When you think about all the articles being written about shortages and fears of inflation, it seems like the US economy is doing very well. You can’t really have those things without consumer demand. Indeed, some are calling for GDP growth of 8% in 2021 and a big increase in inflation.
I’m a little cautious on the GDP growth in 2021 causing sustained inflation (mainly because its high growth lapping a year that was beaten down) (as I previously wrote about). Let’s not confuse a one-time increase in prices with inflation…
But I also get pretty cautious when everything I read is all the same – “a boom is here.”
One piece of data that gets thrown around is ISM Manufacturing PMIs. The latest reading was 64.7%! It’s well above pre-COVID levels.
A Manufacturing PMI® above 43.1 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the March Manufacturing PMI® indicates the overall economy grew in March for the 10th consecutive month following contraction in April 2020. “The past relationship between the Manufacturing PMI® and the overall economy indicates that the Manufacturing PMI® for March (64.7 percent) corresponds to a 6.2-percent increase in real gross domestic product (GDP) on an annualized basis,” says Fiore.
Now, a PMI is a “purchasers managers index” and is basically a survey from a wide array of companies in manufacturing in the US. It basically is asking, “are you growing or shrinking?” across a wide array of topics.
Investopedia says, “when the index is rising, investors anticipate a bullish stock market in reaction to higher corporate profits.”
Actually – it can really be used as a CONTRA indicator.
I went back through the data to 1960 and checked the 6-month, 12 month and 18-month S&P500 returns after the manufacturing PMI was at certain levels. It’s not perfect, but its something.
I’ll just put the data out there – would you rather swing hard with the index around 65? Or below 43? There aren’t many cases when it goes above 70, but that generally does not have a good track record.
Look, I try not to market time. I’m typically nearly-fully invested. But I also understand there’s a time to own some names (e.g. cyclicals) and time to eh… maybe cool it and wait for a better day.
You don’t get better at investing without comparing your process with outcomes.
I’ve been thinking a lot about the point of this blog. Currently, I view it as an investment journal. But, I wanted to accomplish a three things when I started:
Put my investment theses in writing. Compare the thought at the time of writing with the outcome (what was right, what did I miss)
Write down themes or ideas I talk about with friends…that end up being “lost” conversation because we never wrote it down
Have fun. Become a better investor. Become a better writer. Hopefully let others share in the outcomes.
In order to hone in on number one and number three, I am going to track performance of stocks I have written about on this blog with their performance against the Russell 3000. Why the R3k? Because I do some big names, some large names. Rarely anything international, and that’s my personal benchmark of what I would otherwise invest in.
If, overtime, I see that I am consistently underperforming, I’ll re-examine the process.
If I am doing well, I’ll examine which ideas seem to perform the best and why.
A few things to mention:
Unless recommend closing a position specifically, the position runs on
Equal-weighted since I’m not posting my full portfolio and also not writing about why I like one idea over another (but this may change in the future)
Using total return so there may be differences in price change vs. total return if there are big dividends
If I write about something twice, I assume that’s buying it twice, obviously excluding earnings recaps or anything like that. The rationale here is I’ve moved away from earnings recaps and when I write about something twice, its more akin to doubling down.
Competitive strategy series posts are excluded (unless I say the stock looks cheap in the specific post) because the point of those posts is to examine business strategy as opposed to the stocks themselves being cheap
Guest posts are excluded so a very timely cruise stock buy in March 2020 is not in the results
Over time, I hope to advance the write-ups I do in many ways. I also want to advance the tracker, but it won’t be in the near term. In the future, I want to show the portfolio. So, for example, future stock posts will say, “ok, I’m going to buy this name I like, so therefore I am selling xyz…”
But that’s for another day.
Head over HERE for the performance tracker. Or click the menu header above at the top of the site and click Performance Tracking.
Wait a second – aren’t 3D printed homes this just another name for manufactured housing? Seriously. Compare the picture above (3D printed home) with another graphic of a manufactured home from Cavco.
Tying this into this blog, which is investment related, I just did a post on Skyline Champion and Cavco, which prefab homes in a manufacturing site and then send it along to the plot of land desired by the customer. The difference seems to be having a cool name for your process and doing most of the manufacturing onsite.
This home listed in Long Island was for sale for $300k – lauded for its ability to sell at a material discount to homes in the area. But my guess is that’s probably the same price / more expensive than what manufactured housing offers from Clayton, Cavco or Skyline. And the 3D printed house looks…. mehhhh. In this case, the true cost of this home likely came down to lot value in Long Island.
