Better supply chains could lead to extended production and lead times. That’s why companies need wires and cables on transportation channels for faster service to customers. In today’s FA Alpha, we’ll look at Encore Wire Corporation, a company that specializes in delivering electrical building wires and cables, and examine the sustainability of its high returns.
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During the last two years, it became evident that we need better supply chains.
Companies had trouble getting their hands on the needed raw materials, leading to extended production and lead times.
The main reason why this happened is not the pandemic. It happened because the U.S. ignored investments in its supply chain and infrastructure for at least a decade, and we are paying for it.
Now, investments are ramping up in the space as the problems are recognized.
Supply Chain Super Cycle is here. And that means companies are doing whatever they can to improve their infrastructure and supply chains.
They are bringing their manufacturing facilities home and improving the transportation channels to provide better and faster service to the customers.
Of course, the essential things these companies need are wires and cables.
This is where Encore Wire Corporation (WIRE) gets into the picture. The company specializes in delivering electrical building wires and cables for interior electrical wiring in the U.S.
Any company that wants to spend on its infrastructure and supply chain is a potential customer for Encore.
Considering this, Supply Chain Super Cycle has the potential to make the demand for wires and cables boom. And actually, it already has.
The profitability of Encore exploded incredibly in the last year. The Uniform return on assets (“ROA”), which was just below 10% for the last four years, jumped to 44% in 2021.
This is every business’s and shareholder’s dream, but not enough to make new investment decisions.
If developments regarding the sector and the company are already priced in by the market, there would not be much upside potential. An investor should only make an investment when there is a disagreement with the market.
By utilizing our Embedded Expectations Analysis (“EEA”) framework, we can see what investors expect these companies to do at the current stock price.
Stock valuations are typically determined using a discounted cash flow (“DCF”) model, which makes assumptions about the future and produces the “intrinsic value” of the stock.
We know models with garbage-in assumptions based on distorted GAAP metrics only come out as garbage. Therefore, we use the current stock price with our Embedded Expectations Analysis to determine what returns the market expects.
At around $147 levels, the market seems to be very pessimistic about the future of the company.
The market thinks these returns will not be sustainable and expects the ROA to go down back to below 10%.
The market does not seem to believe Encore is going to benefit sustainably from the Supply Chain Super Cycle investments. It is pretending this boost is a one-off thing.
However, considering the company’s position in the space and its ability to acquire new customers with its essential products, these expectations seem too low.
This leads to undervaluations, which does not seem fair for such a company.
The market’s lack of understanding of the sustainability of its high returns, the company’s high growth, and low valuation means that Encore Wire is a great candidate to be an FA Alpha 50 name.
Throughout financial market history, many of the world’s most successful investors have been candid in their belief that Generally Accepted Accounting Principles (“GAAP”) distort economic reality.
Warren Buffett, for example, once said investors should “concentrate on the world of companies, not arcane accounting mathematics.”
Investors who neglect the very real issues with as-reported accounting can find themselves caught up in investing with the crowd, blindly following hot “themes” without a thorough grasp of how to understand the businesses in question.
The only true way to focus on the “world of companies,” as Buffett suggests investors do, is to present a clear picture of how a business operates, something that can only be done by adjusting financial statements to reflect the arbitrary nature of certain accounting rules that leave much to discretion.
The world’s best investors understand the need to make these adjustments, which allows them to focus not on picking out the most popular companies but rather on looking for great names in sleepy areas that the market isn’t paying much attention to. From there, the goal is to then identify quality companies with significant growth potential at reasonable prices.
That’s exactly what we’ve set out to do with the FA Alpha, our monthly list of 50 companies that rank at the top for quality, high growth, and low valuations.
This list has outperformed the market by 300 basis points per year for over 20 years now, effectively doubling the performance of the market by focusing on the real fundamentals and valuations of companies with our proprietary Uniform Accounting framework.
See for yourself below.
To see the other 49 names on the list, click here.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
Today’s highlight, Encore Wire Corporation (WIRE) is one of the top stock picks from FA Alpha 50 this month. To see more stock picks like this, become an FA Alpha get access to FA Alpha 50.