Diploma makes its own case
And it looks like a good one
Diploma (DPLM) operates in three technical niches, with sales roughly evenly divided between them, and between Europe and North America:
- Life Sciences: For example, the supply of blood testing instruments and consumables used in hospital laboratories, usually under long-term service contracts.
- Seals: For example, the supply of seals used in the repair of hydraulic cylinders found in construction equipment, dump trucks, bin lorries and forklifts.
- Controls: For example, wiring and fasteners used in the defence, aerospace, motorsport, energy and industrial markets.
It’s sixth in my table of hidden champions which seeks out potentially great companies at reasonable prices. To rank as a hidden champion a company must have been highly profitable over the course of the last decade without using excessive leverage, and still have a market valuation I can at least imagine paying.
The numbers on my screen are enticing. Diploma has consistently good returns on equity (averaging 16%), without being highly leveraged (68% of its assets are funded by equity), although it’s on the pricey side (24 times average earnings over the last ten years). The earnings figure used in that valuation is extremely conservative though. Diploma’s F_Score is a thumping eight out of nine, implying 2010 was a very good year, at least in comparison to 2009.
The hidden champions strategy is inspired by the book, Hidden Champions of the 21st Century by Hermann Simon, which analyses the mainly German exporters that have driven globalisation (I’ll review the book when I’ve read the final two chapters).
By dint of their expertise in niche markets, which they’ve extended around the world, these companies have earned abnormally high profits for decades.
Actually, I’m going to let Diploma flesh out its credentials, because the strategies listed on its website could have been lifted directly from the hidden champions book.
- Resilience: Because Diploma sells a lot of consumables, for example the reagents used in its medical testing equipment, and service contracts as opposed to new equipment, recessions have less of an impact on sales. Its products, like seals, are used to repair equipment so demand is fairly continuous, and because Diploma is technically specialised it isn’t easy for customers to switch to low cost alternatives (I don’t know whether that’s because there aren’t any, or because it would be expensive to switch).
- High margins: Packaging products with services, like service contracts, or assembly, is a favourite hidden champion strategy because customers are prepared to pay extra for convenience and are less able to compare prices with competitors. That’s not to say hidden champions are price gougers, the customer must still think it’s getting good value.
- Strong management: Training and retaining staff also features strongly in Simon’s book. Staff turnover is lower at hidden champions with Hans Riegel, ceo of Haribo, the sweet manufacture taking the long-service award. He’s been running the company for 63 years. Diploma identifies 60 senior managers who have an average tenure of ten years.
- Soft diversification funded by its own resources: Diploma calls soft diversification ‘value enhancing acquisitions’, but I’ve stuck with Simon’s nomenclature here, which is easier on the eye. Because hidden champions operate in narrowly defined niches their growth prospects are limited unless they diversify. Some expand geographically; others set up or acquire businesses in related niches. Some do both, like Diploma. The trick seems to be to operate the new businesses fairly autonomously – as mini hidden champions.
Diploma has pretty much laid out the investment case. The only questions are do I believe it, and are the shares cheap enough?
Haribo aside, Diploma, like most hidden champions, does not supply a consumer product. Its products are almost invisible to us, forming a small part of a plane we might fly in, or the crane that is erecting a neighbouring office building.
And since my knowledge of controls, seals and life science equipment is minimal I can’t easily validate Diploma’s business model beyond noting its similarities to the successful hidden champion strategy.
But I can check the figures. You’d expect a company with strong management operating in niche markets and expanding using its own finances to have been consistently profitable and relatively unindebted in recent years. That’s what I’m going to double-check next.
About the author
Richard is companies editor of Interactive Investor and a columnist at Money Observer magazine. A keen private investor through his Self Invested Personal Pension, he manages two virtual portfolios. The Share Sleuth portfolio is a hand-picked collection of mostly small-cap value shares, while the Nifty Thrifty is a mechanical portfolio designed to pick large, successful companies at cheap prices.
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