Companies You Don't Know [Fool on the Hill] August 2, 2000

FOOL ON THE HILL: An Investment Opinion
Companies You Don't Know

Peter Lynch has some very simple principles for investing in companies. Buy what you know and use. Don't invest in something you can't explain using a crayon. There are companies that meet these tests, but there are others that fail it, badly. We're going to look at a uranium processor and a surfactant manufacturer, among others, with the least explicable financial models. These aren't necessarily bad investments.

By Bill Mann (TMF Otter)
August 2, 2000

Did you ever wonder why most individual investors seem to be concentrating on two or three hundred different companies? There is a large universe of companies out there, nearly 10,000 listed in the U.S. alone. And yet the vast majority of these companies are completely ignored by individual investors. But someone trades them, right?

I submit that there are two reasons for individual investors' concentration in a relatively small number of companies. The first is an outcropping from Peter Lynch's most famous investment criterion, "buy what you know." The second is that we are as a group enamored with certain industries that, even if we do not completely understand them, we can imagine or visualize the growth. It's easy to figure the growth of the Internet and companies that make products for it. It's much harder to understand air conditioner parts distribution. (By the way, using the "top-down" approach to investing is quite risky. Unless you're a mechanical investor, you should ALWAYS try to know the individual companies in your portfolio backwards and forwards.)

But investors tend to be most comfortable with the companies that they use, that they can understand. Here's an example: I read the other day that most investors who hold Baby Bell stocks in their portfolios own the one that provides service where they live.

In fact, let's take a poll: If you own a Baby Bell -- SBC Communications (NYSE: SBC), the former Bell Atlantic, now called Verizon (NYSE: VZ), BellSouth (NYSE: BLS), or the former US West, now part of Qwest (NYSE: Q) -- let us know if it's your home service. I'll post the results in Friday's Fool on the Hill.

In the example above, there's no reason why someone would logically select an investment just because it is local, and yet people do it all the time. They invest in what they know and use because there is comfort in having something in common with the company you're investing in, using the products, supporting the home team, whatever.

Some pretty darn good companies are completely ignored by individual investors. Mentioning Cisco (Nasdaq: CSCO) -- ahem, just like I've done here -- in an article almost guarantees that thousands of people are going to read it. But I could shout from the mountaintops about the amazing investment opportunity in Church & Dwight (NYSE: CHD) and hear nothing but crickets chirping. Church & Dwight, you say? Yep, the world's largest producer of sodium bicarbonate, complete with an iron-clad brand untouchable by its competitors: Arm & Hammer Baking Soda. Significant growth in sales, a dividend, nice margins, innovative products, increasing free cash flows, and a stock that has drifted downward so that its P/E is below its growth rate. I know, baking soda is yawnsville. But it's a great company with fine fundamentals, and who says investing has to be exciting anyway?

(chirp, chirp, chirp)

But at least we can conceive of Arm & Hammer, and we are familiar with its products. But what about companies that lack consumer familiarity from both an investing and a product perspective? What are the anti-Lynches, the companies with products and business models that are completely unapparent to the majority of us in our daily lives?

For the best anti-Lynches, there should be a few guidelines:

  • No direct contact between the company or its products and the average consumer
  • Minimal brand awareness by the public
  • Complex, obscure, or undifferentiated products
  • Minimal "aha!" factor, meaning that the product or the way the company derives revenues is not easily explained. For example, many investors would not know a Cisco router if it hit them in the head. But it's pretty easy to explain what Cisco's products do, and how the company makes money.
Here are a few of my favorite anti-Lynches. And please note that I am in no way making a judgment on the quality of these companies, just that they are hard for the average person to understand.

1. USEC (NYSE: USU) -- The parent company of the United States Enrichment Corp., USEC operates the only uranium enrichment facility in the United States, and supplies about three-fourths of the Low Enriched Uranium (LEU) to U.S. nuclear power plants. It's also party to an agreement to convert some 500 tons of Russian weapons grade uranium into commercial fuel grade.

Did you know that the nuclear plants had to buy uranium, that it has to be enriched, or that there is a company that does so? How much does raw uranium cost anyway, and is the market for it growing or declining? This is a classic example of an anti-Lynch, a company that does something with such obscure economics that it is invisible to our everyday existence.

2. Stepan (NYSE: SCL) -- Stepan is a chemical company specializing in surfactants, polymers, and lubricants. You more than likely come in contact with Stepan's products every day, though you would not know it. They make a key ingredient in many of the cleaning products you use. Stepan's products are in bath powder, toothpaste, insulation, highway paint, and agricultural products. And no, the same product is NOT in both toothpaste and highway paint.

You've more than likely never heard of Stepan, but this is a $220 million company with an extremely low price-to-sales ratio of 0.36. Stepan is a definitive anti-Lynch. To understand the economics you'd have to know about the purchasing patterns and growth potential for surfactants and its other products. Best I can tell, these are all the things listed in toothpaste ingredients that are hard to pronounce. Looking back over the company's history, they've given shareholders fairly stable growth and a nice dividend, which are things we should not sneeze at. But there are several types of mold spores with more name recognition than Stepan or its products.

3. For my absolute favorite, we unfortunately have to leave the realm of the listed and go to the bulletin boards: SpaceDev (OTC: SPDV). The company seeks to execute Earth orbit and deep-space missions for the commercial sector. Essentially, SpaceDev wants to be the low-cost provider of space missions. SpaceDev has a significant list of clients and partners, and it has an operating profit.

How the layman could do a risk/return analysis of this company is beyond me. SpaceDev may in fact one day be an infinitely understandable business as commercial space exploration becomes the stuff of the mundane. I hope so, because I am a true sucker for the "out there" business model, for which this one easily qualifies.

Peter Lynch's investing success gives his opinion significant weight, and there is an elegant simplicity to keeping your investment dollars in areas you can understand. But learning about companies in other realms is also well worth your while. Of the above companies, the one with the best track record seems to be Church & Dwight, though Stepan clearly addresses some large markets with growth potential as well. SpaceDev? Well, I'm going to enthusiastically hope for its ultimate success, but I'm several generations of commercial space exploration away from dropping much money on its practitioners.

Do you know some good anti-Lynches? I'm looking for companies with the most obscure, least understandable products in industries that do not derive much in the way of customer awareness. I'd love to hear about them on the Fool on the Hill discussion board!

Fiat Fool!
Bill Mann, TMFOtter on the Fool Discussion Boards

Related Links:
  • The Drip Portfolio Peter Lynch's Principles
  • USEC Discussion Board
  • USEC Home Page
  • Stepan Home Page
  • SpaceDev Home Page