Aviva Investors: Pixie dust and demon dust - The little things that make a big difference in equity markets

19 February 2021 | Giles Parkinson, Portfolio Manager

As equity investors monitor the status of their portfolios, it can be easy to forget that each blinking ticker symbol forms part of a complex whole. In a modern economy, the relationships between firms and their customers often hinge on crucial little details, which are ultimately expressed in the form of rising or falling share prices. 

Consider an airline whose fleet of aeroplanes needs to be maintained with after-market components sourced from third-party manufacturers. These replacement switches and gaskets are cheap compared with the airline’s other expenses, such as labour and fuel costs, but without them, the planes cannot fly.

"The relationships between firms and their customers often hinge on crucial little details"

Companies that specialise in producing small parts of a larger system are an interesting proposition for equity investors. We think of these firms as offering pixie dust or demon dust (or a mixture of the two). Pixie dust elevates the quality of a product or service; demon dust helps to prevent a failure of some kind. Both tend to be highly prized by customers because they make a big difference for a relatively minor outlay. The suppliers in question therefore wield considerable pricing power.

Consumer surplus

As we explained in a previous article, pricing power provides investors with a useful indication of a company’s competitive advantage. If a company has nominal pricing power, it can raise prices in line with inflation, allowing it to cover input costs and preserve profits; if it has real pricing power, it can raise prices above inflation. 

Firms that can raise prices consistently in line with or above inflation while retaining customers enjoy a formidable competitive advantage. In an equity portfolio, such stocks can help drive resilient returns over the long term. To identify them, investors need to find market niches in which there is a consumer surplus – a gap between the price a company charges and the value it creates (see Figure 1). 

Pixie-dust and demon-dust businesses are part of the select group of firms that derive their pricing power from the position they occupy within the supply chain. While there are some examples in the business-to-consumer world, they are more common in business-to-business sectors. Take the aerospace parts example – these are considered demon-dust products, because they keep things running smoothly, maintaining aeroplanes in good working condition and preventing accidents.

Figure 1: Consumer surplus and pricing power

Outsourced payroll processing is another good example of a demon-dust service. Payroll providers help ensure their customers’ employees are paid the right amount, on time, with no fuss. No-one ever notices when this process happens as it should – but any mistakes can wreak havoc.   

In the pixie dust category, manufacturers of flavours and fragrances such as Kerry Group and McCormick sell inexpensive spice packs and artificial flavourings to consumer-goods groups and fast-food retailers, which use them to enhance the taste of their dishes. McCormick, which owns the Schwarz brand in the UK, says its seasonings can represent “ten per cent of the cost of a meal, and 90 per cent of the flavour”.1

"Pricing power is often bound up with intangible, qualitative factors"

This is obviously marketing speak, rather than a verifiable claim. But it highlights a salient point: pricing power is often bound up with intangible, qualitative factors that cannot be easily plugged into a spreadsheet or Bloomberg terminal and arbitraged away by quantitative investment approaches. Whether or not the “90 per cent” figure is accurate, ingredients suppliers can reasonably argue they offer customers additional value at a price that looks negligible in comparison with their bigger expenses, such as maintaining distribution chains or sourcing fresh produce. That’s the power of pixie dust. 

Who pays?

In some cases, a company will offer a mixture of both pixie dust and demon dust. An elevator manufacturer is typically a demon-dust business – elevators account for a small proportion of the overall cost of an office building, but they can cause big headaches for landlords if they break down or cause accidents. Reliable lifts are therefore valuable.

But some elevator manufacturers have recently begun to provide supplementary services, such as data-driven, people-flow management tools that can reduce waiting times and ease crowding. Tenants are often willing to pay higher rents for offices equipped with these digitised lifts, meaning the property gains some added value – a sprinkling of pixie dust.

One way of spotting pixie or demon dust is to identify a microeconomic niche where the person or company making the purchasing decision is different from the one who foots the bill. This dynamic reduces the cost sensitivity involved. 

"In some cases, a company will offer a mixture of both pixie dust and demon dust"

Take interior decorating. While the homeowner pays for the materials and equipment used in renovations, the actual purchase is customarily made by a contractor, who may be inclined to choose a brand of paint they know can be applied more quickly than the alternatives, even if it is more expensive. Finishing the project faster means the contractor can fit more jobs into the working week; from the homeowner’s perspective, the saving on labour will usually compensate for the additional cost of the paint. 

This might seem a trivial example, but it accounts for the sizable pricing power of the dominant deluxe gloss paint brands in the US, which market themselves on their ability to get the job done in one, quick-drying coat, rather than two.2

Collecting dust?

By definition, pixie- and demon-dust businesses are constituents of larger, interconnected systems, and can be exposed to risk when end-market demand falls. Shares in flavourings companies such as Kerry Group were among the first to be hit by market jitters during the initial wave of COVID-19 lockdowns in 2020, as investors fretted about the knock-on impact on the restaurant industry and its suppliers.3 Due to the pandemic-related slump in air travel, airlines have deferred maintenance on their fleets, which has hit demand for aftermarket aerospace components over the past 12 months.4

But considered over the longer term, pixie and demon dust are valuable ingredients in any equity portfolio. With their specialist expertise and consumer surplus, these businesses are usually the dominant players in their market niches, and benefit from wide competitive moats.

"While the little details are often missed, they can have a big influence over the long term"

As the examples above show, pixie and demon dust tend to be found in a diverse range of industries. To identify them, investors need to adopt an open-minded approach, and resist the constraints imposed by style biases and received wisdom around sector categories. For example, architectural paint manufacturers are usually classified as materials companies, alongside commodity producers that typically lack pricing power. This means their pixie dust potential can go overlooked.

The power of pixie dust and demon dust illuminates a deeper truth about equity investing. While the little details are often missed amid the day-to-day tumult of the market, they can have a big influence over the long term. Switches and paint-pots and food flavourings – these are a few of an equity investor’s favourite things.