This group is defined by a set of commonalities in varying stages of deployment and maturity. The core principle behind these businesses is the idea that a portfolio of small-cap industrial businesses, independently run and focused on niche markets, can be housed under one parent company's operating philosophy to produce less cyclicality, rapidly evolving and expanding growth opportunities, higher margins, and a lower risk profile than their large-cap or small-cap alternatives.
This group includes Danaher (DHR), with a market capitalization of $32 billion, Roper Industries (ROP), $8 billion market cap, and Colfax (CFX), $1 billion cap. After reading a number of recent transcripts of earnings calls from each company, some common themes emerge.
- A portfolio comprised of niche industrial companies operating in areas with low levels of competition.
- Each discrete business requires low levels of capital expenditure requirements (Roper requires less than 2% of revenue).
- Each entity controls the end market and distribution for their products and offerings in order to maintain a client facing role and control of pricing.
- Management of operating businesses has clear incentive structures and the freedom to make efficient decisions within the framework of the parent company.
- Laser-focused financial and manufacturing oversight derived from the parent company.
- The consolidated excess cash flow generation of the basket of companies is the engine to reinvest in research and development, and to acquire entry into new markets.
Given these broad operating strategies, each of these companies has been able to produce revenue growth well in advance of the S&P 500. In Danaher and Roper's cases, this revenue growth has increased 4x and 5x, respectively, over the past decade.
Danaher is best known for its tremendous operating culture that grew out of exposure to Toyota's manufacturing practices. Renamed the Danaher Business System (DBS), no meeting with the company ever fails to mention the quality, profitability improvements and efficiency gains derived from this continuous re-evaluation of each discrete business. This dynamic view and control of capital efficiency allowed the company to invest $750 million during the 2009 downturn in growth and to further remove structural costs. In a business world where anticipatory behavior is rare, this action set Danaher up for the next leg of growth, including the acquisition of Beckman Coulter, a life sciences and diagnostic tools business, in 2011.
Don't look for self-branded products from any of these companies. With hundreds of them at Danaher, more than 30 at Roper, and a growing list at Colfax, the individual portfolio companies are left intact with their own names and much of the acquired managements. The parent company is there to lend capital, human resources, scale and a binding operating philosophy that varies among corporate cultures. Truck industry freight matching, water purification systems, auto tolling systems, radio-frequency utility meters, and medical imaging are just a sampling of the unique offerings from this group.
The smallest and least-mature public company of the three is Colfax. I included it because it is illustrative of the early evolution of Danaher and Roper. Colfax began a new stage of life in 1995 with an investment from Mitchell and Steven Rales, who also founded Danaher. The business began with the acquisition of two industrial pump companies and now includes a much broader portfolio of fluid-handling products. Like Danaher and Roper, these niche businesses were brought to heightened levels of profitability by a first-class operating structure. With improved cash flow, new acquisitions have entered the business into broader markets and expanded the selling process to a full-service orientation and away from a single-product offering. Most recently, Colfax has made a substantial acquisition of British-based Charter International, a leading supplier of welding and cutting equipment. This transformational deal triples Colfax's revenue run rate and broadens its portfolio in a step function, much like Danaher's humble beginnings with portfolio holdings such as Craftsmen tools.
So much of investing is knowing what to avoid. In the industrial group, there seems to always be a number of investments that look well priced but the business mix is filled with single-customer exposure and the selling of big-ticket capital goods that result in lumpy, unpredictable sales. This trio offers an alternative within the group, with smaller industrial offerings focused on secular trends within the global economy and a continuous cycle of growth to adapt to evolving market needs.