This is the time of the year my Ivey value-investing students have submitted their final stock picks for the year. It was not easy for them to find truly undervalued stocks, given the market’s ascent since January.
That said, my students had less difficulty finding “deep value” stocks (those Ben Graham would have liked, and which have been largely shunned by investors over the past few years), than finding “quality” stocks (those that would appeal to Warren Buffett). Two of the Graham-type stocks that students worked on got my attention and are profiled below.
The first was Hardwoods Distribution Inc. (HDI-TSX), a wholesale distributor of non-structural architectural building products in North America. The stock was identified as a possibly undervalued stock with a price-to-earnings ratio (P/E) of 8.5 times, a price-to-book (P/B) of one and a market cap of $264.4-million at the time of the student report. HDI is an intermediary between hardwood manufacturers and commercial construction customers. It maintains 63 distribution facilities across 28 states and five provinces that are within one hour of their major customers. While the company has made several acquisitions over the past six years, fully 15 per cent of company’s growth in recent years has been organic.
HDI’s senior managers has been with the company for at least 10 years. Management is characterized by strong operational performance and market leadership. For example, revenue, earnings before interest and taxes, and earnings per share have increased by 24 per cent, 18 per cent and 13 per cent, respectively, over the past five years on an annual basis. And this growth was achieved while HDI was involved in a number of major acquisitions, proof of management’s ability to integrate the acquired companies.
Moreover, HDI has managed to increase market share in North America’s segmented market; its current 10-per-cent share is more than double that of the second player in the industry. No single company supplier accounts for more than 5.7 per cent of HDI’s cost of goods sold. At the same time, it has a diverse customer base with no single customer accounting for more than 1.1 per cent of sales. The industry is not very attractive with low barriers to entry, high competition and slim margins. Moreover, the key driver of the industry is housing starts, which is an economic indicator characterized by high cyclical behaviour. Nevertheless, HDI has managed to maintain stable, albeit low, operating margins of around 4.7 per cent over the past four years, making the company of medium business risk.
HDI’s total debt-to-capital ratio has averaged about 42 per cent in the past five years including operating leases, and it is fair to assume that this is the company’s target capital structure. However, most of the company’s debt is short term in nature, a worrisome factor. All in all, HDI’s financial risk is medium with a bond rating of BBB.
HDI has an adjusted return on invested capital of 7.8 per cent and a cost of capital of 6.9 per cent, allowing the company to add value as it grows. Students felt that the company is currently enjoying some demand and cost advantages, which nevertheless are difficult to sustain in the long run because of the relatively low barriers to enter the industry. HDI’s intrinsic value was estimated to be $19.05 and, accounting for a 33-per-cent margin of safety, its entry price to be $12.76, which is just above its current stock price of $12.44, making the stock a “buy” at this moment.
Ingles Markets Inc. (IMKTA-Nasdaq) also met the Graham value investing criteria with P/E and P/B of 5.84 and 0.95, respectively, and market cap of US$568-million, at the time of the student report. IMKTA, founded in 1963 as a family business and publicly listed in 1987, owns and operates 200 supermarkets throughout the Southern United States. It focuses primarily on serving rural and semi-rural markets and has no stores in municipalities with population greater than 100,000 people. Robert Ingle II, son of the founder, is currently board chair, while the chief executive is Jim Lanning, an individual who is not part of the Ingles family but who has worked in various position within the company since 1975.
IMKTA’s operating performance has been very stable. The company’s operating margin has varied between 3 per cent and 3.5 per cent over the past 10 years. Revenue declined only once over the same period, a small 1.5-per-cent drop in 2015. Given its operating stability and domination of the rural grocery market in the U.S. South (a market somewhat insulated from industry disruptors as online ordering and home delivery are far less practical in rural settings), the students felt comfortable assigning the company low business risk. IMKTA seems to be targeting total debt-to-capital (including operating leases) of 67 per cent, which is about right for companies in this segment of the industry that have low business risk. This qualifies the company for medium financial risk and an A bond rating.
IMKTA has an adjusted return on invested capital of 3.02 per cent and a cost of capital of 5 per cent, which suggests that growth will destroy value. Its intrinsic value was estimated to be US$50.53 and, accounting for 33-per-cent margin of safety, its entry price to be US$33.86, which is above its current stock price of US$30.07, making the stock a buy at this moment. It is noteworthy, however, that the company’s intrinsic value has not changed much over the past three years and neither has the stock price. Students had some difficulty seeing the catalyst that would propel the company’s stock to the estimated intrinsic value.
The best scenario would be for the company to be acquired by a large competitor, but Mr. Ingle, who commands 72 per cent of voting power, does not seem to be interested in selling. Another possibility is for the company to benefit from weaker competitors leaving the rural grocery space.
Graham stocks are normally much easier to be found undervalued than Buffett-like stocks, and from the students’ analyses, both stocks above fit the bill.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos