Like many other investors, we are drawn to businesses which are successful in a specialist niche. This largely boils down to the longevity of high return on capital (RoIC) at maturity, because the company’s ‘moat’ is less likely to come under heavy attack from larger competitors due to the constraining element of the size of the niche. This allows for an attractive, if relatively unexciting, investment which can deliver sustained free cash flow to be returned to shareholders or used to expand into adjacencies (though the latter comes with higher risks as the company steps outside its established franchise).

These investment cases move into exciting territory if the niche starts to see accelerated growth because of the outsized positive impact that enhanced growth rates at high return on capital have on valuation (example shown in the table below). The 10% RoIC business that can sustainably grow at 5% rather than 2% sees only a 25% uplift in its valuation, whereas the business delivering 30% RoIC theoretically sees ~80% uplift.

Figure 1.  Sensitivity table showing uplift to ‘fair’ valuation multiple for a business at varying return on capital & growth assumptions[1]

Source: River and Mercantile Asset Management LLP.

We hold several stocks which possess this upside skew to valuation from a boom in demand, with consolidated supply-side dynamics following a modest growth period. Talgo’s energy efficient high-speed trains, with wider and lower coaches, are more profitable for rail operators and therefore more likely to be selected by financially-incentivised customers; liberalisation of the European rail market makes market share gains more likely over the next decade, compared to the prior status quo of national monopolies. Owens Corning today finds itself in a 3 player market producing insulation materials for residential properties; for years a low growth and unglamorous industry but now essential to improving building efficiency and US decarbonisation efforts. Or, staying on the decarbonisation theme, Danieli’s electric arc furnace steel plantmaking equipment has previously been the minority form of steel production compared to blast furnace for cost reasons, but looks set to expand rapidly due to its lower carbon footprint. We cover the latter in more detail within a separate note.