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Meet the Mittelstand: Lessons from Germany's Unseen Dynamos

With the European debt crisis approaching its sixth year, many investors in Europe have been disheartened by a seemingly constant cycle of false dawns and relapses. A notable exception on the Continent has been Germany, which has taken on a pivotal role in attempting to lead the Eurozone out of crisis and has rebounded impressively from the global financial crisis. With so much of Europe still trapped in the doldrums of sluggish growth and high-unemployment, many have offered explanations for Germany’s standout performance in recent years. Some point to the country’s fiscal conservatism, codified in Germany’s Basic Law in 2009, which affords the country lower borrowing costs through stringent limits on sovereign debt. Others attribute the speedy recovery to the Hartz reforms of the early 2000’s, which created a more flexible labor market by reforming Germany’s welfare and employment policies. Germany itself has pointed to both factors as it advocates for austerity policies as a means to fix the broken economies of the Eurozone periphery. Yet while such arguments are compelling, it may be that the drivers of Germany’s recent economic success are due to less replicable parts of its economy. Of particular interest, especially as of late, is the Mittelstand.

The Mittelstand refers to the small and medium sized enterprises that make up 99% of all German firms. Though small in size, these companies together have a significant impact on the world’s fourth largest economy, accounting for nearly 52% of German GDP. Though definitions vary, the typical Mittelstand firm does not see annual revenues in excess of €50 million. Nevertheless, their total turnover in 2011 came to €2 trillion. By comparison, the total turnover in the same year for companies in the DAX 30 (the German blue chip index which includes the likes of BASF, Bayer and Volkswagen Group) only totaled €1.19 trillion. With the Mittelstand such a vital pillar of the economy, it does not comes as a surprise that it has come under the microscope as many countries try to replicate Germany’s success.

Perhaps no one has spent as much time looking at the Mittelstand as Hermann Simon, a German management consultant who has studied these companies for decades. In his 2009 book, Hidden Champions of the 21st Century: Success Strategies of Unknown World Market Leaders, he identifies a number of important commonalities between Mittelstand companies, some less obvious than others. These companies, Simon finds, are “hidden”, not only in that they fly under the radar from the perspective of the public, but also because of the fact that they “operate in the ‘hinterland’ of the value chain, supplying machinery, components or processes that are no longer discernable in the final product or service”.

They are “champions” in the sense that they are the dominant global players in their given markets. These markets, defined by the companies themselves, are extremely niche.

One such example cited by Simon is the case of Winterhalter, a manufacturer of commercial dishwashing systems. Though they are a negligible player in the global dishwasher market, they have chosen to specifically focus on hotel and restaurant dishwashers. In addition, they have built out their range to include ancillary products, including water treatment systems and their own specific brand of detergents that suit the needs of hotels and restaurants. A laser focus on extremely niche markets, Simon argues, allows Mittelstand companies to obtain impressive global market shares and establish high barriers to entry for potential competitors. While this “stick to your knitting” attitude requires commitment and discipline, the rewards are reflected in the number of these companies with impressive market leadership.

These qualities of commitment and discipline are highly valued by Mittelstand companies, and aren’t limited to discussions of market strategy. Overall, these companies adopt a long-term approach when it comes to doing business, not only by building strong relations with their clients, but also with their employees and other stakeholders. 95% of all German firms are family owned, and of these, nearly 85% are managed by their owner. As one would expect, this results in management with a much stronger sense of corporate stewardship and a greater incentive to pursue conservative, enduring goals as opposed to short-term gambles. Furthermore, their strong commitment to their employees also gives them a large pool of dedicated potential successors to draw from beyond family members.

Indeed, many look to the Mittelstand for insights into how to hire and retain high quality employees. Most new hires, many of whom are the product of Germany’s highly regarded vocational education system, will work for their first employer their entire life. According to Hermann Simon, such companies “see employee loyalty, training, motivation and flexibility as pronounced competitive strengths”, laying the “foundation for the external competitive advantages in product quality, service, advice and systems integration”. Whether speaking of firm and manager, or manager and employee, the deep commitment and alignment of interests between stakeholders in Mittelstand companies appears to have a positive impact upon their performance.

