Same as ever: Investing in Continuity
“Prediction is very difficult, especially about the future.” So said Nobel Prize-winning quantum physicist Niels Bohr. Speculating about what will change is especially challenging – but how about what won’t change?
From an investment perspective, thinking about the latter, and the continuity of proven compounders, can be very rewarding. We believe US insulation company TopBuild exemplifies these characteristics in a sector less likely to experience dramatic structural change in the medium term.
As the artificial intelligence (AI) revolution continues apace, analysts are scrambling to project the industry’s growth trajectory and how quickly we might get there – presumably forecasting large numbers to justify some companies’ valuations. This sector has proven fertile ground for investors, with share price rises grounded in fundamentals (earnings), and not just pure speculation. We are not bashing the value of AI investments; in fact, we have exposure through a variety of “picks and shovels” businesses discussed here.
Investing in AI, or any rapidly changing end market, involves speculation about future trends and forecasts underpinned by strong – and sometimes exponential – growth. Given that technology companies make up such a large part of US and global equity benchmarks, there is increasing scrutiny on such forecasts.
Rather than focusing on how emerging trends might shape the future, why not focus on the things that are likely to stay the same? Surprisingly, given that he is a technology champion and one of the greatest innovators of the modern era, Amazon chairman and founder Jeff Bezos echoed this sentiment in a 2012 interview:
“I very frequently get the question: What’s gonna change in the next 10 years? And that is an interesting question. It’s a very common one. I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two…”
When I think about industries less likely to experience structural change over the medium term, housebuilding comes to mind. As a former sell-side house building and construction analyst, I have seen more than my fair share of construction sites. Despite longstanding discussions of innovation and modern construction methods, we have broadly been building houses in the same way for the past 100 years.
Small geographic differences exist – in Scotland they use more timber frame construction and in Scandinavia more modular building – but go to any house-building site and the chances are you’ll still see tradesmen using bricks and cement. While incremental changes to construction methods and materials are likely, we think one area that should persist into the future is the requirement for insulation.
TopBuild is a leading installer and distributor of insulation products in the US and Canada, with 64% of sales coming from residential buildings. Since the company was spun out of Masco in 2015, the group has been busy consolidating a highly fragmented market of mom-and-pop businesses, achieving sales CAGR of 16% and adjusted EBITDA CAGR of 33%.
The company’s capital-light model also provides strong and improving free cash flow (FCF) generation – something we look for in Quality companies.
Management practises disciplined capital allocation, matching acquisitive growth with improving returns; cash flow return on investment has increased from ~8% to ~28% over the same period. Buybacks are also on the menu and the latest repurchase programme totals $1bn against a current market cap of $12.5bn. So far so good – but can we expect this compounding machine to sustain its momentum?
We believe the ongoing need for insulation in new homes over the medium term is one of the less risky forecasts we’ll make in our careers. The product itself may evolve, but as an installer and distributor, rather than a manufacturer, TopBuild’s business model should remain unaffected by a product innovation arms race. Longer-term demand is likely to be supported by a housing shortage in the US and increasing regulatory requirements for enhanced thermal efficiency.
Shorter term, we acknowledge that the inherent cyclicality of residential building could create a bumpy ride, though the group has mitigated this risk by expanding into commercial and industrial markets, which now account for 38% of sales. Challenging trading environments can also create opportunities for adept capital allocators like TopBuild to pursue accretive M&A. Despite short-term uncertainty, a FCF yield of ~7% seems like a reasonable price to pay for a long-term compounder of this nature.
Investing for the long term
We believe understanding the past – and what is likely to persist into the future – is just as important as making speculations about new developments. It seems that many prefer to focus on the latter, which is understandable. To quote Morgan Housel in his wonderful book, Same as Ever: “Change captures our attention because it’s surprising and exciting.”
From an investment perspective, however, owning shares in companies with sustainable growth rates that are undervalued by the market, such as TopBuild, can be just as rewarding as investing in companies whose exponential growth is underappreciated – like some of the AI champions.
I’ll leave you with the words of Winston Churchill: “The longer you can look back, the farther you can look forward.”
IMPORTANT NOTICE
This document has been prepared by River Global Investors LLP (“RGI”). RGI is authorised and regulated in the United Kingdom by the Financial Conduct Authority (Firm Reference No. 453087) and is registered in England (Company No. OC317647), with its registered office at 30 Coleman Street, London EC2R 5AL. This article does not constitute an investment recommendation and should not be used as the basis for any investment decision. Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article.
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