Diversification vs Focus
By Tom Gardner
October 8, 2004
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.