While many companies would likely love to have the same type of long-term orientation as the Mittelstand, few have the same type of balance sheets that would afford them the luxury. Mittelstand companies tend to utilize more stable financing models, choosing to use their own equity to finance growth whenever possible. In so doing they are able to avoid being at the mercy of their next earnings report or the time horizon of a private equity fund, and can instead focus on their own long-term benefit. This provides them with both protection and opportunity. During leaner points in the business cycle, they are under less pressure to cut costs or reduce headcount, and hence are able to stick to their long-term strategy. At the same time, their high equity ratios mean they possess the credit ratings to obtain cheap financing from banks during expansionary periods. Even then though, Mittelstand companies pursue growth cautiously, eschewing the latest and greatest opportunity in favor of safety and stability.

Considering all of these qualities, the Mittelstand can seem like a rather boring place to be: staid family companies staffed by lifetime employees serving niches in wholly unexciting industries. However, this could not be further from the case. For one, these small companies have proven to be highly innovative, sometimes much more so than their larger, better-known peers. From 2008 to 2010, 54% of Mittelstand companies brought a product or process innovation to market, as compared to 34% of EU companies as a whole. Thanks to their close customer relationships, Mittelstand companies have a deeper understanding of their respective markets, and innovate accordingly. Furthermore, this deep understanding allows them to use development resources more efficiently. Comparing a sample of large German companies against a set of Mittelstand companies, Hermann Simon found that while the large companies saw an average 5.8 patent applications per thousand employees, the selected Mittelstand companies saw an average of 30.6; the cost of R&D expenditure per patent for the Mittelstand companies was about 20% that of the large companies. Ultimately, for Mittelstand companies, the quality of their employees means more innovation than would be expected on a relatively smaller R&D budget. Simon believes the low turnover at Mittelstand firms plays a role, and considers employee continuity “indispensable for achieving continual improvements and, ultimately, perfection”. This lean, innovative culture undoubtedly plays a part in allowing Mittelstand companies not only to achieve global market leadership, but also to retain it.

Mittelstand companies are hesitant to seek growth through too much diversification, preferring instead to focus on their specific niche markets. However, they demonstrate little fear of moving into new geographies. Globalization is, according to Simon, the “dominant driver of growth” for Mittelstand companies, as it makes their “narrow markets large and thus contributes to the realization of sufficient economies of scale”. Though global expansion can be a long and arduous process, particularly in emerging markets, it seems that Mittelstand companies are often up for the challenge. In most other countries, small and medium size enterprises rarely participate outside of their home market; in Germany, the Mittelstand accounts for around 19% of total exports.Many of these companies have a prominent presence abroad, with a permanent local sales staff and even production facilities outside of Germany. In exporting not only their goods, but also their global expertise, Mittelstand companies are not just building strong global companies; they are building strong global brands.

Undoubtedly, the Mittelstand plays an integral role in the strength of the German economy. While some countries, like Britain, have recently attempted to emulate the Mittelstand “model”, it is tough to say whether this will be successful. The German economy is unique with its deep, sometimes centuries-old connections between industrialist families, local banks, universities, technical schools and workers. Some have gone so far as to argue exporting the Mittelstand would require exporting the German views on labor and capital. This has not deterred businesspeople from around the world from coming to Germany to learn from these companies. Indeed, with their ultra-niche market focus combined with global aspirations and their culture of continuity and conservatism matched with their ability to incrementally innovate, the contrasting qualities of the Mittelstand companies have made them a popular case study. Given their success, they offer valuable lessons for the entrepreneurs, investors and managers of today’s companies as well as the dynamic firms of tomorrow, no matter what their size.

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This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without notice. Drum Hill Capital, LLC (“Drum Hill Capital”) has no duty or obligation to update the information contained herein. Further, Drum Hill Capital makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Drum Hill Capital believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Drum Hill Capital, LLC.


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