How niches could lead to riches

Conventional wisdom says the bigger the industry, the better the business. Watch Dragon’s Den, The Apprentice or most company presentations, and they’ll boast about the size of their market and what a great opportunity it presents. To me, this is flawed thinking.

The larger a market, the more competitive it’s likely to be. And competition can be a real killer. 

This is why the restaurant and retail sectors have historically been such a bloodbath for investors. Yes, we all eat and we all buy clothes. But huge markets with low barriers to entry attract cutthroat competition, making it difficult to merely survive, let alone make decent profits. 

Why I love niche markets

The ideal business for me is a dominant player in a growing niche. 

A niche can be tiny or quite large. However, it will lend itself to specialists not generalists and will usually be narrow enough for just a few players to dominate. This should make it difficult or unattractive for other competitors to enter. 

Consider the UK housing market. Buying and selling houses is a much bigger market than online property advertising. But it’s also far more competitive. The largest estate agent, Countrywide, has a market share of just 2.7%.

There are only two major online property advertising portals – Rightmove and Zoopla, with the former enjoying a market share of 88%. Look at the margins of Countrywide and Rightmove – it’s really no contest. 

Operating margin: Countrywide vs. Rightmove

It’s hard for competitors to unseat a business as dominant as Rightmove. Many have tried, but there’s a limit to how much any business can spend to capture a market opportunity of a few hundred million pounds. 

By dominating its niche, Rightmove has delivered spectacular returns for shareholders. By contrast, Countrywide was recently acquired for £130 million, a far cry from the £750 million valuation it attained when it listed in 2013. Past performance is not a guide to the future.

Rightmove versus UK stock market over last 15 years

Great innovators, ferocious defenders  

Specialist businesses in small niches tend to be great innovators and ferocious defenders of their markets. If you are a more generalist business serving bigger markets, that’s hard to compete with. It’s also rarely worth the effort.

Take Diploma plc, a distributor of medical products and industrial seals. Diploma consists of 30-40 independently run businesses, each serving a specific niche. The business has been wildly successful over the last 15 years. I believe a key reason is its niche market focus. 

Diploma versus UK stock market over last 15 years

One of Diploma’s niches is the distribution of medical instruments to the Canadian healthcare market. Conventional wisdom says the US would be a better place to operate. It’s a huge market with so much opportunity. But that means there’s lots of competition.

Canada’s population is around a tenth the size of the US. It’s also more challenging to serve – with a huge territory, two languages and a harsh winter climate. For most medical suppliers, it’s not worth setting up the infrastructure and salespeople. Instead, they go to Diploma. Even better, they usually sign up for exclusive agreements, limiting competition in the niches Diploma focuses on.  

Disruptive threats

As well as restricting competition from existing players, a niche market can protect against the threat of disruptive new entrants. 

A few years ago, investors worried that Amazon would disrupt virtually every industry. Distribution businesses, like Diploma’s aftermarket seals business, were thought to be especially vulnerable. Well, so far, Amazon hasn’t made a dent on Diploma. I believe a big reason, again, is the niche market focus. 

Seals are used in industrial machinery, particularly hydraulics where they prevent leakage and hold pressure. They’re about the most boring thing you can imagine. However, they are critical for the machinery to operate.

Diploma’s aftermarket seals business supplies repair shops with replacement parts for broken machinery. It stocks about 70,000-80,000 seals, of which perhaps 5% are ordered regularly. That leaves about 65,000 less-common seals sat gathering dust most of the time. But if the customer needs one of those 65,000 seals quickly, and it isn’t in stock, they aren’t going to stick around for long. 

Diploma’s ability to carry that inventory is down to its scale and expertise. You could think of it as the Amazon of seals. Does Amazon itself really want to fill its warehouses with 65,000 seals hardly anyone will order? So far, it hasn’t – and I struggle to see why it ever would. The niche and specialist nature of the market mean it probably wouldn’t be worth the effort.

I’ll take boring over exciting

Niche markets are rarely exciting and are often under-the-radar. You won’t find many business school graduates dreaming up ways to break into the aftermarket seals business. That said, boring shouldn’t be mistaken for low growth.

True, some niches offer limited opportunities. Diploma will always be somewhat constrained by Canadian healthcare budgets (although the ageing population means they tend to grow over time). But niche businesses are often very good at finding ways to grow. 

This is because they spend every minute of every day thinking about their industry. Years nurturing relationships means they’re often the first port of call when their customers need solutions to problems. If a Canadian hospital comes to Diploma and says “any chance you can supply this new medical device”, Diploma can go out and source it for them. Over time, its niche grows.

The best of both worlds

Niches generally don’t offer the explosive growth opportunities that large, fast-growing markets can. But nor do they face the same competitive threats. It’s competition, not lack of market growth, where most businesses come unstuck. 

I think the most compelling investment opportunities offer the best of both worlds. A niche small enough to keep competitors at bay, with attractive long-term growth prospects. I consider Diploma to be a great example: note this is not a personal recommendation. You can expect to see a number of similar companies in my investment portfolio with Wealth Club, expected to launch by the end of the year.