Let’s call a spade a spade…
I struggle to see how 3D printed homes will disrupt current manufacturing processes, especially in comparable product categories. A lot of these 3D printed homes still need fabrication work onsite after they are completed, too.
Here is the cement-based 3D printed home. The machine builds the structure by adding layer and layer of cement, but it looks like the guts of the home are still fabricated without machines. Not to mention you still need someone to install windows, doors, cabinets, countertops, and electrical work.
My guess is that, today, you can only build these structures where the land is very flat – otherwise it will throw off the machine. Technology improves, but it will improve in the manufacturing process in “traditional” areas too.
This same thing happened in Japan, where manufactured housing and 3D printed homes are more commonplace. Much has been written about applying what Japan does to the US.
But outside of low-cost housing, however, Americans desire too much choice and they might as well choose a Clayton Home over a “Google-backed startup” 3D printed home. Japan differs a bit too, in that their homes depreciate over time, whereas everywhere else they appreciate. So it makes sense to build cheap and quickly, raze it later, and start fresh.
We clearly need housing solutions. There is a housing shortage in the US, as I discussed in this post. I worry about that shortage leaving groups of people in the US behind. And I am afraid our employment trends mean that the shortage in construction trades will likely get worse. This will continue to drive up the cost of building. It’s no wonder why there are growing calls to democratize housing.
But solutions have been discussed in the US literally for 90 years. Architect Buckminster Fuller had the idea for a “Dymaxion House” which was a aluminum, grain silo-looking house that could be shipped and easily assembled with less waste. Frank Lloyd Wright did as well. The idea being that if the automobile was being democratized, so should housing.
Obviously, it never panned out.
The undertones sound exactly the same as today as the 1930’s, though. We need to improve cost, we need to save energy, we need to become more efficient. Democratize housing.
We have solutions to that today, but either consumers aren’t choosing it, there are zoning issues, or something else.
I personally have trouble seeing 3D printed homes offering a meaningful solution in the near term.
I’m thinking of starting a new segment called, “Contrarian Corner.” In these posts, I will try to point out the other side of a company perception, trade, or view that I see as pervasive in the market.
When everyone crowds to one side of the boat, there are typically better opportunities to sit on the other side.
Right now, it seems “inflation is coming” is a pretty consistent view. (Somehow, the people shouting inflation think they are contrarian?) Every report, article, or tweet is talking about it…. I really try to avoid macro talk, but this is too good to pass up.
My favorite example of this is pointing to lumber prices as an indicator of runaway inflation. This totally ignores prior supply / demand dynamics that led to this surge. To me, its picking a data point to support a view.
I follow lumber prices, so I know why they are up. Canadian lumber is high-cost supply. The crash in prices in 2018 meant many mills to the north were unprofitable and were curtailed. Add in forest fires and impact from the Pine Beetle and supply was constrained. Lastly, Canada implemented caribou protection which curtailed logging activity. Lumber prices were still very low so even mills in the US shut. Now that housing has come back strong, this caught supply off guard and prices surged.
Is that inflation? Or is that a short-term supply demand imbalance? Prices are now at a level where everyone can make money if they can get supply back online. Would you make a bet with me that lumber prices will be higher than where they are right now in 3 years?
The median growth of the 20 advanced nations in this study fell by half as their debt levels moved from less than 30 percent of GDP to 90 percent or more. The drop-off was particularly significant at the 90 percent threshold: between 60 and 90 percent of GDP, median growth was still 2.8 percent; above 90 percent it was 1.9 percent. The drop in average growth between countries with debt ratios of 60-90 percent of GDP, and those above 90 percent of GDP, was even greater: 3.4 percent to 1.7 percent
What happens when you go from 100% to 120%? Japan is approaching 200% debt to GDP and we all know the impacts there (their central bank also straight up buys equity ETFs)
Essentially, the marginal benefit we get from adding a new dollar of debt is going down. And has been for quite some time.
Yes, the coronavirus stimulus was big. But a lot of it also went to plug a big hole in the economy. We had stimulus checks. That put money directly in the pocket of consumers, but it didn’t create a new income stream for them. Wages didn’t go up and in my view and so the spending will be a 1x boost in some select sectors. Unless all the debt we just used goes to create a new income streams, all we’re doing is exchanging current consumption for future consumption.
Velocity of money is going down.
I’m going to let Dr. Lacy Hunt explain the next bit. For context, he’s a manager on Hoisington bond fund and has been right on bonds for about 40 years (i.e. he’s been long duration). I highly recommend his investor letters. All of these are quotes from his Q1’2020 letter, with my emphasis added:
When the Fed buys government or agency securities from the banks, holdings of government debt declines and the banks’ holdings of deposits or reserves at the Fed go up.
