Process is key when selling beloved stocks

The Fairlight investment strategy aims to compound investor wealth over the long-term by investing in a concentrated portfolio of high quality global small and mid-cap companies.

Identifying quality businesses and blindly holding them for years though does not guarantee investment success. Valuation, also plays a fundamental role and so the investment team is constantly assessing what the current valuation of portfolio companies imply for future returns and portfolio risk. As a result it is not uncommon, particularly given our preference for the Fund to be fully invested at all times, to have to sell one of our favourite companies with the view to enhance returns, minimise risk or both. This is exemplified by our recent decision to sell the Fund’s investment in Nordson Corporation.

Nordson has been a successful investment since the inception of the strategy in 2017. The company still possess the quality characteristics that we look for in a business and has been performing in line with expectations over the past several years. However, we have become increasingly worried about management’s discipline when it comes to making acquisitions. While there is only minor evidence that Nordson’s recent deals are likely to destroy shareholder value, it is our view that we can reallocate capital to other opportunities where we are not required to take that risk.

Diversified, niche B2B manufacturer

Nordson mainly sells specialised machines that dispense adhesives, sealants, and other fluids. Its products are found across many manufacturing facilities around the world and are mission critical when producing, for example, food and beverage packages, personal hygiene products, smart phones and medical devices.

Despite its industrial nature, Nordson’s business has historically proven resilient to economic shocks thanks its exposure to multiple geographies, products and end-markets. Also, almost half of its sales are linked to the crucial replacement of spare parts and consumable products, the demand for which tends to be less cyclical. During the global economic crisis of 2008-09, for instance, after falling 27%, sales recovered almost immediately.

Nordson earns high margins given the specialised nature of its machines. Nordson’s machines allow customers to automate many processes and improve the quality of their final products and so they are willing to pay the premium price associated with them. So, Nordson has historically benefited from strong pricing power generating an impressive and stable gross profit margin of around 55%. Notably, the company has also been leveraging the cost of its highly technical and large salesforce which has helped the operating margin to expand over time to today’s 29%.

Nordson’s free cash flow conversion is also impressive. The company develops all its key technology in-house but sources more commoditised components from third-party suppliers which reduces the need to invest heavily in factories and equipment to meet growth. Cash conversion has indeed been averaging about 100% over time. Management has been reinvesting this cash wisely, expanding the product range via small acquisitions while returning the surplus to shareholders via buybacks and dividends.

The combination of attractive end-markets, high margins, low capital intensity and a sensible capital allocation has allowed Nordson to deliver annual EPS growth above 10% while maintaining returns on capital of at least 15% over many economic cycles.

Acquisitions can be risky business

Historically, Nordson’s capital allocation has included making small bolt on acquisitions, which has been a successful strategy for the business. However, the recent purchases of CyberOptics (US$380m), ARAG (US$1b) and Atrium (US$800m) look significantly riskier than past acquisitions. Before discussing the specifics of these deals though, it’s worth reviewing Fairlight’s view on why acquisitions can be risky:

• Loss of Focus: Generally, management teams are experts at operating their businesses, not integrating acquired companies. Acquiring a new company can result in management getting distracted and neglecting the existing business.

• Employee Turnover: A transaction event is often a chance for the founders or existing owners to ‘cash out’ and leave the business. During the integration, different cultures might clash and redundancies may result to meet ‘cost synergy’ forecasts, creating undesirable employee turnover. This can lead to the loss of critical institutional knowledge, mentors and access to deep industry networks.

• Information Asymmetry: When pursuing an acquisition target, the buyer is at a structural informational disadvantage. The seller generally has intimate knowledge of the business built over years of operating experience, which is difficult for the buyer to replicate during a limited period of due diligence.

• Competitive Auctions: In a bidding process, it is common for buyers to lose sight of the underlying value of the asset and overpay in order to secure ‘the win’.

‍Expensive acquisitions

In Nordson’s case, we are mainly concerned about the latter two points. Both CyberOptics and Atrium were publicly listed companies before Nordson acquired them. ARAG, was privately owned, but was purchased after a competitive bidding process launched by its former Private Equity owner. Stock markets are generally some of the most efficient financial markets in the world and Private Equity firms are notoriously savvy sellers. While we hold Nordson’s management in high esteem, it’s statistically less likely that they were able to purchase these businesses cheaply.

Assuming all expected synergies will be realised, Nordson paid on average 16x EBITDA for these businesses, a meaningful premium to what it has historically been paying for its acquisitions. While the average quality of these recent purchases appears higher, both CyberOptic and ARAG were acquired just before cyclical downturns hit their respective end-markets, which suggests that the multiples paid were likely even higher. Additionally, the larger average size of these acquisitions brings greater complexity and it also means that any misstep will likely impair Nordson’s return on capital for a number of years (Figure 1).

Figure 1.

The Fairlight View

Selling a beloved stock is never easy but can often be necessary to manage portfolio risk. At Fairlight we have applied significant effort in building an investment process that helps us to make the hard decisions based on fundamentals and remove emotion where possible. This often relies on a probabilistic approach to investing where we tend to emphasise the prior probabilities of outcomes over our own ‘feelings’. Furthermore, having a long list of fully researched investment opportunities also helps to frame selling decisions around trying to find the optimal use of capital rather than singling out mistakes.

While our judgement of Nordson’s latest deals may prove overly pessimistic, it is informed by a plethora of studies which show that acquiring relatively larger businesses from sophisticated sellers is statistically more likely to destroy value. Given the abundance of attractive investment options on our bench, the decision to sell Nordson and reallocate the proceeds to higher conviction, lower risk opportunities was ultimately the only sensible course of action.

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