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Know when to hold, know when to fold. The case of Stella-Jones

 

Pretty much everyone in the investment world agrees that buying is easier than selling. At Baskin, we try to invest in companies with outstanding economics that are run by competent and intelligent management teams. Once we find one of these superior companies, we will continue to buy the stock as long as the price is reasonable.

The decision to sell a stock is not as simple. If a stock we own rises to an expensive valuation, the underlying company will still continue to generate strong free cash flows to be used for the benefit of shareholders. Selling a stock after it rises will trigger capital gains taxes, transaction costs, and force us to invest in a potentially inferior company. For these reasons, we are typically reluctant to sell after a stock rises.

However, the hardest situation is when a stock we own falls in price. There are many reasons a stock may fall:

Did we make a mistake in the judgement of the company quality? If so, we should sell and take the loss.

Did we pay too much for a nonetheless high-quality company that is now becoming more appropriately valued? If so, we should not sell, but instead take advantage of the price weakness and buy more.

Is the market overreacting due to short-term bad news where the long-term prospects of the company are unchanged? If so, we should be thrilled and be willing to buy even more.

Accordingly, the appropriate response to a declining stock price is highly dependent on the situation. It would be very unfortunate to continue to add money to a low-quality company that we believed to be of a high quality. However, it would be almost as bad to sell shares of a very high quality company after a price decline only to see the stock price double or triple as the market recognized the fundamental qualities of the stock. It is our job as professional investors to determine which scenario is applicable, and it is a never-ending process for us to continually find new information so we can learn more about our portfolio holdings.

One stock that we own that has fallen since we purchased it is Stella-Jones. Soon after we purchased the stock, Stella-Jones announced poor financial results and lowered its expectations for 2017. To recap our thesis, Stella-Jones is the largest manufacturer of wooden railway ties and utility poles in North America with around a 50% market share in wood ties and about a 40% market share for utility poles. For reasons explained below, we think that Stella-Jones is a terrific company with outstanding economics.

In North America, around 90% of railway ties are made of wood, and a wooden railway tie can only be replaced with another wooden railway tie. Furthermore, to prevent wood rot, wooden ties are coated with a substance called creosote, which is a distillate of coal tar. Because creosote is carcinogenic, and the production of creosote is harmful to the environment, manufacturers need to be licensed by the government, creating a barrier to new entrants in the industry.  For these reasons, it seems likely that Stella-Jones will continue to make railway ties as long as railroads operate in North America, even though demand may fluctuate year over year, and will continue to enjoy a large share of the market.

Like railway ties, utility poles are critical to the infrastructure of North America. Wooden utility poles have a useful life of 40-80 years. A large portion of the US power grid was built in the post-war period, so there are literally millions of utility poles that need to be replaced in the next couple of decades especially in weather-sensitive coastal regions.

Stella-Jones also has a growing residential lumber segment, and has a history of generating strong returns from acquisitions.  For these reasons, despite the poor forecast for 2017, we continue to believe that Stella-Jones is a company well positioned to meet the continued demand for railway ties and utility poles in the future, and is run by a highly competent management team. Thus, it does not appear we made a mistake regarding the long-term business quality and opportunity of Stella-Jones.

However, did we pay too much for Stella-Jones? At the time, we paid a below-market multiple for the stock even though Stella-Jones was trading at a premium to other wood products companies. We thought at the time that the price was reasonable, but did not anticipate demand for railway ties being so weak in 2017. So it is possible that we paid too much for the stock when considering the cycle of railway ties, but that does not mean at all that we should sell now given our expectations for the future.

So for the final question, has the market overreacted to short-term bad news? Most analysts have reduced their earnings estimates for Stella-Jones for 2017 due to the company’s reduced guidance, while maintaining the long-term outlook for the company. For long-term growth companies, one year of results does not mean much; our reliance on long-term cash flows is much more important. Even if one thinks that railway tie demand will take somewhat longer to return to prior levels, this is still relatively immaterial when looking at the future prospects of the company. Stella-Jones’s stock is down about 30% from its 2016 high. This certainly seems to us to be a substantial overreaction, and we are thrilled to continue buying Stella-Jones at its now cheaper price.

Ernest Wong

April 6, 2017

Clients of Baskin Wealth Management are shareholders of Stella-Jones