What is the thesis behind one of your beaten-up cyclical holdings, Commercial Metals [CMC]?
JD: The company collects, trades, recycles and markets steel and other metals. It runs a scrap-metal recycling network and also manufactures finished metal products for sale. This is a tough business, but the company has proven quite adept at maintaining reliable raw material supplies and keeping costs down, which has resulted in two decades of uninterrupted profitability. I’d argue that the market is overestimating the company’s cyclicality – over several cycles, it has more than survived the down times and thrived during good times.
I often talk about how I hate to pay a premium for glamour, but I’m very happy to get a discount for “unglamourousness,” if you will, and I think Commercial Metals has a big discount in that regard. Investors look at something like this as an old, buggy-whip type company, which is not at all the case. In the latest quarter it delivered nearly $3 billion in revenue for the first time in its history – seven years ago that quarterly number was a little over $600 million. That’s a fairly dramatic increase, from price increases, acquisitions and organic growth.
The company’s geographic markets are well diversified, with around 60% of revenues coming from the U.S. and 40% from several international markets. In recent years they’ve grown particularly well in Central and Eastern Europe, for example, which should provide significant opportunity over time.
The shares certainly qualify as out of favor, down nearly 65% so far this year to a recent $10.60.
JD: This is a classic example of the type of screamingly inexpensive stock that attracts us. Commercial Metals earned a return on equity last year above 25% and while it won’t do that every year, it will have handsome returns in most years. Its debt-to-equity ratio is just under 50%, which puts it in the bottom third of all U.S. companies. But at the current price the stock trades at only 4.6x trailing earnings, 74% of book value and 0.13x annual sales.
Over what time horizon are you expecting this to pay off?
JD: We typically buy with a time horizon of three to five years, although our actual holding periods end up averaging between one and two years. If history is any guide – and we believe it will be in this case – there will come a time in the next few years when people are enthusiastic about the company and the stock sells again for a market multiple. At that point, earnings will be healthy and will likely return to at least the level of the past year. Given that the shares trade for less than one-third of the market multiple today, we can be patient in waiting for enthusiasm to return and still expect to earn an excellent return.