverage to make the entrance into retail work. GIL has assembled an excellent management team to make it's move into retail and I would be surprised if the company fails to execute on its plan.
Despite its great track record, the company faces numerous risks, which still make the stock too pricey for me. As mentioned, the company's foray into the retail channel is still in its infancy and it remains to be seen whether it can duplicate its success. The company operates squarely in the highly politically charged, protectionist environment in which we currently live. While politicians haven't been able to enact many silly import and export duties, it's probably just a matter of time before a trade war starts in earnest. It always amazes me that politicians will defend dying industries like textiles and clothing to save a few jobs in their home-state, in the process raising the price of your socks and underwear. In addition, I still have difficulty investing in an industry that faces almost no barriers to entry longer term. I prefer a brand strategy which creates a higher barrier to competition. That said, no one can argue with GIL's exceptional execution heretofore.
Conclusion
Instead of lamenting your fate as the markets fall apart, do some follow-on reasearch on these exceptional companies. Then upgrade the quality of your portfolio as the opportunity arises.
It would be interesting to take a look at these companies and try to understand the few things that make them tick. Do they have strong leadership? Good values? Both? I am reticent to say 'good staff' because good staff ultimately depends on the company's leadership and management skills.
A good product? As you've already said, their product is not entirely different from others. I personally think that their values and ethics are what gets them ahead – without even knowing much of the company. I've noticed a trend of many people to rather deal with reputable companies (and reputable in every proper, honest sense of the word) and pay MORE for the product, knowing full well that they will get all the product promises to be, good service, and actually downright honesty from the company. Perhaps we would benefit at a deeper look at some of these companies you've mentioned here.
Posted by: Travel Goods | July 07, 2007 at 11:19 AM