Beyond OUTR, we had a few new positions suffer declines in 2015, though I don’t believe they’re mistakes. Midway through the year, feeling happy with a 10% gain and idle cash, I was attracted to two companies, DNOW & MSM, that harbored key elements I look for in businesses: staying power and unique competitive positions within their respective industries. Both companies are distributors with business models that generate cash in downturns and require minimal capital expenditures. Further, both DNOW and MSM enjoy scale advantages, strong balance sheets, and seasoned management teams with strong track records.

In both cases, what appeared moderately cheap (perhaps I could have exercised better price discipline) became cheaper as industry headwinds intensified. I was somewhat ambivalent to the declines (which reflected industry challenges), as part of the investment appeal rested upon my view that growing stress would benefit both companies at the expense of competitors.

MSC CEO Erik Gerstner explains in the most recent Q:

Economic slowdowns are the times when MSC makes its greatest strides. These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately. History tells us what will happen to local distributors if this downturn prolongs. Reducing their inventory leaves customer service vulnerable. Clamping down on receivables disrupts long-standing customer relationships. Laying off people creates hiring opportunities to acquire industry talent not typically available.

We are just starting to see the very early signs of these things occur in the marketplace. The pace will accelerate the longer these conditions hold. We are pleased with our share gain performance to date and would anticipate it to continue or even accelerate the longer these conditions last, and that will lead to disproportionate top-line growth when the environment does improve.

Although there are important nuances among distribution companies (I’ll spare you the details), I believe both DNOW and MSM share significant competitive advantages. We’re confident the challenging conditions that now prevail will create opportunities for both firms to gain market share, improve underlying economics, and grow intrinsic value over time.


The above commentary has been excerpted from the annual letter of Arlington Value Capital.

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