This article originally ran April 28, 2004. It has been updated.
The brilliant business analyst and writer Peter Drucker has made me a lot of money over the years. The 95-year-old dedicated his professional life to an engaging and exhaustive exploration into how organizations succeed and stumble. His insights double as a blueprint to market-beating investing.
I want to share with you a key Druckerian principle that has helped me find some fantastic small-company stocks in my newsletter service, Hidden Gems.
Drucker believes that most people and, by extension, most companies are terribly unfocused. They have too many loves to satisfy and too few commitments. They dabble here, dally there, and fail to master anything. Peter Lynch, the greatest mutual fund manager of all time, called this phenomenon di-worse-ification. Drucker hates it just as much, naming it a primary driver of sustained mediocrity.
So, why do American companies diversify?
Loads of public companies actively diversify because, in the short term, all that variety and expansion generates buzz. Aggressive extensions into new markets make CEOs look ingenious. Buyouts, product launches, and new divisions are the stuff of an emerging empire. They grab the headlines and turn executives into visionary white-horse heroes. And that's delicious to investors targeting quick-hit investment gains.
But what about the long run? After all, what are the chances that American audiences will, for example, give a damn about Paris Hilton in five years? The long run is won by those who pursue excellence through their specialized talents. Take, for example, athletic-shoe designer Saucony (Nasdaq: SCNYB ) . The company maintains a tight focus on making high-quality running shoes. Boring! Where's the sex appeal? Where's the glory?
Well, the company learned that sex appeal doesn't often deliver permanent value. In the 1990s, Saucony took a dangerous detour into the bicycle business. Management felt its running shoes gave it permission to enter into the expanding market for sports equipment. Whoops! Executives underestimated the complexity of the business, and the move dropped the stock from $50 to $5. Ever since, Saucony has maintained the discipline of focus. Hidden Gems analyst Zeke Ashton recommended the stock in August 2003. In February, management elected to pay out a $25 million special dividend to shareholders rather than use the capital to expand. Ashton's recommendation is up 163% for our members.
The only stock to outperform Saucony in Hidden Gems is another disciplined small company that has risen 187% since last November. Middleby (Nasdaq: MIDD ) is now the leader in commercial ovens for restaurant chains. It wasn't always so. In the 1990s, Middleby was getting picked apart by competition. It was a tiny public company, capitalized at less than $100 million, yet it was trying to win the markets for everything from restaurant deli cases and refrigerators to mixers and blenders to the kitchen sink. The stock was left for dead, selling off more than 50% to below $5.
Then a strange thing happened. Rather than count on expansion to save its hide, Middleby's board of directors installed new management, which aggressively abandoned product lines. CEO Selim Bassoul simply walked away from 25% of the company's sales, choosing to focus all energies on its high-margin commercial ovens. Just as with Saucony, so too with Middleby: Executives chose to pay out a special dividend rather than plow cash into expansion.
The power of focus
Operational focus is crucial to the success of most every small company in the world. Yet few small-business leaders practice it. In Hidden Gems, it's my goal to help you find the most disciplined companies, poised to become Peter Lynch's next great 10- and 20-baggers. The next monster winner among small caps will be a company focused like Starbucks (Nasdaq: SBUX ) with coffee. Wal-Mart (NYSE: WMT ) with discount retailing. Moody's (NYSE: MCO ) with commercial credit ratings. Pfizer (NYSE: PFE ) with pharmaceuticals. eBay (Nasdaq: EBAY ) with auctions.
When these companies were small caps, they had enough capital to expand into wildly diverse product and service categories. Instead, with attractive opportunities to grow organically, they drilled down into their core business, innovated within a defined space, scavenged for economic efficiencies, and made their stockholders rich. Focus, you see, is how competitive advantages are gained, how defensive moats are carved, how commercial niches are dominated, and how long-term margins of safety are widened for investors.
In my experience, the small companies you'll want to own are more likely to expand dividends than product lines. They're more likely to buy back stock than buy up competitors. Meanwhile, their failing competitors will forever look outside for growth. Even with a core business growing 15% or more, they'll blow money on the new-new thing, lose sight of their unique talents, and fall behind.
Don't invest in the jack-of-all-trades. In fact, promise me that the next time you go in search of truly great small-cap stocks, as we do every day in Hidden Gems, you'll remember this Italian proverb:
Often he who does too much does too little.
As with each of us, so too with the companies we invest in. If you want to find the next stock to rise 10 times in value, you won't find it glad-handing every new opportunity. Peter Lynch knew that. Peter Drucker wrote about it extensively. Heed the words of the masters and let's beat the market.
Take a no-risk free trial of Hidden Gems and read up on Tom's latest recommendation. It's a tightly focused small company that Tom believes will be a long-term market beater. For your free trial,click here.
Fool co-founder Tom Gardner owns shares of Pfizer. The Motley Fool has a disclosure policy.