The bank balance sheet is unchanged except that the banks are selling government paper of longer maturity and they receive an overnight asset at the Fed. Those deposits do not circulate freely within the economy. (Diligent Dollar Note: QE is not just printing money)
If the Fed’s purchase of the debt is from non-bank entities, there will be a transitory rise in M2. Further M2 expansion from that new level will depend on the banking industry. The banks high level of reserves at the Fed will result in no further increase in money unless they and their customers make the collective decision for new bank loans to be originated and the loans are used to expand economic output
This is what happened in 2010-11. M2 surged transitorily to a nearly 12% rate of growth along with an increase in loans. The money and loans were used to shore up financial conditions rather than channeled into the purchase of new goods and services. As such, the velocity of money fell dramatically, and the Fed’s purchases of securities did not lead to increased economic growth and inflation. After financial conditions were stabilized, the depository institutions held large amounts of excess reserves.
I feel like the first two bullets need re-emphasizing, because a lot of people associate QE with money printing. Joe Weisenthal put it (again, my emphasis added):
When the Fed buys a Treasury, what it’s really doing is replacing one kind of government liability (maybe a 10-year Treasury) with another kind of government liability (an overnight reserve held at the Fed). If you’re a bank that sold a Treasury to the Fed, you’ve given a long-term asset that yields something for a short-term asset that yields something else. No new money has entered the system. The government doesn’t have any less debt. All that’s happened is that the consolidated government balance sheet (the Treasury and Fed combined) has shortened the term structure of its liabilities. After the Fed buys a Treasury there’s less long-term debt outstanding and more short-term debt outstanding. That’s it.
Bottom line: in order to actually get a boost to GDP and inflation, you need the velocity of money to go up. All these headlines of GDP growth in 2021 tend to be missing the point. If we have 8% growth in GDP following a year where GDP was down 3.5%, then you just have 2% growth on a 2-year basis. That’s not that great considering all the debt taken on. And then you actually need the banks to lend out the capital, but that depends on risk they see in the market, returns, and whether people need the capital for investment.
Add in worsening demographics (and I think its possible we are sitting where Japan and Europe are sitting 5 years from now.
I think what will happen is inflation expectations will continue to rise short-term as the economy re-opens and we have some supply constraints that gives further pseudo-inflation scares, but long-term the writing will be on the wall.
So bottom line: Do I think reflation will happen? Yes. We will be lapping a serious decline in our economy and there are supply constraints. Do I think those supply constraints will be overcome? Yes. And therefore, I think we will continue on the longer-term deflation trend.
Something different today – I’m going to make a counter argument on a battleground stock. WD-40 stock is one of those names that easily is discarded by analysts for trading at too high of a multiple (myself included, typically). But comparing multiples is not valuation.
For context, WD-40 multiple can be defined as high – currently trades at 35x EV / LTM EBITDA and ~52x price to LTM EPS – and it has expanded significantly over time, too.
Again, this is not valuation. In fact, as I try to lay out in this next chart, you could argue that WD-40 stock has been consistently undervalued by the market. Obviously hindsight 20/20 with a share price going up.
But the red line shows the price where you could buy the stock versus the orange dashed line which is where you would need to buy to realize a 10% IRR (ex-dividends).
Therefore, I’m going to try to look at WD-40 stock with fresh eyes.
I do have biases, so I am going to lay those out upfront. However, I will not cling to any of those biases in my model.
Here is my assumptions about WD-40 stock and why it trades so rich:
Interest rates are very low. WD-40 is a high quality company, has little debt, and probably grows at GDP+.
If I’m a large diversified asset manager, such as a pension fund, and I need to invest in something for 30 years, I can either pick a ~1-2% bond or a high ROIC company that has staying power and will grow earnings above GDP.
The choice obviously isn’t that simple, but bear with me.
WD-40 stock also has a 0.85% dividend yield at the time of writing, which will probably grow vs. be fixed with a bond
As such, as rates have continued to decline over time, the multiple paid for WD-40’s earnings have gone up
In essence, this is a classic “bond proxy” stock. And investors will get punished severely if rates rise.
Again, that’s just my bias as I look at WD-40 stock and I think previously, that would have caused me to do zero work.
Here is a waterfall chart outlining the source of WD-40 stock returns. As you can see, most of the shareholder returns come from multiple expansion (used to trade at 20.5x LTM EPS in 2006 and now trades at ~60.0x:
So I’m going to ignore this narrative for now and ignore the valuation and just plug into (i) the business, first and (ii) what management is saying that could drive the stock higher.
