Despite the high valuation of the U.S. stock market, we are still finding attractively valued companies based in the U.S. During the second quarter, in both of our equity strategies, we established a one percent position in Houston Wire & Cable—one of the largest distributors of electronic and mechanical wire in the United States.
Based in Houston, Texas, Houston Wire & Cable was founded in 1975 and has 13 distribution centers across the country. They efficiently distribute products to their customers with 24/7/365 service and a 99.99 percent order accuracy rate. During the latest calendar year the company distributed over 30,000 products. During its 41 years Houston Wire & Cable has gone through a number of public and privately owned phases. From 1975 to 1987 the company was privately owned. In 1987 they completed their first public offering. In 1989 Alltel acquired the company. In 1997 Alltel sold the company to Code, Hennessy & Simmons (CHS), a private equity firm. In 2006 Houston Wire & Cable entered its second stint as a public traded company as CHS took it public.
There are three characteristics we like about Houston Wire & Cable. First, for a cyclical company, we think it is an attractive business. Since going public, the company has generated positive cash earnings in eight of nine years and returns on invested capital has averaged 15.1 percent. (A return on invested capital of 15 percent or higher is generally considered to be an above average business.) Their business does not need a lot of capital expenditures — illustrated by the fact that capital expenditures have averaged 3.6 percent of operating cash flow over the past nine years. (This is well below our “rule of thumb” that deems an attractive business as one that regularly has a ratio of capital expenditures to operating cash flow below 33 percent.)
Second, management has displayed a capital allocation strategy that is very shareholder friendly. Over the past nine years, in lieu of engaging in aggressive acquisitions, management has returned a large amount of cash to shareholders via dividends and share repurchases. At the time of our purchase the stock had an attractive dividend yield of 4.5 percent and diluted shares outstanding have fallen by 19 percent since the end of 2007. Management has opportunistically repurchased shares when its stock has been undervalued. Over the past nine calendar years a total of $126.2 million has been returned to shareholders ($56.6 million through dividends and $69.6 million through stock repurchases) with very little increase in debt. This amounts to about $14.0 million dollars per year or an 11.6 percent dividend/stock buyback yield—based on our purchase price. This is very attractive.
The third, and most attractive characteristic of our purchase, is the significant undervaluation of the shares. The company’s valuation meets a criteria of one of my favorite value investors, Seth Klarman, who said many years ago that he likes to own “belt and suspenders stocks”. This is a situation where a company’s valuation is cheap compared to its earnings (i.e. belt) and their balance sheet/theoretical liquidation value (i.e. suspenders).
On an earnings basis we think Houston Wire & Cable is worth 15 times normalized earnings, which as of the latest quarter was $10.33 per share. The chart to the right compares Houston Wire & Cable’s stock price (red line) against our estimated intrinsic value (blue line) since the company went public in 2006. Notice how the value of the company’s
business/estimated intrinsic value (blue line) has been relatively stable but its share price (red line) has fluctuated wildly. As value investors we try to take advantage of “Mr. Market’s” emotions and look favorably upon a situation when a company’s stock price (red line) is well below our estimated intrinsic value (blue line). In the case of Houston Wire & Cable, we were able to purchase shares at an average price of $5.28 or 51 percent of estimated intrinsic value. This is the so called “belt” that Seth Klarman references in valuation support.
The so called “suspenders” of valuation support is based on comparing the price of Houston Wire & Cable’s stock to its theoretical liquidation value (the difference between tangible assets and liabilities on its balance sheet). Given the fact that the company has consistently generated a return on invested capital of 15 percent, we think it is highly unlikely the company’s share price will drop below this theoretical liquidation value, which stood at $4.72 at the time of our purchase. The chart on the bottom right of the page compares the stock price/liquidation value ratio of Houston Wire & Cable against its stock price since going public in 2006. Even during the Financial Crisis of 2008 and 2009, a period of extreme economic stress, the stock did not fall below its liquidation value. Hence, at the time of purchase we thought the downside risk of owning the stock was a relatively modest 10.6 percent to $4.72. If we compare our purchase price of $5.28 for Houston Wire & Cable to 85 percent of estimated intrinsic value, we get an upside return potential of 66.3 percent. When comparing the ratio of upside return potential and downside risk we get a very favorable ratio of 6.3 to 1.
Much of the success of a long-term investment strategy involves putting money into situations that offer what are called asymmetrical return opportunities—where the upside return is much greater than the downside risk. Not all of these so called “belt and suspenders” stocks will turn out profitable. However, over time with the so called “law of large numbers”, most of these types of investments will turn out successful and contribute to the long-term goal of generating an above average rate of return.
(Note: Some clients may question why we only bought a one percent position in Houston Wire & Cable. At the time of our purchase the company’s market capitalization was $87 million and traded about 79,000 shares a day. This is what some investors call a micro cap company and it took us a little over a week to establish our position. We end up purchasing 65,522 shares—just shy of a day’s average trading volume. We think it is important to limit the amount of shares owned to a level close to the average share amount traded so we can get out of the position in a timely manner.)
The above post has been excerpted from a recent letter of Granite Value Capital.
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