In building a house, the wedge-shaped keystone is the final piece that goes in the arch above a window or door and locks all the stones or bricks in place. And while that stone is relatively small, it strengthens the overall structure. So it is with Mawer Investment Management Ltd.'s keystone business model. It's a vital part of the stock-picking process for the $2.5-billion Mawer Global Small Cap, which has a 5-star Morningstar Rating.
"The keystone business model falls under the category of mental frameworks or models. A couple of years ago, Kara Lilly, an investment strategist (with Mawer) wrote about it, although we have had other names, such as the mountain-rope analogy," says equity analyst Karan Phadke. Based in Singapore, he works with the fund's four-person team headed by Christian Deckart and Paul Moroz, portfolio managers at Calgary-based Mawer.
The mountain-rope analogy is the same notion as the keystone, says Phadke (pronounced "Fad-keh"). "When you are climbing a mountain, you don't scrimp on the cost of the rope. The keystone is that small wedge at the top of a stone arch, which allows the arch to support itself, even though the keystone itself is small and doesn't weigh a lot," says Phadke, adding that other investment firms also use analogies for their investment models. "From an investment standpoint, it refers to a mission-critical product or service where the cost is very small relative to the value you get -- and the risk of failure is very high if it does not turn out right."
A native of Johannesburg, South Africa, Phadke joined Mawer in 2016, after stints at the CPP Investment Board and management consultants A.T. Kearney and earning a bachelor of science with high distinction in actuarial mathematics at University of Toronto. From his Singapore base, he scouts prospective blue-chip small companies for the 75-name portfolio, in which the managers replace five to 10 holdings a year.
"The keystone is one piece within a broader understanding of a business. There are lot of things that can determine whether a business can be good," says Phadke. He notes that the team identifies companies through an array of quantitative tools developed by its internal strategy lab and in-depth interviews with management, suppliers and customers. "But we found this can be one where it has an outsized influence in how a business ends up performing over the long term."
Conversely, the investment team also refers to the "hamster-wheel business model," in which a company must constantly find new customers or risk seeing its revenues dry up. "We don't want these kinds of businesses," says Phadke. "We like businesses where the customers love the product and are loyal. At the end of the day if you have loyal customers, employees and shareholders, you usually have a pretty good business."
Take, for instance, Kws Saat SE, a German agricultural company that sells seeds for crops such as sugar beet, rye, corn and rapeseed in about 70 countries around the world. "The cost of the seed relative to the whole crop is estimated to be 5-10%. But the seeds can drive the entire yield of the crop and provide resistance against factors such as poor weather. Conversations with industry participants led us to believe that farmers really care about the performance of the seeds and may even have a strong emotional attachment to them," says Phadke. "They are unlikely to scrimp on price for want of a poor crop. So seeds are a keystone product."
What drives home the thesis that Kws is a wealth-creating company is that it has an extensive research and development facility that can tailor seeds for a particular crop and soil types. "It's hard to replicate these intangible assets, and in our view that underpins why Kws is able to earn good returns on capital," says Phadke. "We have found that the company is quite protected from commodity- price volatility, likely due to a degree of pricing power. Even though they sell to farmers, their own business has been quite stable. We estimate that 80% of their profits come from markets where they are either number one or two."
Acquired three years ago, the stock has appreciated and recently traded at about 22 times forward price-to-earnings. It's not cheap, admits Phadke. "But we still own it because it's a very sustainable business with a long runway to keep growing over time. In that framework, the valuation is reasonable. What we really like about it is its durability."
In a similar vein, the Mawer team likes U.K.-based Croda International PLC, which makes the active ingredient in anti-aging creams, sunscreens and cosmetics for a wide range of branded companies. "The cost of the ingredients is about 0.1% to 2% of the total cost of the products. But they are important to the branded manufacturer," says Phadke, adding that cosmetics companies are also benefiting from broader themes such as an aging population.
Croda, whose stock is up about 90% in the past 18 months, has the opportunity to improve its earnings through innovation and better pricing, says Phadke. "Every year they come up with new patented active ingredients. That should provide a runway to continued improving profitability."
Phadke notes that choosing stocks solely on the basis of the keystone business model is no guarantee of success. "You can still have a bad management team or pay too high a price and therefore still have poor performance from a share-price perspective." Understanding the competitive situation is also vital to the analysis, he adds.
"The keystone business model is a starting point. There are a lot of other pieces that you have to evaluate to see if the risk-reward of a given stock makes sense," says Phadke. "As long-term investors, what matters most to us is a business's fundamentals. Is it wealth-creating, run by excellent managers and trading at a reasonable valuation?"
