Building materials: part 1
Many of the companies I discuss on this blog are not just good businesses, but obviously good. Visa, Moody’s, Sherwin-Williams, and Heico are wonderful and readers of this blog need not be further convinced of that fact. And notwithstanding regulatory or macro pressures that cast doubt on their prospects at certain points (interchange regulation in the case of Visa, the GFC ratings fiasco in the case of Moody’s) these companies are great for pretty much the same reasons they were great 10 or 15 years ago. They are better, more fully fleshed versions of their past selves, sure, but the core value drivers, end markets, and sources of competitive advantage are largely unchanged. A description of Sherwin William from 15 years ago would not read that differently from a description of Sherwin Williams today.
There’s another class of companies that at one point in time were thought to be just okay but then go on to earn exceptional returns because, whether through design or accident or both, they cannonball into an enormous new pool of value that would have been nearly impossible to predict ten years in advance, as much as we like to claim otherwise with the benefit of hindsight. Microsoft and Nvidia in the mid-2000s come to mind. As I wrote in Nvidia writeup from July 2021:
There is a time and place for grandiose convictions. In 2005, pounding the table with: “Nvidia’s going to be the dominate stack for the biggest compute trends” would have been prescient but also, I submit to you, absurd and unjustified. But any claim more specific than that would have mandated that you blow out of the stock. In 2007, the thesis that Nvidia’s MCP and Windows Vista would catalyze mainstream GPU adoption would have broke 2 years later. The same is true if in 2009, following a ~60%-70% decline in Nvidia’s stock over the previous 2 years, you believed mobile was the next gargantuan opportunity. In 2012, many analysts still believed that Windows RT (Windows 8 for ARM) was going to be a the third major operating system, alongside iOS and Android, and presented a vast growth opportunity for Tegra. No one at the time was really talking in earnest about megatrends like machine learning, big data, and “the metaverse” that would really come to make the difference.
The same could be said about Microsoft. Investors see where Microsoft is trading today and berate themselves for not buying in 2011 when the stock was trading at 12x earnings. But Microsoft is not only a different bet today than it was in 2011, but different in ways that were unknowable at the time. Central to most long pitches back then was that desktop Windows was a resilient cash gushing platform, that mobile wasn’t a real threat for such and such reasons or that Microsoft would carry its dominance of PCs into mobile or something. But MSFT has 10x’ed over the last decade for reasons (mostly) unrelated to desktop Windows and despite its failure in mobile. You can’t even latch onto the catch-all “culture” argument – i.e., “nobody knows what the future holds but this company has an adaptive culture and a great leadership team, so they will figure it out”. This was still the Ballmer era. No reasonable person looking at Microsoft should have cited “dynamic culture and management” as part of their pitch. Not even Microsoft knew what it was going to be at the time. We tend to focus on whether an investment decision turned out to be right or wrong rather than the degree of conviction justified by what was knowable at the time.
Finally, some companies are dismissed from consideration outright either because their economic sensitivity is erroneously conflated with business quality or because they traffic in commodities or because they fail to meet certain quality heuristics – i.e., they aren’t capital light or don’t command pricing power. The same way that Moody’s is just “known” to be great, these companies are just “known” to be mediocre….until they aren’t, until at some point the market realizes that the industry structure or revenue mix or operating discipline has changed in such a way that a historically low returns are set to inflect higher.
The US rail industry was a century-long wreck through 1980, when deregulation introduced price competition and forced a frenzy of consolidation. Consolidation was followed by the adoption of Precision Scheduled Railroading (PSR), an operating philosophy that optimized rail networks and was in large part responsible for the industry’s operating margins more than doubling, from ~16% in 2002 to ~35%-40% today. Likewise, deregulation whittled the less-than-truckload landscape down from 528 carriers in 1976 to just 159 in 1989. Of the 60 largest LTLs in 1980, only 8 were still around by 2003. Old Dominion Freight Lines then demonstrated how a disciplined operator could sustain exceptional returns in a capital intensive industry with cyclical demand, as it recycled the benefits of scale economies and operational excellence into more service centers and trucks, allowing them to provide better service, steal more share, realize more fixed cost leverage, and generate still more cash flow to reinvest in their network. United Rentals and Sunbelt did the same in heavy equipment rentals, accumulating procurement advantages and branch density as they acquired their way to ~30% of the market today, up from just 9% in 2010.
Companies in the midst of such transitions offer a rich vein of opportunity and often go ignored because typically, while returns are on their way to inflecting, the legacy bad co-exists with the incipient good. Until the transformation is too obvious to ignore, the bias against them lingers. Their surface-level attributes don’t scream “quality”. The industries in which they operate have long generated god awful returns. And that’s kind of the point. Certain companies evolving to a better place are steeped in just the right amount of “ick” to offer compelling risk-adjusted outcomes. Unlike 2024 Moody’s, they aren’t widely understood to be exceptional businesses; but unlike 2012 Microsoft, the upside potential is less about imagining a radically new industry configuration than about executing along a known path.
This multi-part series concerns the building materials (BM) industry, specifically the layer downstream of timber growers and upstream of home builders, home centers, and remodelers. Investors applaud canonical compounders like NVR and Home Depot and have in recent years been losing their minds over Floor & Decor. But beneath that strata of the value chain is a thriving ecosystem of manufacturers and distributors that is rarely discussed by generalists or even dismissed as unworthy of study.