First and foremost, here are some of my initial takeaways (some obvious):
WD-40’s name comes from “Water Displacement, 40th attempt”. Basically a secretive lubricant.
There are some other facts, myths, and legends on their website, including a bus driver used WD-40 to remove a python from their undercarriage.
WD-40 is an excellent company.
Highly recognizable brand is worth something that is hard to quantify
Earn extremely high returns on invested capital (ROIC) – I estimate ~65% pre-tax in TTM
High ROIC is also demonstrated by high margins, low capex: they have 24% EBITDA margins and spend 1.5%-2.0% of sales in capex.
LT target is to operate under the 55/30/25, which is 55% gross margins, 30% cost of business, and that implies 25% EBITDA margins. They are already pretty close to these metrics.
Management is pretty conservative and leverage is consistently low (0.5x net debt to EBITDA)
Management lays out their multi-year initiatives and harps on those initiatives. Every… single… call…
Management has also been consistent… like, the people themselves. Garry Ridge has been CEO since 1997.
Some other things I learned after further work:
I expected WD-40 to be a big emerging markets play. It kinda is, but not the way I thought.
Yes, 65% of revenues come from outside the US, but a lot of that is developed or developing Europe, LATAM, or Australia.
China is $15MM of sales in the TTM, which is just ~3.5% of total sales. India is also small.
If you think they can win emerging Asia – that growth is still on the come. If WD-40 can be as successful there as it is here in the US, then there is a long runway for growth.
Over the long run, they expect to grow APAC 10-13% annually.
WD-40 sells through distributors in new regions and slowly moves into direct sales model
If I were an investor, I’d actually be frustrated with how slow China growth for WD-40 seems to be.
One benefit of WD-40 though, as mentioned, is that they’ve had the same CEO for 2 decades and he’s remarkably consistent.
Here are his thoughts from a 2006 earnings call when they first entered China:
You can actually see this play out in the employee count. However, I wouldn’t really call it a “success” so far. They aren’t really getting better and better leverage on employee costs.
Sales per employee (blue line) is consistently going down, which is counter to what I would have thought.
Ridge, the CEO, knows China is key as he said in an interview in 2015 and the commentary makes total sense to me.
For context, he brings up factories because an average household consumer maybe uses $0.40 of WD-40 per year. Someone in a workshop may use $40-$70 per year.
This is a small company. They do just $435MM in revenue and $106MM in EBITDA.
Seems like a conscious decision. Whereas Rust-Oleum owner, RPM, uses cash to buy other brands, WD-40 basically said it doesn’t want to do that – it doesn’t want to di-“worse”-ify.
Instead, they are focused more on “specialist” brands, such as a silicone lubricant, bike chain lube, or marine grade products, among many others.
It is unclear whether that’s really the best approach, but I can’t argue with their shareholder returns so far.
Growth has been… just OK. Sales have grown at a 3% CAGR for 14.25 years and EBITDA has grown at 5%. Excluding the run-off products discussed below, sales have grown at a 5% CAGR, too.
I will say this is basically all organic. And if we go back to “bond-proxy” status, earnings held up pretty well in the GFC (were down 15% from peak, but snapped back fast) so the reliability of those slow earnings is rock solid.
If all companies earned the same ROIC, then growth would be the only differentiating factor between investments. And WD-40 clearly is top quartile for ROIC.
But back to China / EM, I feel like management hasn’t pushed growth their enough. They do discuss it a lot on calls, but would expect sales to be much, much higher than current or even projected. They would drive so much more value given their ROIC if they pushed growth here.
WD-40 owns some home cleaning brands, but they are essentially in run-off and management expressly says they just harvest the businesses for cash (see how orange bars have shrunk)
The company (maybe not too unsurprisingly) spends little in advertising. It spends about the same each year in advertising as it did in 2006, yet gross profit is +60% higher
Capital allocation: investor in 2006 would have gotten all his cash back from FCF
In 2006, WDFC traded at 11.6x EBITDA, 20.5x EPS and ~23x FCF.
Not “cheap” by any means… The market cap was ~$576MM
As shown below, an investor then would have received more than the market cap through dividends and share buybacks since then.
Obviously left with a much more valuable piece as well
What type of Moat Business is WD-40?
Connor Leonard did a guest post on Saber Capital’s blog back in 2016, (Saber is run by John Huber and I highly recommend you check out his posts or twitter). In that, Connor outlined four different types of businesses: No moat, Legacy Moat, Legacy Moat with “Outsider” Management and Reinvestment Moat.
