There are two sets of circumstances that can potentially lead to making a life-changing investment. The first type is the one that gets all of the attention: It involves a company gaining market share in an industry with a very large niche. An obvious example of this type of growth is Coca-Cola. People recognize that the soft drink industry is super huge (each of the seven billion people in the world are potential, realistic customers) and Coca-Cola has reached the point where 3.5% of all liquid consumed in the world can be traced to a beverage that is earning profits on behalf of Coca-Cola shareholders. Because the market is so large, and the profit margins are so great, shareholders in Coca-Cola have been able to turn $1 invested in 1970 into $190 today even though 96.5% of the liquid in the world is consumed through some other owner. When markets are that big, even a small slice of the pie results in riches.
Because the large industries are easy to understand and relatable to most people, companies that operate in the food and beverage industry tend to get most of the attention when it comes to investments that are both lucrative and can be held for the very long term. But there are other types of conditions that can lead to great growth of over time—the thorough penetration of a very small market in an industry that is highly profitable. This is where you try to find a niche, earn a large spread between the price you charge and the costs of productions, and then keep your mouth shut while you come to dominate the industry.
An example of this type of company is Zoetis. It is not a household name to many, but it makes the medicines and vaccines that are used to cure or offer preventative aid to dogs, cats, chicken, cattles, horses, fish, and sheep. It primarily operates in the United States, Western Europe, and Canada, but is in the early stages of expansion into the Pacific and East Asia. It has 37.7% operating margins, and has about 1/5th of the global animal health industry. Collectively, the world spends $22 billion on animal medicine, and Zoetis owns $4.7 billion of that market.
For most of its history, Zoetis was part of Pfizer. In the early 1950s, Pfizer purchased an animal health division and used the cash from it to fund research development, cash dividends, and from the 1990s onward, share repurchases. It provided a great stream of cash for Pfizer’s board to allocate over the past five decades. The issue, however, is that this animal health division didn’t receive much in the way of reinvestment.
This is part of the dark side when companies engage in empire-building and acquire a bunch of business segments. Human nature being what it is, you can see how this might happen intuitively. Imagine if you owned 20 operating businesses—hotels, bowling alleys, clothing lines, perfumes, and a water-bottle processing plant. You make about $25 million per year, and the water-bottle processing plant makes $2 million in annual profits. Because it is such a small part of the empire, it is easy to run on auto-pilot; take those $2 million in profits and spend it on your lifestyle or reinvesting into the area of your business that is growing the fastest. If you had a perfume line with 60% margins, you’d probably take the water-bottle profits and expand the perfume business.
This could be perfectly rational behavior from your perspective, but it does result in one consequence—the water-bottle processing plant will be developed less than would be the case if it were the sole, crown jewel asset. If the only thing you had to your name was that water bottle plant, you are going to be constantly thinking about innovations, growing market share, and at a minimum, maintaining the moat that exists in your niche. You might enter partnerships with local universities to use their logo on water bottles and sell them outside the homecoming game. You will be quick to notice trends that people prefer water bottles that can be squeezed rather than the hard shell ones. You might hustle and call local grocery stores to see if they will carry your water bottles as part of a trial run to see how well it sells, with the hopes that it might lead to something permanent. When something is all you got, you will pay more attention to it than what it is one of many things vying for your attention.
On the corporate level, this is what Pfizer did in 2013 when the company split off Zoetis and severed its ownership of the healthcare division (in terms of structure, you had to voluntarily swipe out some of your Pfizer shares for Zoetis shares, allowing Pfizer to sit on the acquired shares of its own stock to either retire and increase the earnings per share or use to fund future acquisitions). And because Zoetis is now trading on its, with the retained profits being earmarked specifically for reinvestment back into Zoetis, the company is showing early signs of faster growth than had been the case while it was part of Pfizer.
The animal health industry grows at 5-6% per year, and Zoetis had traditionally grown profits around 8% or so when it was part of Pfizer. Since becoming unleashed, it has been growing profits in the 12-14% neighborhood. And the dividend, which was recently increased by 15%, still doesn’t account for 20% of profits (so Zoetis makes $700 million in profits per year, and sends $140 million to shareholders as a dividend while keeping $560 million on hand to reinvest into the growth of the business).
There are concerns. When Pfizer unleashed Zoetis to the public, it did not give Zoetis a healthy balance sheet to start its trading from a position of strength. There is a range of balance sheet treatments that parent companies can give the new, smaller companies—it can act like Procter & Gamble did when it received an anti-trust order from the U.S. Supreme Court in 1969 to spin off Clorox. Because so many P&G executives had high opinions of the growth future for the bleach industry and wanted to build in the company parallel to their P&G stakes, Clorox was able to begin trading as a standalone company in 1969 with hardly any debt so that it could grow fast and triumph through adversity if necessary.
The other extreme approach, which a coal company headquartered in St. Louis saw a few years ago—is to unload toxic debt onto a spinoff so that the parent company will get stronger and the spun-off company won’t have much of a chance at survival. The outcome of this for the coal spin off involved eventual bankruptcy, and then lawsuits alleging fraud by the parent company that continue to be litigated in court to this day. This is obviously the kind of scenario you want to avoid.
When Pfizer unloaded Zoetis, it gave the company a balance sheet with a moderately higher than usual debt load. Zoetis carries $3.6 billion in debt, and it has been gradually repaying it over the past two years of being a public company. The issue here isn’t that Zoetis will face bankruptcy or something like that, but rather, that some of its growing profits will be used to pay off pre-existing debt obligations rather than grow the business. That’s the kind of thing that turns a 13% annual growth company into a company with 11% annual growth. Not a crisis, but not welcome news.
Of course, because Zoetis is growing at such a fast rate, the debt gets easier to pay off. In much the same way that a $50,000 student loan obligation gets easier to handle when a person goes from making $60,000 in year one to $110,000 in year five, Zoetis will find its $3.6 billion obligation easier to handle when it makes $1.4 billion in profits in 2019 compared to the $700+ million in annual profits now.
I mention this not to say that the solvency of Zoetis is in question, but rather, to suggest that some type of discount should be applied to the price of the company’s shares. That is not what is happening right now. It is trading at almost 40x earnings. I would not consider it a fair shake to buy this company unless it were trading at 25x earnings or less, and value investors probably ought to get interested in the company around the 20x earnings mark.
You don’t want to fall into the recency bias trap of the past few years where you say, “Everything’s been going up. I’ll never see those kinds of lower valuations again. I should just pay up.” Companies with smaller, concentrated niches like Zoetis tend to come down quite substantially in price during stock market corrections because a lot of people don’t consider them (due to their smaller economics of scale) when flight to safety is on the mind.
If someone wants to make a buy-and-hold for a very long time investment, it can be wise to wait for a pullback and then look to companies like Zoetis during a recession. Companies with dominant positions in small niches see their stock prices get cheap in a way that the Nestles and Coca-Colas of the world do not during moments of extended market pessimism, and that is why it is useful to be aware of these types of investments in addition to the obvious blue chips.
It is a three stage process. You identify the companies like Zoetis that are very strong, but don’t get much coverage because their sector is small compared to the larger arenas that a lay man can easily understand. Then, you establish a price at which there is something resembling a margin of safety. Knowing that Zoetis is a company that meets these conditions is not enough; you need to buy it closer to 20x earnings rather than 40x earnings. Then, you need to put yourself in a position to have the cash on hand and actually execute on it when the moment arrives.
Originally posted 2015-03-29 21:06:42.