From Capital Returns (the excerpt below was from a Marathon letter in February 2015):
Companies which provide indispensable services to their customers often prove to be excellent investments
The typical growth stock starts out with high returns, rising turnover, and glorious prospects, only to stumble in later years. The trouble is that profitable and growing businesses tend to attract lots of competition, especially when they operate in exciting areas, such as technology. Investors who buy growth at high starting valuations generally end up disappointed. There is, however, a certain class of company which we have found is well worth paying a premium for. Our preferred growth stocks undertake apparently unglamorous activities that are essential to their customers – so essential, in fact, that customers pay little attention to what they’re being charged.
When Marathon encounters such companies, the common refrain of managers is that their products (or services) constitute only a small part of the customers’ total cost and yet are of vital importance to them. It may be that a particular component is “mission critical” for an industrial process or a company’s workflow. For instance, customers may face a very high cost if they have to shut down a production line when a crucial component fails. Hence, reliability weighs more highly than price. The product may also be essential by virtue of its quality, safety or performance attributes.
Having a high perceived value for customers often combines with some other advantages, which limits competition, ensuring high and sustained returns. These may be economies of scale in manufacturing and distribution, regulatory barriers and high switching costs. Companies talk about “value based,” or “technical” selling, which often involves having highly qualified sales staff “embedded” in the R&D departments of their customers. Sometimes this means that the component is mandated for use over the lifecycle of a product, as is commonplace in the automotive and aerospace industries.
...While the high profitability of the companies under discussion may be below the radar of their customers, it has not escaped the attention of investors. In the past, when we encountered such wonderful businesses we were prone to assume that high valuations meant they were fairly priced, or even overpriced, in the stock market. A few years later, however, when we reengage with the same firms, we often find that their share prices have shot up. When we first met with Spirax-Sarco in 2005, for instance, it was valued at 17.5 times earnings and the shares were trading around £8. We demurred. Five years later, at our next meeting, the stock was trading above £18. Again, we concluded that it was fully valued. Since then, the share price has almost doubled again. The lesson seems to be that a full price is often justified for high quality, “under-the-radar” businesses.