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:

  1. Life Sciences: For example, the supply of blood testing instruments and consumables used in hospital laboratories, usually under long-term service contracts.
  2. Seals: For example, the supply of seals used in the repair of hydraulic cylinders found in construction equipment, dump trucks, bin lorries and forklifts.
  3. 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.

  1. 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).
  2. 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.
  3. 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.
  4. 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.

Comments

Hi Richard

Interesting to see what you conclude in terms of whether they are cheap enough.

Diploma made it onto my screen of '19' but I bumped it down the pecking order in terms of companies to look at because they were only 10-15% off a 5 year high, whereas other candidates had a much bigger 'discount' to their 5 year high price.

The chart is as scary as scary can be Yorkiem, but I long ago made a decision to ignore charts :-)

You're right though. I have real difficulty contemplating anything over a 10 year PE of 16 (giving it room to go up to 20ish) so this one's going to be something of a dilemma for me. And with the market so high I'm afraid that's the 'new normal'. If only I'd come across Diploma in 2008... Then again you can say that about many shares can't you...

Exactly! The lesson that I'm slowly learning is that a value investor needs 'patience, patience and more patience'

I'm looking at Unilever at the moment because it ticks all of the boxes, but it still looks a bit pricey (= not sufficiently cheap) on a 10 year PER of 17x.

The current price is around 1850p, but was trading as low as 1250p some 24 months ago. To me this is a kind of Buffett share, and if I had picked up on it two years ago, I would be sitting on a 50% gain on a share that I would be happy to hold for a long, long time. Hindsight is a wonderful thing!

I think it boils down to one of your previous posts where there was a discussion about whether quality or price comes first. I'm increasingly of the opinion that the quality threshold should not drop, but you need to wait for the right price...patience, patience and more patience.

There's a great Ben Graham quote that sums up what you are saying (from the Intelligent Investor):

"Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions"

They'll be writing case studies about Unilever if the ceo keeps it up. He's got a very interesting style - not at all profit first. Back to basics business sense - put the customer first etc.

Well, it looks like I made a reasonable call on DPLM after all. Fancy that!

Now, if only my PIC (Pace) suggestion wasn't such a gaff. Despite showing good prospective prospects, PIC was hammered because of its exceptional charge on business closure, and its unexpected announcement that a customer had delayed a purchase. PIC still seems to have a good growth story behind it, and it trades on a PER of about 7. Since I first started mentioning it, I realised that it is higher risk than I first thought. The balance sheet is more geared than awhile ago, and I misjudged how risky high tech stuff can be. I think potential investors have to ask themselves these pivotal questions: do investors still believe in its growth story, that the customer delay truly is only a delay, and that the recent mishandling is excusable? If so, then PIC will prove a steal. There is risk, there is reward. We may look back and see how PIC was an "obvious" bargain. Then again, we may not, and its reputation as a "serial disappointer" may remain intact.

As regards the PE10 calc, I think one must be cautious about how one applies it. It should be OK for a "cigar butt" company, but not if the company is a true growth company. For a company like DPLM, you have to ask yourself to what extent it is cyclical, whereby you are paying for temporary good earnings, and to what extent it is growth, whereby PE10 is rather meaningless. DPLM has an excellent balance sheet, and it is innovative, so there is reason to suppose it will grow for many years to come. So judging it on a PE10 does, of course, make it look expensive. Yet it has a reasonable rolling PER of 13 (well, it did before today. The price has skyrocketed on recent news).

Same deal with ULVR (Unilver). Unilever is a far safer company to invest in, and trades at a similar PE to DPLM. It is a risk/return thing, though. DPLM has a much greater potential to gallop, and a greater potential to loose investors money. My response to someone saying that ULVR is on a PE10 of 17x is: "yes, it's a safe quality company whose revenues and profits I would expect to increase slowly over time, what else would you expect?". It is trading on a PER of 13, not prohibitive for a company of such quality. ULVR is a defensive company, not a raggedy cyclical one, so you can't really expect ot pick it up for a PE of 5. Maybe one day, if the markets take a horrendous dive and ULVR makes so many mistakes that its former quality is destroyed, you'll see it. But I think you'll be waiting a long time for that to happen, unrealistically so.

