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Notes and musings from a Value investor

Excessively good?

28 February 2017
Author: Alastair MundyHead of Value

I was recently chatting to a chap who runs a shop on our local high street. He sells what my mother-in-law eloquently describes as toot (i.e. tat) and appears to have secured a decent living partly because of the reluctance of the large discount retailers to compete against him (something which he humbly assured me is a consequence of the low footfall in the high street rather than the leading edge innovation he has introduced to the sub-sector).

Apparently pleased to have found someone to talk to, my new-found entrepreneurial friend shared the secret of his success with me. He explained that whilst he stocks numerous items ranging from foam footballs and paper clips to colanders and out-of-date diaries, the bulk of his profits are made in the hair accessory department (more commonly referred to as a shelf). The other products need to be more competitively priced as his customers have a number of alternative places to purchase them.

As I wandered home with my 250 brown envelopes, it struck me that my toot man’s experience was not uncommon among much larger listed companies. Over the years it has at times become apparent that electrical retailers made a sizable percentage of their profits from extended warranties, that hotels did extraordinarily well from customers using the fixed line phones in their rooms, travel agents from changing sterling into foreign exchange, pubs from fruit machines and banks from selling unnecessary insurance on which it was virtually impossible to claim. More recently, we have seen examples of pharmaceutical companies’ reliance on just one or two highly profitable products and plant hire companies benefiting from a few handsomely priced contracts. These pockets of super-normal profitability, never highlighted by company management, were masked by the overall profitability of the companies, and, ultimately, eroded by factors such as regulation, competition and changing customer habits.

It is not just the initial shock of the unwinding of excess profits that it is important. If the affected company is unable to boost profits in other divisions then a new, lower, range for the company’s potential returns may be created, a danger for those of us who focus on mean reversion.

With these pockets of supernormal profits typically well hidden, and management reluctant to admit to their existence, it is often difficult to identify them. And, of course, these excess returns are often highlighted as examples of supremely talented management teams or of companies with high barriers to entry. So where are the current places to look for them and worry? Financial services companies making high returns from inert customers, bookies generating even greater profits than thought from the high stake machines in branches and cinema chains benefitting from prices in their food and drink outlets areas that make customers choke on their popcorn all appear vulnerable. My man in the toot shop may well find his through-the-cycle returns are pretty durable. Other companies may not be so lucky.

Alastair Mundy
Alastair Mundy Head of Value

Important information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Investec Asset Management.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Investec Asset Management, issued February 2017.

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