Investing for long term wealth creation – part three

In our third article on long-horizon investment strategy, we focus on two more industries benefiting from non-cyclical trends to growth: animal health care and manufacturing technology.

Animal medicines: catering to the rise of the fur children

With a general global trend towards high-density urban and independent living, more and more people are finding comfort in companion animals.

According to a Nielsen survey conducted by Harris Poll, 95% of owners view their pets as extended members of their families and 33% of pet owners (and 41% of millennials) noting that money is no object when it comes to spending on their pets.¹

Within this sphere, Idexx and Zoetis are market leaders in different parts of the animal health value chain. Idexx focusses on animal diagnostics and related equipment within veterinary practices, whilst Zoetis focusses on manufacturing animal medicines and drugs.

In terms of competitive advantages, both companies are prominent in their field; with Idexx alone accounting for 80% of the industry’s research and development expenditure for animal diagnostics. Idexx’s business model is very sticky as there are high switching costs involved; clients have committed significant capital to purchase the specialised equipment and rely on Idexx’s market-leading knowledge and support, reliability and reputation. Customer retention is around 98%.^₂

Zoetis’ business model also appears stable with largely recurring revenues; over 80% of profits are derived from the sale of consumables and repeat prescriptions².

In terms of capital allocation, both companies are very cash generative with significant operating margins and return on capital. There is also an ongoing strategy of reinvesting free cashflow back into the business, along with any excess cash above reinvestment requirements generally returned to shareholders.

Given their supportive and sustainable cash flows, generated under stressed market conditions, we believe these companies may also lose less than the general market.

Manufacturing technology: opportunities in an intelligent future

Products and machinery are becoming smarter and more sophisticated by the moment. They need sensors to accumulate data, connectors to connect devices to each other and to the internet, and vision products to capture unstructured data and be intelligent. Good examples of this type of company are Keyence, which produces sensors and other devices used for measuring and monitoring, and Amphenol, which manufactures a range of cables and connectors. Both companies have a broad exposure to a number of exciting structural growth drivers, including the Internet of Things, electric vehicles, industrial automation, machine learning, and robotics.

To illustrate the point, the information requirement for cars is exploding due to increasing safety, infotainment, and fuel-efficiency requirements. Wireless charging smartphones have two to three more connectors than plug-in charging phones. Industrial warehouses are now built with hundreds of robots and thousands of cameras and sensors to effectively pick, pack, and ship products for e-commerce. There are numerous and ever-expanding niches throughout all of these processes for the kind of products sold by Keyence and Amphenol.

However, perhaps the strongest arguments for both companies are their competitive advantages. They are both suppliers renowned for their product quality, reliability, and customer service. Many of their products are mission-critical to the performance and safety of the end device or machine, yet they are typically a low component of the overall cost of manufacture. That gives them stable and strong pricing bases from which to operate.

Both companies are also extremely efficient on the cost side; largely due to the efficacy of their lean business models. Amphenol is highly entrepreneurial and has a decentralised management structure. Keyence runs an outsourced fabrication model (a.k.a. “fabless”) where the manufacture of components is contracted out; i.e. it does not own factories. Their operating model confers them a unique advantage; the ability to be both highly innovative (with 70% of their products being world firsts) and customise at scale by offering high value added solutions to around 200,000 global customers. This approach is reflected in operating margins of around 55%³

Both companies spin-off considerable free cashflow and, with low capital reinvestment requirements, are presently in an enviable position of being able to choose between organic growth, completing accretive acquisitions, or returning cash to shareholders on an ongoing basis.  

¹ Nielsen, Nothing is too good for Fido: pets that have it all, August 2017
² Investor’s Business Daily, Millennials Aren't Killing This One Health Market, August 2017
³ Keyence annual report 2018