July 11, 2023
A common misconception we encounter in discussions with our investors relates to the apparent incongruence between the small cap nature of the Fund and the quality focused investment philosophy where a track record of profitability for many years is a key criteria. The question often posed is “are smaller companies not generally startups with short track records, with immature products and business models and hence riskier and more volatile?” While this may be true in an Australian context (nearly one third of the ASX300 Smaller Companies Index is loss making and the average constituent has a market capitalisation of US$1bn, only 1,500 employees and was founded in 1997), it is our view that in a global context small does not necessarily equate to lower quality.
To illustrate, the Fairlight portfolio currently has an average market capitalisation of US$15bn, every holding is profitable with an average of 10,000 employees and an operating history stretching over 40 years (including 4 companies that were founded in the late 1800s). Indeed, one of the core opportunities that the Fairlight Fund looks to exploit is the underappreciated and undiscovered nature of global small cap companies combined with surprisingly strong quality characteristics.
Spirax Sarco, a global leader in steam systems
A current holding that exemplifies the capacity for a smaller company to have the quality characteristics of a long track record and a mature, proven business model is Spirax Sarco, a UK based manufacturer of industrial steam systems and pumps. The business has been in operation for over 130 years, tracing its origins to a small firm of merchants (Sanders, Rehders & Co. or ‘Sarco’) founded in 1888 who imported German made steam traps into the UK. Today, the business employs over 8,000 people, serves 100,000 customers and has over 1,500 different products.
While steam systems may sound unexciting, they form a critical part of industrial manufacturing infrastructure in any use case that requires transfer of heat. Almost every food and beverage facility worldwide would require a steam system for example, and Spirax is the world leader in this niche. Spirax also enjoys the favourable industry characteristic that steam systems require; regular maintenance and replacement parts which provides a valuable source of recurring revenues.
As is often the case, the financials generated in a boring niche are exciting to Fairlight with Spirax boasting a track record of unbroken dividend growth stretching over half a century (see Figure 1) and an operating profit margin today of 25%.
What history can tell us about the future
The great challenge of investing is that all our knowledge and experience relate to the past, however all our decisions pertain to our view of future events. While history cannot predict the future, it is the experience of the Investment Team that it is a reasonably strong indicator (we have discussed the tendency for quality to persist in the past here). One heuristic that can be used for forecasting the longevity of an object is Nassim Taleb’s Lindy Effect, which states that the most probable future life span of an object is equal to the time it has already existed. Put simply, the longer something has been around, the more likely it will continue to persist into the future.
With the Lindy Effect in mind, it is instructive to revisit the history of Spirax Sarco. In its early days Sarco relied on the importation of German steam traps, however with the outbreak of the First World War the business was forced to design and manufacture its own. This initial design, the “Sarco No. 9 steam trap” was hugely successful and remained in production for over half a century. The design has since been further improved and as part of a recent factory tour Fairlight was able to witness steam traps still being produced today, over a century later. As long-term investors we take comfort in the knowledge that this business and its products have survived and prospered through booms, busts, world wars, technological upheaval and if the Lindy Effect is to be believed, will likely do so again for the next hundred years.
Competitive advantages in a historical context
An important part of Fairlight’s investment process is the evaluation of competitive advantages and culture. Given the intangible nature of these characteristics and our role as outsiders, a key risk is the misappraisal of their strength or sustainability, especially with the tendency for management teams to exaggerate and be overly promotional. In Spirax’s case, the multi decade, consistent execution of the same strategy provides inarguable proof points as to the strength of both the culture and competitive advantages. Today, Spirax’s key competitive advantage is its 1,200 strong sales force of technical engineers who provide advice and support to customers throughout the purchasing process. The assembling of this sales force around the globe has taken decades with the early roots of this direct selling strategy tracing back to the 1930s:
“Our whole policy has been to build up an organisation of technical representatives and engineers, capable of giving advice to steam users on all aspects of their plant and equipment.” - Spirax News (1939)
Culture, growth and greenwashing
Despite being in operation for over a century, we believe Spirax still has a long runway of growth ahead as an important contributor to global decarbonization efforts. The raising of steam by burning fossil fuels is a major contributor to global carbon emissions. In order to meet net zero targets corporations around the world will need to electrify their boilers and increase the efficiency of their steam systems; products and advice that Spirax offers. While some companies talk loudly about their environmental credentials to greenwash their stock prices, Spirax has an energy saving culture and track record of practical applications that date back far before global warming was cool. In 1907 the business was initially named the ‘Sarco Fuel Saving and Engineering Company’ and during the Second World War Spirax was engaged by the UK Government as the nation’s foremost experts in fuel efficiency to give lectures across the country to factory managers:
“Remember, ships were being sunk and lives lost bringing oil to this country to be wasted in boilers and process plants and heating systems. At the end of the war our engineers were the most knowledgeable group of specialists in the use of steam to be found in the world.”’ - Lionel Northcroft - Spirax Sarco Managing Director (1939 – 1968)
The Fairlight View
The Fairlight investment strategy is focused on global small and mid cap companies because we believe this cohort provides the opportunity to find companies that are both small enough to be underappreciated (and undervalued) by the market with long growth runways ahead of them, but large enough to possess the quality characteristics we require to reduce risk. With a track record of quality spanning over a century, and yet boasting many growth opportunities, Spirax Sarco meets Fairlight’s criteria perfectly.