It seems to me that WD-40 could fall into one of the last three buckets. The brand value of WD-40 is clearly a legacy moat, but the question is whether or not there are really reinvestment opportunities.
I don’t really consider management here to be “outsiders” but it is hard to argue that earnings have been allocated poorly. The CEO also hasn’t succumbed to debt or M&A pressures by the market. So they haven’t been allocating dumb-ly.
As Connor says,
“[It is] the rare company that has all of the benefits of a Legacy Moat along with ample opportunities to deploy incremental capital at high rates within the current business. In my opinion this business is superior to the “Legacy Moat – Outsider Management” because it removes the variable of capital allocation: at the end of each year the profits are simply plowed right back into growing the existing business.”
WD-40 has plenty of opportunity to reinvest in China and India, but I also still think the capital required to grow there will be pretty limited.
And there lies the point of his post – introducing a fifth model of “capital light compounders.” Those that can grow earnings with very little capital. Instead of reinvesting into the business with long-runway, they systematically repurchase shares.
In my view, you are essentially creating a scarce asset. The powerful business is acquiring itself each year, and crowding out other purchasers of the shares each year.
I did a deep dive on WDFC and built projections on that. Frankly, I did them a bit more aggressively than I normally do, but I was using mgmt’s LT targets as a guide (they are shooting for $700MM of sales by 2025).
Frankly, that may be pretty hard target and I actually don’t have them hitting their sales target. Just look at their performance pre-COVID. It wasn’t on-track. However, I do have WDFC expanding margins as they leverage their costs better and beating the 25% EBITDA margin target. It seems to me they already have the infrastructure in place to grow Asia significantly.
I have them using their FCF to repurchase shares and pay their dividend.
While capex might look low, they’ve actually been overspending recently (the big bump in 2017 was building a new office building; in 2020 it was building capacity for their Smart Straw product). At the end of the day, that’s essentially what high ROIC means – they can grow FCF with limited incremental capital invested.
They can’t really buyback too much of the market cap each year at these levels.
I did a DCF which I don’t normally do, because they can be overly precise and subject to wide swings based on small assumption changes, but I wanted to back into a “what do you need to believe” case.
Firms create value when they’re returns on capital are higher than their cost of capital. The cost of capital, or WACC, is the return offered for the risk that the projected cash flows don’t occur as planned. If future cash flows are more uncertain, investors require higher rates of return for the risk.
For example, here’s the value of a firm under different ROIC vs. growth assumptions with a 10% WACC. If the firm earns < 10%, they are destroying value even if they grow. The important thing is that an already high ROIC business gains more value by growing faster, not by increasing ROIC a bit more (though a low ROIC business will do better by increasing ROIC). This furthers my frustration that China growth has been so slow.
WD-40 cash flows are highly certain (implying a low WACC) and given their ROIC is around 65%, there is a huge spread between this cost of capital and ROIC.
As you can see below, we get in the ballpark of the current stock price using a 5.5% discount rate and assuming the stock grows 3% into perpetuity. Cross checking that with the implied terminal EBITDA multiple, pretty interesting to see it is very high (~29x).
If WACC moved higher (to a not-even-high number), the stock could get crushed.
If you are saying this discount rate is too low… theoretically… it isn’t. Just theory and I’ll touch on this at the very end. Again going back to the stability of WD-40 cash flows, it results in a really low cost of equity. Debt is super cheap right now too, but they barely have any.
The other factor where this DCF is weak is the terminal value: the terminal value math implies a company’s ROIC will equal its WACC in the terminal period (because of competition) and growth steps down. It’s interesting that if I just stretch my DCF out 2 more years, I get a $350 share price (assumes 5.5% WACC and 3% LT growth rate) as WD-40 still earns more than their cost of capital.
I think WD-40 is a great company and they will continue to compound earnings. I think I have a lot more appreciation for why it is valued like it is valued and hope readers do as well.
Will I be adding it to my portfolio? No.
The company is clearly earning high returns on capital… but I care about returns on my capital. And my opportunity cost is higher.
If a business could invest $1,000 in a factory and earn $400 in dividends, that’s a 40% return on capital for the initial investor. But if someone buys those shares for $4,000, they’ll only receive a 10% return on capital. Price matters.
But I will be looking for other names that are viewed as “too expensive” with perhaps faster growth and similar reinvestment runways.
March 28, 2021 Update: It has come to my attention that Greenwald dedicated part of his book to WD-40. Definitely worth a read: