Europe: crisis and opportunity

The situation in Europe has presented us with an opportunity to acquire shares in a business that we have admired for several years for a more reasonable price. In this case, the accelerating decline in the British pound in September helped shift the odds in our favor.

The company has been in business in one form or another since 1888 and has thrived through two world wars, the Great Depression, periods of significant inflation, disinflation, import and export restrictions and changes in technology. It is the market leader in its key markets and supplies components that are critical to the operations of many large manufacturers.

A key to the company’s longevity is its unique approach to selling. As early as 1930 management defined a way of doing business and a direct sales philosophy that it continues to pursue successfully today. The company employees highly qualified engineers as its sales representatives and those engineers are tasked with knowing their customers’ businesses inside and out, and helping them identify affordable process and operational improvements that lift operating efficiency and profitability. Most of those sales are relatively small purchases, which come out of operating rather than capital budgets, meaning they are less likely to be cut during a downturn. The firm doesn’t sell products, but expertise and solutions. This sales approach allows the firm to generate sales and grow in partnership with its customers.

Despite decades of strong organic growth and acquisitions, the company still occupies a modest share of market in each of its core business lines and it continues to expand thoughtfully into adjacent markets with lots of room for future growth. These acquisitions are typically meaningful, but not so large as to be exceedingly risky or distracting, and the company maintains a conservatively leveraged balance sheet. One such acquisition for a very modest sum in 1990 has grown to become the leader in its field, generates an operating margin of 33% and now contributes over 40% of group operating profit.

The company has grown profits steadily since listing in 1959 and has increased its dividend by 11% every year for 53 years. History doesn’t repeat, but the qualities that made this an enduring business for the past 134 years persist and we think can help it endure for another 134 years.

Unfortunately for us, these attractive business attributes are no secret. Plenty of investors have recognized the excellent qualities of this company, which means the company’s share price ordinarily trades at a very high price. A high price paid can turn a terrific business into a poor investment.

Over the past year, however, the share price has fallen by over 40% on concerns of a global economic slowdown (and the fact that the shares were simply too expensive to begin with). In addition, since October of last year the Pound Sterling has declined from being able to purchase 137 US cents to a little under 109 cents—a fall of around 20%. Priced in US dollars, the company’s shares are selling for less than half their value of one year ago.

The company’s business has been globally orientated, producing and selling products in various markets and countries since the beginning of the last century. Some of these currencies have also decline against the US dollar as has the British Pound, nevertheless the net impact is still likely to be a lower share price in US dollar terms relative to earnings that reflect a mix of currencies. It should be noted, however, that even with a more than 50% decline in US dollar terms, the stock is still not an outright bargain. In fact it may rate as one of the most expensive stocks we have purchased on close to 25 times next year’s earnings. But great companies are rarely without friends.

We continue to add to our holdings and will accelerate purchases if the stock price falls further. From current levels we expect to generate an attractive return. The business generates returns on capital of over 20% and is able to reinvest around two-thirds of its earnings (even after 134 years!). High returns and the ability to invest meaningful amounts of capital at those returns are the key to long-term compounding of shareholder value.