This article is authored by MOI Global instructor Keith Smith, fund manager at Bonhoeffer Fund, based in Rochester, New York.
Keith is an instructor at Best Ideas 2024.
What are the characteristics of a good investment theme? First, the investments that are a part of the theme must generate an adequate expected return. In today’s interest rate environment, where an investor can obtain low teens expected returns from well underwritten first lien debt on a growing capital light firm, the expected returns need to be at least in the mid to high teens. Positive equity returns are generated from two sources:
1) from growth in underlying firm cash flows as a result of being internally re-invested, shares being repurchased or paid out as dividends, and
2) the increase in the cash flow valuation multiple the market applies to the cash flows.
The more predictable source is through growth as changes in cash flow multiples reflect the speculative element of market pricing. Therefore, in searching for higher expected returns, growth should carry most if not all the load. Lower multiples provide a margin of safety against multiple contraction and should not be relied upon to generate most of the return. If multiple expansion occurs, it is a bonus.
Another characteristic of a good investment theme is that it should be applicable to multiple industries and have generated excess returns in the past. Consolidation is one such theme. Over the past few years, a number of industries have gone through consolidation with economics of the leading firms in the industry getting better with time. In many cases, the valuation of these consolidating firms are based upon their historical performance and not their improving current and future performance. Thus, there is a lag associated with valuation multiple appreciation as well as cash flow appreciation. This can lead to a favorable situation where both cash flows and multiples increase at the same time. Three examples of the growth/consolidation theme are found in our subject companies (North American Construction, The Ashtead Group and Builders FirstSource).
Consolidation and organic growth are important sources of scale for many businesses. Evidence of scale is seen in higher margins and higher asset turns over time. Scale occurs primarily at either a local level (as in retailing businesses) or on a national level (as in consumer durables or staples). As a firm grows, bureaucracy can dilute the positive effects of scale. Scale can also enhance larger players’ moats, as the larger firms can afford technology to improve productivity, reduce bureaucracy and provide less costly and more timely products and services.
Consolidation can occur geographically or functionally along a value chain. If done geographically and if more synergies are realized locally than nationally, cluster or customer density are important. Generally, fragmented markets are consolidated via both organic growth (gaining market share) and consolidation. Depending upon the difficulty, cost and timing of gaining market share and the price of an M&A targets, many times M&A is a better approach to consolidation than organic growth.
An interesting question is where in the consolidation life cycle does it make sense to invest? In the emerging portion of the life cycle (the top firm have less than 1% of market share), many of the economies of scale and synergies are not reflected in the financials of the firm so the valuations are typically lower and potential for growth is higher. Specialization can create favorable economics in the emerging portion of the life cycle. Later on, in the consolidation lifecycle, the economies of scale and synergies are more evident in the financials, but the valuation is typically higher. Investing in these consolidation situations as they develop can benefit from an increase in business quality not reflected in the recent price. All of the firms examined below have expected equity returns of greater than 20%.
The first firm we will look at is North American Construction (US: NOA), which is specializing in mining construction services (including moving dirt and road construction and repair) in remote locations for both mining and infrastructure firms. This a nascent fragmented market in North America and Australia. The mining segment of the construction services market is fragmented with many players having less than 1% market share. NOA has developed operational key performance indicators (“KPI”)s (such as equipment utilization) to help estimate NOA’s return in invested capital (“RoIC”) for projects they bid on. These KPIs provide guidance on what projects to bid on. A few other high RoIC specialty construction services firms have recently emerged in Australia, namely Duratec and Mader, which also focus on specific segments of the construction services market. Beginning in oil sands construction services, NOA over time has expanded its functional footprint (into mine management services) and geographic footprint (into Australia). NOA’s management team has also used traditional capital allocation such as leverage and share buybacks to enhance shareholder returns over time.
The second firm is the Ashtead Group (UK: AHT), which has historically rolled up and gained market share in the equipment rental market in the United States, Canada, and the United Kingdom. Equipment rental firms can achieve local economies of scale (clustering) through shared equipment pools (higher utilization), cross selling opportunities, technology automation and service opportunities. Ashtead uses a hybrid consolidation approach. Ashtead purchases firms providing new rental equipment types (such as cleaning equipment) or equipment rental firms in new geographic areas. Once a beachhead is established, Ashtead relies on organic growth for growth within a region or functional area. Ashtead has developed a nationwide distribution platform where new products and services can easily be distributed and provided to its customers. In addition, Ashtead’s management team has used traditional earnings growth techniques such as leverage and share buybacks when Ashtead’s stock price is low and there are no immediate consolidation opportunities available in the market.
The third firm is Builders FirstSource (US: BLDR), which has rolled-up and gained market share across different segments and geographic regions for the supply of value-added building products and building product distribution across the United States. As a part of the roll-up process, BFS is increasing its total addressable market both geographically and via new product/service offerings. Like Ashtead, BFS has developed a nationwide distribution platform for the distribution of new value-added building products and services. BFS’ management team has also used traditional earnings growth techniques such as leverage and share buybacks when BFS’ stock price is low and there are no immediate consolidation opportunities available in the market.