This article is part of Todd's monthly series "Seeking Small Caps With Moats." The introductory article can be found here.
If you’re an investor that stresses over daily share price fluctuations, small cap shares are probably not for you. There’s nothing wrong with that - know thyself, after all - but a common mistake investors make is to equate share price volatility with risk and dismiss small cap shares for being too “risky”. Bear in mind that though share price volatility works both ways, curiously, few equate upside volatility with risk.
A much better definition of investing risk is the permanent loss of capital. Indeed, the risk of losing a substantial amount of your capital is what really keeps investors up at night. Investors can reduce the incidence of permanent losses of capital by figuring out what a company is worth and then paying a lot less.
Easier said than done, of course, but with fewer institutional investors and analysts patrolling small cap shares, mis-pricings are more likely to be found in this area of the market. As such, patient individual investors with a long-term approach can take advantage of small cap price fluctuations when the market overreacts to negative news. In fact, we might even realise a “double” margin-of-safety if we can purchase at a discount high-quality companies that possess economic moats (durable competitive advantages), have good balance sheets, and are managed by smart capital allocators.
In strong markets like this one, the frequency of these opportunities is low, but every so often the market will panic about short-term results and overlook a company’s longer-term advantages.
Consider the case of Dialight (DIA), a £304 million high-performance industrial lighting company whose shares are more than 30% off their 52-week high. The company, which supplies light emitting diode (LED) fixtures primarily in the hazardous and heavy industrial lighting markets, has seen its share price appreciate over 700% in the last five years and has traded with a premium multiple to the market as a result of its robust earnings growth. Dialight's recent share price decline, however, began on 12 September after the company issued a trading update regarding delayed obstruction system contract awards that it expected to drive much of this year's earnings growth.
Whilst these contracts are surely important to near-term results, the recent volatility could present a reasonable opportunity to buy Dialight shares as long as a) the company possesses an economic moat, b) the economic moat isn’t being eroded by competitors, and c) the company’s growth runway remains substantial.
To determine whether or not Dialight possesses an economic moat, let’s start by taking a look at its historical margins and returns.
These are fairly encouraging numbers as it appears Dialight has generated returns on capital above its cost of capital since at least 2009 and has consistently produced free cash flow despite depending on cyclical end-markets like mining, chemicals, and manufacturing. These numbers seem to suggest that Dialight possesses an economic moat, but before we can conclude that its economic moat remains intact, we need to pinpoint the sources of the company’s durable competitive advantages.
The two most likely economic moat sources for Dialight are intangible assets and switching costs. Dialight’s valuable intangible assets include patents, complex manufacturing knowledge, and regulatory barriers in the heavy industrial and hazardous location end-markets. All of these factors should limit competitors’ ability to eat away at Dialight’s profit margins in the increasingly important lighting segment. Dialight supports its intangible asset advantage by investing between 4-5% of its annual turnover on research and development, which seems an adequate sum. The returns on R&D must remain high, however, if Dialight is to stay “a generation ahead” (the company’s phrase) of its competitors’ technology.
Switching costs could also be an economic moat source due to the mission-critical nature of Dialight’s products. The lighting systems on an offshore oil rig or at a chemical plant simply cannot fail for both safety and productivity reasons, and yet they often represent a tiny fraction of total costs to operate such facilities. Then there’s the energy savings associated with LED lighting versus conventional lighting - up to 60% in some cases - in addition to lower maintenance costs and better reliability. Whilst these savings apply across the LED lighting industry, few firms have the reputation and production scale to properly service large scale projects for multinational customers. From covering the engineering and construction market, I’ve come to learn that most petrochemical, oil and gas, and mining projects will be larger in scale, more complex in design, and located in more remote locations than in previous periods. This trend should benefit Dialight versus smaller competitors.
That said, competition does indeed exist and it seems Dialight’s advantage in the obstruction signals market (lights used on tall structures) has slipped due to stronger competition in the Americas. Dialight’s responded to this threat by switching its focus in the region to lighting systems monitoring and control, but there’s a chance the business doesn’t fully rebound to its previous competitive strength.
Overall, then, it seems that whilst Dialight’s advantages may be eroding in the obstruction signals business, that weakness is being offset by increasing competitive strength in the heavy industrial lighting segment. Morningstar doesn’t have full analyst coverage on Dialight, and the company hasn’t been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, but after reviewing the evidence, it’s my opinion that Dialight has a narrow economic moat that can help it generate returns above its cost of capital over the next 10 years.
The company’s growth runway also looks healthy, driven by heavy industrial lighting demand (both new projects and conversions from conventional lighting) and geographic expansion into emerging markets. Though demand from mining customers may be slow in the next few years as the industry recovers from a recent capital spending binge, strong petrochemical project demand in North America supported by low natural gas prices should be a tailwind for Dialight.
Dialight's management has smartly defined its niche of hazardous and heavy industrial lighting, which should steer capital spending toward that rapidly growing and advantaged area of the business. I think the company was wise to divest its non-core utility switch business in 2012, as it allowed the company to more fully concentrate on its chosen niche. Given the cyclical nature of its end-markets, Dialight appropriately has no debt and a slight net cash position of £1 million as of September.
It's worth noting that a number of Dialight insiders have been buying the stock recently. In mid-November, the chairman bought 2,500 shares at 913p, the CEO bought 2,000 shares at 916p, and two non-executive directors bought more sizeable stakes of 10,000 shares at 900p and 10,870 shares at 915p. I would have liked to see more invested by the chairman and the CEO, but this activity does provide some confidence that the broader leadership team at Dialight feels the share price is attractive after the sell-off in recent months. Further evidence of the board's long-term confidence could be its decision in July to significantly increase its interim dividend by 22.5%.
In terms of valuation, my discounted cash flow model suggests current prices near 915p are baking in steady margin contraction and slower top-line growth through 2018. This outlook is likely too negative given Dialight's strengthening competitive position in the lighting segment. My base case fair value estimate is a range between 1,200p and 1,300p, making today's prices quite attractive. Supporting my outlook is that I consider Dialight to be an attractive acquisition candidate for a North American industrial conglomerate looking to strengthen its LED lighting technology position. In 2012, for example, GE purchased Albeo Technologies, a small LED solutions business, and Eaton Corporation purchased electrical and lighting company Cooper Industries, so industrial lighting appears to be an attractive growth area for industrial conglomerates. In fact, I wouldn't be surprised in Dialight is attracting interest right now following the dip in its share price.
If you have any questions, comments, or feedback about Dialight, please feel free to contact me here.
Todd Wenning does not own shares of any company mentioned. He will wait at least two trading days after publication before purchasing any small cap share mentioned.
