Insight Article Desktop Banner
 
 
Global Equity Observer
  •  
August 26, 2024

Niches: Searching for roads less travelled

Insight Video Mobile Banner
 
August 26, 2024

Niches: Searching for roads less travelled


Global Equity Observer

Niches: Searching for roads less travelled

Share Icon

August 26, 2024

 
 

One of the benefits of conducting fundamental research with a well-resourced investment team is the capacity to search far and wide for investment candidates. While many of the companies we own are large businesses with well established, familiar brands, in our experience, excellent companies and investment opportunities can also be found by looking at players focused on specialised niches — particularly those that play a critical role within a market and enjoy close customer relationships. Undeservedly – but perhaps not surprisingly – these companies often sit outside the market limelight, and can fall between the cracks of sell-side coverage.

 
 

The strengths of niche operators
By niche we mean a specialist market that is served by a modest number (preferably a handful!) of competitors. For a company, there are some clear benefits to successfully implementing a focused niche strategy. By virtue of a concentrated market structure, a niche operator should be able to enjoy excellent margins and therefore likely superior long-term returns. The fact that the markets they focus on tend to be fairly modest in absolute size can also reduce the risk of significant competition, as larger and seemingly juicer opportunities are to be found elsewhere. A further benefit of modest size is that there tends to be fewer anti-trust issues.

Arguably most important, however, is that a successful niche operator is likely to have a culture focused on profits and returns, and not on sales. It will often have a more focused investment strategy, crucially also for mergers and acquisitions (M&A). By their very nature, M&A deals will tend to be smaller and “bolt on”, rather than higher-risk jumbo or “transformational” acquisitions. Deal rationales will often be more focused on important questions such as “why is this an attractive market to operate in for the long term?” rather than the toxic “what is the EPS-accretion that a spreadsheet spits out?”

A criticism levied at niche operators is that they simply lack ways to grow, especially if they already dominate a market segment. However, the reality we typically observe is more nuanced. Niche operators often successfully outcompete less focused peers who are also busy operating in far larger but structurally less attractive end markets. Well-run companies can also be in a position to grow the overall market they operate in. They operate from a position of strength, with the management resources to innovate in new areas and expand the range of products available or the potential customer base.

Successful niche operators
Niches can form high quality pockets within larger, more mature and competitive sectors. From the perspective of an investment prospector, the securities exchanges form a rich vein of excellence within the financial industry. They operate essential and difficult to displace market infrastructure, typically enjoying very deep moats from a combination of branding and network effects. As a result, securities exchanges can deliver very attractive profitability and high returns – financial plumbing may not be particularly glamorous but it can be lucrative.

For a company, an appreciation of the benefits of being a niche operator can result in a deep-rooted culture of continuous improvement, even as the underlying business increases in size. A U.S. tech company we own has industrial roots, but today its revenues are split approximately 75% vertical software and 25% medical & water products.1 The company is focused on operating “market-leading business in defensible niches” and has consistently become a higher quality business, as measured by returns on operating capital, profitability, cash generation and markedly reduced cyclicality.

By their very nature, niche operators can often play a vital but less visible role. One U.S. business services company we own plays a key position as the dominant proxy infrastructure provider. The company is deeply embedded in the U.S. financial markets, as can be seen by its very high and consistent recurring revenue retention rate, which has averaged 98% over the last 15 years.2 We think this is a company that probably is “under-researched” by Wall Street, something almost certainly not helped by the fact that while it considers itself a fintech, and largely serves financial customers, it is classified as an industrial!

Recipe for compounding
Our investment philosophy focuses on high quality companies with a strong and resilient compounding outlook. By focusing on attractive niches, well-managed companies can carve out consistently profitable, high return businesses. In our experience, management teams with an appreciation for niches are often good custodians of shareholder capital. In any given year, the results are unlikely to blow the lights out, but a taste for niches is a good recipe for strong, consistent, long-term compounding.

 
 

1 Source: Company reports and FactSet.
2 Source: Company reports and FactSet.

 
richard.perrot
Executive Director
International Equity Team
 
 
 
 

Risk Considerations

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small- and mid-capitalisation companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. ESG strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.

 
 

DEFINITIONS

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.

Return On Capital (ROC) is a measure of a company’s efficiency at allocating the capital under its control to profitable investments, calculated by dividing operating income by total capital.

IMPORTANT INFORMATION

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

A separately managed account may not be appropriate for all investors. Separate accounts managed according to the particular Strategy may include securities that may not necessarily track the performance of a particular index. A minimum asset level is required.

For important information about the investment managers, please refer to Form ADV Part 2.

The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.

This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

This material is not a product of Morgan Stanley’s Research Department and should not be regarded as a research material or a recommendation.

The Firm has not authorised financial intermediaries to use and to distribute this material, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this material is appropriate for any person to whom they provide this material in view of that person’s circumstances and purpose. The Firm shall not be liable for, and accepts no liability for, the use or misuse of this material by any such financial intermediary.

This material may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this material in another language, the English version shall prevail.

