Lets kick things off with a case study, Hardwoods Distribution Income Fund (TSX-HWD.un). According to Buffett your investment idea should be very simple and should be explained without any difficult math, discounted cash flow analysis, etc. I will give the short Buffett version, and a much longer explanation of this investment. So here goes:
The Short Version
Hardwoods has fallen on hard times through the recession. Despite the losses from bad debts (customers who didn’t pay) and writing off of goodwill, the company's core business hasn't changed at all. Sales have fallen from $360 million per year in 2006 to $200 million in 2010. The company's Net Profit margin as percent of sales historically has ranged from between 3.2% to 4.9% in normal times, with 3.8% being the most common. Once operating conditions return to some level of normalcy, probably next year, the company will earn around $6.4 - $7.8 million. If we divide this by number of shares outstanding (14.4 million), the company will earn between $0.44-$0.54 per share.
Now we go look at the share price and it currently trades at $2.06. That means the company is selling for around 4 times it's annual profit in a year. I should add that this multiple is based on the new lower level of sales and assuming the lower end of the profit margin, conservative yet reasonable assumptions.
Clearly buying this company with an earnings yield of 25% you will do just fine in the long term. If we apply a conservative earnings multiple of 8.5 times, Hardwoods is easily worth approximately $4.25/sh.
Hardwoods Inc is a Vancouver based wholesale lumber distributor. Their many areas of focus is Western Canada, and Western US states. It has been in business for something like 70 years. The former owners (Sauder family) have a long history in the lumber industry. The business is amazingly simple, they buy hardwood lumber and sheet goods and resell them for a profit. Looking back over their filings since 2004 their gross margins have ranged between 18-19% (percent of sales). So basically that is their markup on the products they sell. Out of the gross profit they have to pay all of their overhead, salaries, and other cost such as bad debts. The company requires very little maintenance capital and it leases much of there facilities.
Looking back to the period from 2004 to 2007 the company, at the end of the day, earned a Net Profit (percent of sales) of between 3.2% and 4.9%. In 2005 & 2007 the company's net profit was 3.8%.
During the period that followed 2007 the company has struggled with debt covenants, and bad debts. Obviously being tied to the housing market caused a dramatic drop in sales and bad debts. The company was loaded with debt before going public in 2004. Beside this, the company has written off all the goodwill it had on its books creating large losses in the process.
Despite tough operating conditions the company has paid off substantially all of their debt during this period and the losses associated with bad debts are subsiding.
Sales have fallen from $360 million in 2006 to around $200 million in 2010. The bad debts of the recession are nearly behind them and once again this company will be a cash cow. Applying the conservative net profit margin of 3.2% and 3.8%, the company will earn somewhere between $0.44/sh and $0.54/sh. At the current share price of $2.06 the shares are trading at roughly 4 times normalized earnings.
As above, applying a conservative valuation of 8.5 times normal earning this company is easily worth somewhere around $4.25/sh. It's trading for approximately 50% of it intrinsic value. It's like getting a dollar bill for 50 cents.
No catalyst required, the company just isn't followed by analysts, is small and thinly traded. It is a pure Graham-Buffett investment.
Is Hardwoods a bargain? You bet.
I should add that the company is currently an income trust and will likely convert back to a corporation before the end of the year. The company is thinly traded however volume seems to be picking up as of late. This makes it opportune for individual investors. You will have to be patient but even paying $3 would be a fair price.
So in summary, this is simple value investing case study. It is a simple company trading at a steep discount to intrinsic value. The odd are heavily stacked in your favor that this no-brainer will be an investment success. This won't make you money tomorrow, but two years from now it will be trading higher than today.
Price is what you pay, value is what you get - Charlie Munger
Disclosure - long HWD.un at time of writing