North American Galvanizing and Coatings (NGA) provides rust protection for metals for commercial and industrial customers. It trades with a P/E of just 8, despite the fact that it has no debt and just booked record earnings in the first quarter of 2009. Its revenue has nearly doubled in the last three years, from $47 million to $86 million, despite the recession. So why is this yet another of the many investments not worth a swing?
The answer has to do with the company's cost structure, which is heavily reliant on the price of zinc. Compared to other commodities, the price of zinc is especially volatile, having fluctuated by at least 90% in each of the last three years! Value investors prefer to avoid companies which are reliant on commodity prices, as their cash flows are very difficult to predict.
Some may argue that since NGA is both a buyer and seller of zinc, it can pass on price increases to its customers. Unfortunately, this argument ignores the fact that substitutes do exist. The primary substitute for zinc that is used for protection from rust is paint. Indeed, a quick look at NGA's operating history suggests that customers are quite willing to switch between the two: there is a clear pattern of volume declines when zinc prices increase, and vice versa.
While an investor could luck out by having zinc prices (and therefore the company's costs) hold steady or trend favourably in relation to substitutes, this is hardly the modus operandi for a value investor, who prefers to only take risks when the odds are firmly in his favour.