The whole or any part of this material may not be directly or indirectly reproduced, copied, modified, used to create a derivative work, performed, displayed, published, posted, licensed, framed, distributed or transmitted or any of its contents disclosed to third parties without the Firm’s express written consent. This material may not be linked to unless such hyperlink is for personal and non-commercial use. All information contained herein is proprietary and is protected under copyright and other applicable law.

Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

DISTRIBUTION

This material is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

MSIM, the asset management division of Morgan Stanley (NYSE: MS), and its affiliates have arrangements in place to market each other’s products and services.  Each MSIM affiliate is regulated as appropriate in the jurisdiction it operates. MSIM’s affiliates are: Eaton Vance Management (International) Limited, Eaton Vance Advisers International Ltd, Calvert Research and Management, Eaton Vance Management, Parametric Portfolio Associates LLC, and Atlanta Capital Management LLC.

This material has been issued by any one or more of the following entities:

EMEA

This material is for Professional Clients/Accredited Investors only.

In the EU, MSIM and Eaton Vance materials are issued by MSIM Fund Management (Ireland) Limited (“FMIL”). FMIL is regulated by the Central Bank of Ireland and is incorporated in Ireland as a private company limited by shares with company registration number 616661 and has its registered address at 24-26 City Quay, Dublin 2, DO2 NY19, Ireland.

Outside the EU, MSIM materials are issued by Morgan Stanley Investment Management Limited (MSIM Ltd) is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

In Switzerland, MSIM materials are issued by Morgan Stanley & Co. International plc, London (Zurich Branch) Authorised and regulated by the Eidgenössische Finanzmarktaufsicht ("FINMA"). Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland.

Outside the US and EU, Eaton Vance materials are issued by Eaton Vance Management (International) Limited (“EVMI”) 125 Old Broad Street, London, EC2N 1AR, UK, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority.

Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy. The Netherlands: MSIM FMIL (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008 Paris, France. Spain: MSIM FMIL (Madrid Branch), Calle Serrano 55, 28006, Madrid, Spain. Germany: MSIM FMIL Frankfurt Branch, Große Gallusstraße 18, 60312 Frankfurt am Main, Germany (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Denmark: MSIM FMIL (Copenhagen Branch), Gorrissen Federspiel, Axel Towers, Axeltorv2, 1609 Copenhagen V, Denmark.

MIDDLE EAST

Dubai: MSIM Ltd (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158).

This document is distributed in the Dubai International Financial Centre by Morgan Stanley Investment Management Limited (Representative Office), an entity regulated by the Dubai Financial Services Authority (“DFSA”). It is intended for use by professional clients and market counterparties only. This document is not intended for distribution to retail clients, and retail clients should not act upon the information contained in this document.

This document relates to a financial product which is not subject to any form of regulation or approval by the DFSA. The DFSA has no responsibility for reviewing or verifying any documents in connection with this financial product. Accordingly, the DFSA has not approved this document or any other associated documents nor taken any steps to verify the information set out in this document, and has no responsibility for it. The financial product to which this document relates may be illiquid and/or subject to restrictions on its resale or transfer. Prospective purchasers should conduct their own due diligence on the financial product. If you do not understand the contents of this document, you should consult an authorised financial adviser.

U.S.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

Latin America (Brazil, Chile Colombia, Mexico, Peru, and Uruguay)

This material is for use with an institutional investor or a qualified investor only. All information contained herein is confidential and is for the exclusive use and review of the intended addressee, and may not be passed on to any third party. This material is provided for informational purposes only and does not constitute a public offering, solicitation or recommendation to buy or sell for any product, service, security and/or strategy. A decision to invest should only be made after reading the strategy documentation and conducting in-depth and independent due diligence.

ASIA PACIFIC

Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this material have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this material shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This material is disseminated by Morgan Stanley Investment Management Company and should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore.   Australia: This material is provided by Morgan Stanley Investment Management (Australia) Pty Ltd ABN 22122040037, AFSL No. 314182 and its affiliates and does not constitute an offer of interests. Morgan Stanley Investment Management (Australia) Pty Limited arranges for MSIM affiliates to provide financial services to Australian wholesale clients. Interests will only be offered in circumstances under which no disclosure is required under the Corporations Act 2001 (Cth) (the “Corporations Act”). Any offer of interests will not purport to be an offer of interests in circumstances under which disclosure is required under the Corporations Act and will only be made to persons who qualify as a “wholesale client” (as defined in the Corporations Act). This material will not be lodged with the Australian Securities and Investments Commission.

Japan

For professional investors, this material is circulated or distributed for informational purposes only. For those who are not professional investors, this material is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”).  This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions.  All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.20% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This material is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

 

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The contents presented herein are provided in Singapore by Morgan Stanley Investment Management Company (Unique Entity Number 199002743C), which is regulated by the Monetary Authority of Singapore. Any asset management or other services are provided in Singapore by Morgan Stanley Investment Management Company and you should contact Morgan Stanley Investment Management Company in relation to any questions you may have on the information presented on this website.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Subscriptions    •    Privacy & Cookies    •    Your Privacy Choices Your Privacy Choices Icon    •    Terms of Use

©  Morgan Stanley. All rights reserved. Morgan Stanley Investment Management Company (Unique Entity Number 199002743C) is regulated in Singapore by the Monetary Authority of Singapore.