Hi Mark, well done. I agree the ten year PE is of limited use if you think a company will keep growing as it values the shares as if the last ten years were typical, when earnings are very low compared to future profits if the continued growth scenario comes to pass.

Another way of looking it though, is as a conservative measure. It's unusual for companies to grow rapidly for a decade or more so generally speaking companies with high 10 year PEs should be avoided. If we assume the company won't grow, despite all the positive signs, then we can buy at a reasonable price with some confidence that even if our vision doesn't pan out we should do OK (i.e. what value investors call a margin of safety). I don't like depending on a particular set of future events (i.e. continuous growth) for profit.

The question is, where do you draw the line? What is a reasonable price for a company that fits the champion template? I've been using long term PE of 20 as a rule of thumb, so Diploma was already looking expensive at 24. If I was very confident, I might break that rule and that is why I'm planning to take a closer look at the company.

Today's 16% rise doesn't help!

Mark/Richard

Interesting discussion re PE10. I'll second the question of 'what is a reasonable PE10'? At 1250p, ULVR was a screaming buy (in hindsight) on a PE10 of 12x, but is it at 1850p on a PE10 of 17x?

There must be some academic studies out there that have looked at it? Good for Graham's cigars, less so for a Buffett?

For the record, I've dipped my toe into ULVR as they ticked all of my boxes (apart from PE10). I anticipate holding them in my SIPP for at least three decades!

AFAIK Benjamin Graham invented the PE10. He vacillated between a max of 16 and 20 depending on which edition of Security Analysis you read. It was a rule of thumb, but based I think on the earnings yield. In other words discounting future growth, a company on a PE of 16 would return the reciprocal of its PE or just over 6% on its purchase price per year. A company on a PE of 20 would return 5% (i.e. if you pay 20 times earnings and earnings stay the same in future you get 1/20 of your earnings back every year). He couldn't see why you'd get out of bed for anything less than that - however highly you regard the company.

Keith Anderson, now a lecturer at the university of York, did his doctorate on the PE ratio in the UK and found that long term PEs are far more predictive of future returns than single year PEs: http://www-users.york.ac.uk/~ka536/ - like all such studies he demonstrated the lower the PE the better. However he wasn't considering quality factors like ROE or F_Score in tandem with the PE.

Greenblatt's magic formula suggests more expensive companies can be extremely profitable if they are also high quality (based on return on capital) but he uses a one year measure of earnings power (earnings yield) not the long-term PE.

Strangely there has been very little research into long-term PE's. Keith thought his was the first since Graham (apart from Robert Shiller's famous CAPE which measures the value of the market, not individual companies). One problem I suspect is the data. If you want to test a 10yPE over, say, 20 years you need a reliable 30y dataset. I don't know how long that kind of data has been available.

I think it's reasonable to suppose strategies that combine the long-term PE and quality measures would be very successful in digging up value stocks, which is why I made it the basis of selection for the Thrifty 30 portfolio (with a smattering of net-nets thrown in for good measure).

So, horses for courses then. Thanks for the link to Keith Anderson - I hadn't considered his work for a while, but it's always work a revisit. Onto a long overdue rejig of my portfolio allocation and Rules...gulp.
.

Good luck with it Yorkiem. We're all inveterate tweakers :-)

Lovely looking company. Seems pricey after the trading statement though. :(

[...] Diploma makes its own case [Beware: Stock picking!] – iii blog [...]

Richard, thanks for the Anderson link, I'll take a look at that.

Yorkeim, "So, horses for courses then." Exactly! 2010 marked a bit of a turning point for me, when I finally realised that I wasn't as smart as I thought I was ;) It's always a dilema - should I go for a Graham statistically cheap approach, or should I move more towards a Peter Lynch approach? The problem with Lynch is that it requires an investor to know more, and is a much softer art to acquire, something which is a bit alien to my mindset, too. I'm steadily acquiring more of an interest in his way of thinking, and I think I should reread his books.

