Global alchemy

The smart money is on premium brands that hold tight to marketing and design, and send everything else offshore

By Rob McConnachie
Globe Investor Magazine,
November 18, 2008
Illustration by Matthew Hollister

Rob McConnachie, CFA, is the chief investment officer of Dixon Mitchell Investment Counsel, a Vancouver-based wealth management firm.

I'm forever telling people they should build a portfolio that won't bend to the market's cruel mood swings. Remember how, earlier this year, going long commodities and short financials was the thing to do? It turned out to be a brilliant six-month strategy. If you're looking for good long-term investments, however, here's an idea worth considering. In fact, it could prove to be the most crucial measure of a company's ability to survive a long downturn and then thrive during the next century.

Everybody knows about the rise of emerging markets as a manufacturing force. But investors often overlook some of the biggest winners from this great upheaval: the platform companies. These firms have broken their businesses into three components, or platforms-design, production and marketing. Recognizing that production is the costliest and least profitable platform, they've outsourced most of it and kept the more lucrative parts of the operation for themselves.

An archetypal platform company is Nike, which farms out nearly all of its manufacturing to low-cost countries like China and Indonesia. As a result, the sports-equipment maker can spend its time and money on what it does best: creating nifty products and marketing the hell out of them. Other global names that have successfully exploited the same platform model include French luxurygoods maker LVMH and Finland's Nokia, the world's largest cellphone producer.

Not all platform companies are thriving, but on balance they seem to be faring better than competitors. They enjoy the best of both worlds: growing demand for their goods from developed and emerging economies, minus inflationary manufacturing cost pressures. In other words, the more that platform companies outsource, the lower their expenses go. Free from the burden of fixed-cost plants and equipment, they're also nimble at responding to changes in consumer demand.

For investors, platform companies are appealing. Without factories to finance, they don't need much capital to expand- a huge advantage in today's very tight credit market. Instead, Nike, Nokia and LVMH concentrate on using design innovation and clever marketing to command high prices for the products they sell. These three companies build a wall around themselves through brand cachet, not cheap manufacturing. Even so, the cost to make their premium products- whether real or perceived-isn't much more than for similar, lower-priced goods. This is reflected in their return on equity: On average, it's more than double that of the MSCI World Index.

If history is any guide, you are better off buying companies that outsource manufacturing than those that specialize in it. Look what can happen when firms spin off their production components into stand-alone divisions-IBM with Celestica in 1996, and BCE Corp. with the remainder of Nortel in 2000. While both spinoffs thrived at first, over time their margins shrivelled as growing competition triggered a price war. Their mistake? Churning out commodity-like products that any Asian manufacturer could match. Investors have been burned by other manufacturing outsourcing companies in recent years too, such as Magna International for the auto industry, Patheon for pharmaceuticals and Quebecor World for publishing.

So, how are the platform companies doing as a group? Hong Kong-based investment and research firm GaveKal rolled out its Platform Company Fund in September, 2006. Since inception, the fund's net return has more than tripled the MSCI World (8.1% versus -9.4% as of September). With their high margins, low capital expenditures and abundant free cash flow, I'm betting that platform companies will keep rewarding