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For Safety and Growth, Invest in ‘Third Place’ Companies

By Andrew Packer   |   Tuesday, 11 Oct 2011 08:45 AM

Coke and Pepsi. McDonald’s and Burger King. Ford and General Motors.

In some industries, two companies often dominate. But that doesn’t make the entire industry a duopoly. If anything, smaller players in this industry can offer growth opportunities. But usually, one position in an industry in particular offers the trifecta of safety, growth, and income.

I call these “third place” investments.

As an investor, finding companies in third place behind two companies fighting for market share can make for better returns. Why? Because these companies have more growth ahead, and don’t have to spend as much time worrying about what a close peer is doing that may cause competition.

For example, in the 1980s, Coca-Cola and Pepsi engaged in heavy marketing campaigns that compared their product to each other in taste tests, as well as the rollout of new flavors. Each company was so brutal to the other in their marketing that one name stuck out to describe what happened: The cola wars.

But while Coke and Pepsi had the first and second most popular sodas, the third, Dr Pepper, wasn’t owned by either of them. It did enjoy the same advantages of the cola industry as its substantially larger competitors, such as a strong brand that loyal followers were willing to pay for.

It’s been several years since Dr Pepper-Snapple Group (DPS) was spun out from Cadbury. Since that time, the company has paid off debt ahead of schedule, implemented a 3.3 percent dividend, and has enjoyed modest growth in a US cola market that hasn’t grown.

On one level, that’s the power of being third: You don’t get the attention of the biggest players, but you still have the same advantages they do, with some better growth potential to boot.

Along those lines, look at Yum Brands (YUM), which has had to compete with the likes of McDonald’s and Burger King. Through its restaurant chains Taco Bell, Pizza Hut and KFC, Yum is still less than a third the size of the Golden Arches.

But when it comes to global growth, Colonel Sanders gets more customers than Ronald McDonald any day. Yum Brands has been rapidly expanding in emerging markets, notably China, at a faster rate than McDonald’s. Yum Brands 2,800 restaurants in China outnumber McDonald’s 1,300 locations by more than two-to-one.

The company’s 2.3 percent yield isn’t quite as good as McDonald’s, but Yum has grown its dividend by five-fold since 2004. By comparison, McDonald’s has grown its dividend by four-fold over the same period. That’s a great record of dividend growth, but given the growth prospects, Yum is a better bet.

When you’re number one, you’ve got to look out for the person most likely to replace you and knock you down a peg. In investing, there are often better opportunities looking for the company that’s number three in a profitable industry.

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