What can space shuttles teach us about investing?

On January 28th, 1986, the space shuttle Challenger exploded shortly after launch, tragically killing all seven astronauts on board and costing the USA an estimated $3b in delays and destroyed equipment. The cause of the disaster was ultimately traced to one component; a rubber O-ring that was designed to form a seal between sections of the rocket to avoid hot gas from escaping during launch and damaging other parts of the vehicle. A myriad of management failures allowed NASA to launch on a day when overnight temperatures had dropped below freezing, causing the O-ring to become brittle and fail to form an airtight seal (a risk that several engineers had warned management about), ultimately leading to the explosion 73 seconds after launch. After a lengthy investigation into the cause of the accident, NASA overhauled its risk management processes and added another backup rubber O-ring to the rocket design.

The space shuttle successfully flew again two years later in 1988. The total cost to develop the space shuttle program is estimated at over $10b. O-rings can be purchased for a few dollars.

Diploma, a global distributor of mission critical, high value to cost products

At Fairlight, one of the indicators of quality we look for in an investment is a company that sells a product with a high ‘value to cost’ ratio. This ratio compares the cost of a product with either the benefit received by the customer, or the loss incurred when the product is not used. Generally, a company that sells products with a high value to cost ratio has resilient revenues (customers are unlikely to stop purchasing), strong pricing power and high margins.

Diploma, held in the Fund since 2021 and currently one of our largest investments, is a UK-based distributor of products that are low cost but essential to the functioning of its clients. The business focuses on three main niches:

• Seals (e.g. O-rings and gaskets) for industrial machinery such as tractors, forklifts, and bulldozers. When machinery breaks down a customers’ priority is speed and getting the correct part to ensure limited downtime on a construction site.
• Controls, wiring and cabling for specialised technical applications such as aerospace, defence, rail and motorsport where the cost of failure is high.
• Medical consumables used in surgery and pathology testing where accuracy is critical.

While the invention of the rubber O-ring dates back to 1896, it would be a mistake to characterise Diploma as a slow growth company. Revenues and earnings have increased nine-fold since 2009 (16% p.a.), while the company has paid a dividend that has increased for 25 consecutive years. A patient investor who bought stock at the IPO in 1985 has been richly rewarded with a 306x return on the initial outlay.

Figure 1. 

Decentralised, acquisitive operating model boosts growth and reduces risk

Diploma’s surprisingly strong growth outcomes can be attributed to a decentralised operating model which enables it to deliver the rare combination of strong organic growth and a value accretive acquisition strategy. Diploma focusses on buying small ($5m - $20m enterprise value), family-owned businesses which are too small to attract the attention of many bidders. As a result, Diploma is generally able to purchase at attractive multiples of 5x to 8x EBIT.

Instead of integrating, acquired companies are given the autonomy to run their own business in a decentralised model that Diploma has tuned over decades. The large pipeline of small acquisitions has meant management have been able to reinvest all excess cash into acquisitions generating day-one returns on capital above 15%, an excellent outcome for shareholders. The acquisition model also counterintuitively reduces the volatility of the business. When organic growth slows due to tough economic conditions, management tends to increase the pace of deals at lower prices, thus increasing returns on capital and accelerating earnings growth. 

For further detail readers can refer to past articles Fairlight has written on the advantages of decentralisation in 2022 and underappreciated serial acquirers in 2020.

The Fairlight View

When searching for quality businesses, one of the key attributes we look for is businesses that deliver more value to customers than they extract in price, products that form a small portion of the customers’ total budget and products that are consumable or maintenance related and hence purchased regularly and with predictability. Companies that sell products that meet these criteria will usually have strong pricing power, high margins, high customer retention and low variability in revenues which ultimately reduces risk for investors. Often products that fit this description are particularly uninteresting and serve boring niches, however, as Diploma illustrates, the returns for investors can be spectacular.