Getting some credit
Howden have been one of the strongest performers in my portfolio and are one of its formative members, but I mustn’t let nostalgia and the fact I like the company get in the way of making an informed judgement. Eliminating our biases is easier said than done, particularly as Howden is a company that feels like it follows my journey as an investor. My buying reasoning back in mid-2011, as I was just getting to grips with investing and different techniques, was basic and a little quirky. I’d identified that I liked the company, but couldn’t particularly articulate why, beyond it being stable and reasonably cheap. Unlike some of my early choices, though, Howden never struck me as an amateur mistake – an oversight of something, or a fundamental misunderstanding. The opposite, in fact – the more companies I looked at and had to compare them to, the more I liked Howden’s way of doing things. For a far better explanation of Howden’s business model than I’ve ever been able to put on paper, look here.
The price is up about 110% in the time I’ve held it, though, and that should give anyone pause for thought about the continuing value. It is essentially the same business, too, with everything basically identical except for a few more depots (and the improved revenue and profits that come with that). Such a large price appreciation with a relatively small change in profits and (though this is a subjective metric) prospective profitability means the market has dramatically changed its opinion on Howden. What was a definitively ‘value’ company, selling at a small multiple of profits even with obvious growth prospects, is now priced more like the maturing, yet still growing established business that it is.
I don’t hold many companies like Howden Joinery. My lot, in my experience so far, has mostly been with cheap companies. They might be cheap for a reason, of course, perhaps having a price that overdoes the pessimissm, but you’re unlikely to find diamonds by looking only in the bottom x%. In short, there’s a quality spectrum, and I’ve tended to focus on the lower end of it. That’s a consequence of the way I’ve screened for shares – using loose proxies for value like P/E and P/TBV too stringently means you’ll be focusing on ‘cheap companies – good and bad’. A more holistic approach allows me to look for ‘good/great companies trading at average valuations’. That’s something I’m trying to figure how best to do with the tools currently available to me.
And that presents me with an unusual dilemma. What price is reasonable to pay for Howden’s quality? Quality, as I’ve mentioned before, is best represented numerically to me in two ways – consistency of expected cash flow, and high returns (supernormal, in excess of cost of capital). A quality company, like Coca-Cola, has a large enough competitive advantage that their cash flows are more or less secure, and they earn above-CoC returns. Aside from the quality issue, there’s also the question of growth. Management have been saying for years that they think the UK could manage more than 600 depots. They currently have 529. I’ll also rehash a graph from my first post on Howden, though note that my forecast depot figures are now off. I’d penciled in 30 opening; in actuality, only 20 did.
So there’s an extrinsic growth driver – management spending money on new depots they think will be profitable – and an intrinsic growth driver, too. There are potentially others, of course – overseas expansion(they have some depots in France) being the obvious one. There’s both a clear negative and clear positive to that idea. Positively, the business model is provably superb, and the company has proven expertise in executing it. Negatively, there are all sorts of differences – including ones I’m sure I can’t even comprehend – between countries. France’s population density, for instance, is an obvious factor that probably dampens the profitability of a ‘local hub’ model like the one Howdens have. Management say the ‘inherent costs of doing business in France’ mean it’s unlikely to ever be as profitable as the UK.
If you’re into DCFs, I reckon Howden Joinery is one you can fairly easily model with one. A quick back-of-the-envelope valuation I just jotted down came up with a value almost identical to the current market cap – and that’s without tinkering or pre-manipulating the inputs to come up with the output.
They key drivers, I think, are twofold. Firstly; do you think Howden Joinery has a sustainable competitive advantage? It will need this to justify it’s current valuation, at a level many times its current tangible operating assets. It needs to earn high returns to justify that. Personally – I think their advantage is sustainable. I think they have an entrenched, well-differentiated, customer-focused product, a supply chain which is neither cheap nor fast to build (deterring entrants) and, I suspect, enough saturation to put off prospective competitors, too.
Secondly, though, just how much growth do you think there is? If we take management’s 600+ depots at face value, there might be perhaps another hundred from here – about 9-10% more depots. The developing depots question is more difficult to quantify. Looking at it now, I actually suspect you could probably tease out a relationship from the data, but the figures might be a little noisy for it. How much more growth can we expect from new depots maturing? Totting it all up, I guess the underlying company maybe has 30% to go from here. It’s a guess, but it’s a guess with a tiny bit of guidance from what we know.
I think we’re probably about fair value here. The question for me now is whether to sell, which entirely depends on if I find somewhere else to put the money.