I'd also like to point out that a PE10 can be dangerous, too. If you look at a company like HMV, then it is very cheap on this basis (mind you, it's on a PER of 2, so it's cheap even by last year's PER). But it has a declining business, and there's every chance that it will become bankrupt. In a case like this, the PE10 will get you into trouble, not bail you out of it. The saving grace is that HMV has a bad balance sheet, so a cautious investor would probably give it a wide birth. One thing that Richard mentioned in an interview (I'm pretty sure it was Richard), was that retailers often have fixed leasing obligations which don't show up on the balance sheet. So HMV is in even worse shape than is immediately apparent.

I think that PE10 seems most appropriate for cyclical companies, like house builders. Companies that are in structural decline, or growth, tend to give the wrong answer.

Take care, guys.

Thanks Blippy. That's a really good summary. The statistics provide a degree of certainty, while the soft stuff can prove an endless distraction. You've really got to be committed to go down the Lynch/Buffett road.

You're right about the PE 10, but it begs the question. What tools do you use to assess a growth company? The problem is you've already made a judgement before you even start the valuation - that a company will go on growing.

I think it's easier to spot a 'bad' company because once they've gone bad the stats are there for all to see in the balance sheet and in the case of operating leases ('twas me who said it), in the notes to the accounts.

Spotting a 'great' company is much tougher. You'd need to find out its market share, the size of the overall market, decide whether it has a defensible competitive advantage. This information is rarely published in annual reports, it's not in screeners, and if the company even knows, it's probably highly protective of the information. These are also some of the most dodgy stats out there. Who defines the company's market - the company usually, and its massive of course! Then you need those stats for its competitors as well.

I know I've been banging on about it, but the Hidden Champions book is exceptionally good on the soft stuff.

Even so, I feel much more comfortable overriding the PE10 for HMVs (i.e. companies I perceive as troubled) than the Diplomas (potential hidden champions).

It's not just us that suffer this problem. Buffett is constantly ruling out investing in high growth companies because he just doesn't have anything to add to the analysis that's already out there. In other words - for all he knows Apple, say, is correctly valued. I say Apple, because he mentioned it in this context just today: http://www.bloomberg.com/news/2011-03-21/buffett-says-less-sure-about-ou...

Hi Blippy

You were doing so well until you mentioned HMV! I think there is lots of interesting stuff to play out on this one, but it's giving me an education in "I finally realised that I wasn’t as smart as I thought I was". Life is one long journey and all that...

In terms of Rules and parameters, I think that I'm heading down a two-pronged road (don't they call it bi-polar these days?) with road one leading me to "classic undervalue" (Graham, Net Nets, low PE10) and road two leading me to "long-term value creation" (Buffett, Greenblatt, don't lose money etc). This can be neatly summarised by Richard's reworked screens, with my road one equating (ish) to his Bargain and Thrifty screens and road two equating (ish) to Nifty and Hidden Champs. Richard - imitation is best form of flattery ;)

So, yes, horses for courses and more importaantly, two lots of Rules or at least different relative weightings (work in progress) for my two roads.

In terms of retailers, I believe that there are proposed changes to accounting rules which will force companies to capitalise future lease obligations on the balalnce sheet - ie retailers' balance sheets are going to look even worse than they do currently - which could be an opportunity for value investors if the sector becomes even more unloved due to a technical accounting change...but that's a tad contrarian!

We're all imitators Yorkiem! I'll be interested how you fare with the Buffett/Greenblatt high road. It seems like the holy grail to me, the perfect company at a reasonable price but I'm much more comfortable sifting among the dregs. I'm not saying it very well, but I think the kind of problems facing struggling companies are suited to statistical analysis but growth is much harder to pin down. See: http://blog.iii.co.uk/targeting-diploma/ and the comments afterwords.

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