Selecting A Second-Tier Company

By Glenn Curtis AAA

When looking to invest in a particular industry, many inexperienced investors will place their money in the largest company in that industry. The reasons for this can vary, but it is often because these companies are the most well known or investors feel their size gives them an advantage over competitors.

But far too often, the share price of the top-tier player trades at too high of a premium. As a result, the investor may be forced to look toward the second- and third-tier players for value.

The good news, however, is that there are ways to determine whether the second- and third-tier players are the better values, and are worthy of an investment.

Accelerated Earnings Growth in Proportion to Other Value Indicators
In order to be successful investments, second- and third-tier companies need to have something that sets them apart from the top tier players. To that end, probably the most important thing that can make these smaller companies stand out is accelerated earnings growth. (To learn more, see Earnings: Quality Means Everything and Everything You Need To Know About Earnings.)

Why is fast earnings growth so important for second- and third-tier players?

It's because in addition to giving companies a higher profile among analysts and investors, healthy earnings growth gives the investment community hope - hope that one day these second-tier companies can capture market share and even become the market leaders. Incidentally, strong earnings growth, especially when compared to the largest player's growth, is an indication of the second tiers ability to compete in the market space along with the strength of its business model.

Lowe's Vs. Home Depot
Take, for example, the comparison of Lowe's and Home Depot. Home Depot had long been the industry's 800-pound gorilla, and it dominated every new market it entered. But then along came Lowe's. This competitor aggressively erected stores in many of the same markets and experienced terrific growth, particularly in the late 1990s and early 2000s.

Home Depot and Lowe's were both adding stores at a break-neck clip between 1999 and 2001, a period when the housing industry boomed in North America. Over this period, Home Depot grew its earnings by 31%, while Lowe's, because it was able to capture increasing market share during this same time, grew its bottom line by 52%.

The fact that Lowe's was able to grow at a much faster rate than the home improvement industry's No.1 player did two things: It let the analyst community know that Lowe's could compete and succeed, despite the competitive pressures in the market and some of the barriers to entry it had to overcome. It also suggested that the Lowe's concept may one day be preferred to the Home Depot offering. In other words, it gave investors hope.

Compare Growth Rates
Of course, earnings growth isn't the only factor that investors should consider, and it wasn't the only factor that was considered as investors piled into Lowe's stock. During that time, Lowe's seemed more attractive on many levels, including gross margins, price-to-book value, return on assets and return on equity. It also boasted more favorable debt loads. (To learn more, see Analyze Investments Quickly With Ratios.)

For the record: Between January 1999 and December 2001, Home Depot's stock rose 31%; Lowe's stock price rose some 84% during that same period. This is a case where going with the smaller player will often be a rewarding move for investors. (For related reading, see Is Growth Always A Good Thing? and Venturing Into Early-Stage Growth Stocks.)

So again, the best advice here is to compare growth rates. And then see if the smaller company (with the faster growth rate) is also substantially cheaper using other valuation standards. If so, you may have a winner on your hands once the larger market appreciates the value of that second tier player.

A Viable Niche
Just because a company is growing fast doesn't mean its stock is good buy or that it is necessarily the more valuable company. However, when a second-tier company is growing faster than the top tier company in its industry, it does indicate that the smaller player may have carved out a viable niche or offering for itself.

What are some of the signs that a company may have found its niche and hit its stride?

Beyond earnings growth, telltale signs include: increasing acceptance of the company's product among the general public, a growing store count or expanded distribution network and firm pricing. In fact, a company's ability to compete in terms of price with a No.1 player may be the best sign that its concept is working.

Let's return to the Lowe's/Home Depot example. Lowe's proved to Wall Street that it had hit its stride by growing its store count by 29% to 744 stores between 1999 and 2001. The company also became much more competitive in its pricing. As a result, more and more people began frequenting its stores (evidence of this can be found in the earnings growth.)

Of course, Lowe's didn't stop there. The company also became heavily involved in the communities it entered. The company funded charities and aggressively sought to educate the communities it entered on construction techniques (through classes held at stores). Lowe's also made sure to stock up on products that were unique, or necessary, to a particular region. Lowe's made unique inroads with home improvement customers, and managed to generate an element of loyalty that the top-tier company had trouble garnering.

Therefore, when analyzing a second-tier company, delve into the details. Sample the product and determine whether the company's offerings are unique, because a second-tier competitor will always languish unless it can set itself apart from the industry's leader.

(To learn more, see What is an economic moat?)

Long Term Valid Concept
There are so many things that can change the marketplace, from rising labor costs to technological improvements, to legal and regulatory issues. For example, the risk of litigation caused many tobacco companies after World War II to diversify their businesses into foodstuffs.

Investors must determine whether a second-tier company can continue to grow and create a presence in a given market, or if the primary player in the industry, coupled with other extraneous macro- and microeconomic factors will ultimately put that company out of business. (For related reading, see Macroeconomic Analysis.)

Proven Track Record
While there can be no doubt that buying into an initial public offering (IPO) such as Lowe's (or even Home Depot when it first went public) can be a profitable venture, it makes sense to wait until the company turns in a couple of years' worth of financial results before delving in.

Why?

The first few years in any business are when a company is most susceptible to failure. After two or three years, most companies get their bearings and know what they need to do to be competitive.

To be clear, there is still risk, even after a few years, and even after an IPO is conducted. But the good news is that the major uncertainties have probably already been addressed on someone else's dime! (For related reading, see IPO Basics, The Murky Waters Of The IPO Market and IPO Lockups Stop Insider Selling.)

Publicity Hounds
Every company needs exposure, but secondary and tertiary players need a little more. To that end, look for companies that are aggressively trying to get out the word. Companies that do frequent road shows, and that meet with the investment community on a regular basis, tend to receive more analyst coverage as well.

Bottom Line
Bargains can be found among the second- and third-tier players in an industry - if investors know where to look. Keep an eye out for the clues detailed here and you could find yourself holding a stake in a winner.

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