While names like General Electric and Boeing are familiar, that doesn't mean they should be automatically in your portfolio. In fact, their lesser-known peers in the industrial sector, such as TransDigm (NYSE:TDG), Graco (NYSE:GGG) and Gentex (NASDAQ:GNTX), are much better investment choices, given that they dominate their respective niches.
The proof of the pudding is in the eating
The financial track records of niche dominators speak volumes about their attractiveness.
TransDigm, a supplier of small, niche aerospace parts, has increased its revenue in every year for the past 10 years. The gross margin for Graco, a manufacturer of viscous pumps and sprayers, has been consistently above 50% for the past decade. Gentex, best known for its auto-dimming mirrors, has delivered a return on invested capital, or ROIC, in excess of 15% from 2010 to 2013. All three companies have been profitable every year for the past decade.
Why niche dominators win
Niches dominators usually do well for two reasons. First, the niche market is relatively small compared to the overall industry. As a result, industry giants with deep pockets don't think it is worthwhile to compete since the niche market offers little revenue upside relative to their top-line numbers.
Second, the niche dominators already enjoy significant cost advantages associated with spreading huge fixed costs over a larger revenue base. New entrants will find it difficult to steal market share from incumbents to a point where they can be sufficiently price and cost competitive.
With respect to the second point on high customer captivity which deters competitors, all three of these niche dominators boast high customer switching costs.
Automakers spend millions of dollars each year on advertising, but any accident involving their cars can undo all the good work, and be extremely damaging to their reputations. Gentex's auto-dimming mirrors help to increase driver safety, by eliminating potentially vision-impairing glare that could lead to accidents.
Still on the topic of cars, first impressions count when it comes to making the automobile purchasing decision. Graco's equipment (used in the pumping, metering, and dispensing of various types of fluids, paints, and coatings), plays an important role in ensuring that botched paint jobs don't make an automobile less appealing than it should be.
Moving on, aircraft safety is paramount as thousands of lives are at stake with each flight. More importantly, the long and tedious process in qualifying new aerospace suppliers and the relative low cost of niche aerospace parts, as a proportion of the total aircraft cost, suggest that TransDigm's customers would rather stick with the status quo.
The mission-critical nature of their products makes it less likely that customers of the three niche dominators will switch to other suppliers. For example, TransDigm is the single supplier for three-quarters of the products it manufactures.
Good capital allocation makes all the difference
The most common concerns that investors have about such niche players is that growth opportunities are scarce and management of these companies tend to invest excess capital in unprofitable opportunities outside their core competencies. As a result, niche dominators either return excess capital to shareholders or reinvest the cash into their core businesses if growth opportunities still exist.
Graco and Gentex have rewarded their shareholders with dividends every single year for the past decade. Both had reduced their share count over the past 10 years. Graco saw its number of shares outstanding reduced from 70 million in 2004 to 63 million in 2013; Gentex currently has 144 million shares outstanding versus 156 million a decade ago.
In the case of TransDigm, it's expecting a growth rates in the high single digits for both its commercial original equipment manufacturers and commercial aftermarket segments. Stable passenger traffic supports TransDigm's aftermarket business, while new aircraft platforms such as the Boeing 787 create growth opportunities for its commercial OEM business. In addition, although TransDigm doesn't pay regular dividends like Graco and Gentex, it has returned excess capital to shareholders periodically, having paid out special dividends in 2012 and 2013, respectively.
Foolish final thoughts
In investing, it's typically the minority that wins. Following the herd by buying the most well-known companies is hardly a formula for success. On the contrary, niche dominators, (with a good track record of capital allocation like TransDigm, Graco, and Gentex), deliver far more promise, especially considering their strong historical financials.
Find out about this top stock for 2014 -- for free
My definition of good stocks are the big fishes in the small ponds, rather than the whales of the industry. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.
Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Gentex and TransDigm Group. The Motley Fool owns shares of Gentex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.