Anabatic Fund recently released its Q4 2020 Investor Letter, a copy of which you can download here. The fund posted a return of -11.7% in 2020 (net of fees) compared to the S&P 500 Index which returned 16.3% in the same period. You should check out Anabatic Fund’s top 5 stock picks for investors to buy right now, which could be the biggest winners of this year.
In the Q4 2020 Investor Letter, Anabatic Fund highlighted a few stocks and Armstrong World Industries Inc (NYSE:AWI) is one of them. Armstrong World Industries Inc (NYSE:AWI) is an international designer and manufacturer of walls and ceilings. In the last three months, Armstrong World Industries Inc (NYSE:AWI) stock gained 35% and on January 26th it had a closing price of $81.15. Here is what Anabatic Fund said:
“Armstrong (AWI) remains our largest investment, a position it has occupied for five years. We made our initial purchases in late 2015 and early 2016, adding more shares in 2017. During 2020 we added only a small number of shares given the already large size of the investment. 17 Our average cost is $37.20 per share.
The 20% decline in the price of AWI shares in 2020 makes it feel like a lifetime has passed since 2019, when our AWI shares returned 63% and lapped the return of the broader U.S. equity market. But it’s worth remembering that AWI has still been a very good investment for us. Using February 1, 2016, as a proxy for the weighted average date of our investment in AWI shares, the stock has more than doubled, returning 18.5% per year for almost five years.18 Over just the last three years – including a 3.8% decline in 2018 and the 20% decline in 2020 – AWI has still returned more than 25%, or 7.9% per year, although that trails the S&P 500’s return by almost half.
It is odd that a dominant, predictable business has produced such lumpy returns, and those lumpy returns are magnified by our concentrated position. Markets are known to do such things. I would be more than happy to sign up again for the returns we’ve earned over the last five years. Despite the rollercoaster ride, we should be glad to trade patience for a good return. That lesson applies to the future, too.
Looking back at 2020, the 20% decline in Armstrong’s share price would imply that the company had a rough year. A look at the actual business tells a different, far more stable story. Despite having to shut down production and deliveries for most of the second quarter, and despite a huge reduction in the usage of all kinds of commercial space, the company suffered only a moderate decline in year-over-year results. Sales for 2020 will likely fall by ~10%, but Armstrong should still post an operating margin better than 25% and a free cash flow margin above 20 percent. 20 Few companies can point to profitability at those levels at the peak of a cyclical boom, let alone in the teeth of a pandemic-driven recession. Armstrong’s 2020 results also compare favorably to 2018’s results, with flat or higher sales, an improvement in margins, and a significant boost in free cash flow.
Another way to frame the situation is to consider the structure of our ownership. If we owned the entire company and could distribute the excess cash generated this year – after all expenses, taxes, investments, capital expenditures, acquisitions and share repurchases – we would have a check in the mail for more than $200 million. That would be a one-year return (or yield) of approximately 10% on our cost basis. 21 Likewise, we would have received cash equal to roughly half of our entire 2015-16 purchase price in just the past five years, and we would still own a dominant, healthy business with decades of profits and cash flow ahead of it. That experience would create a far different mindset about the company’s 2020 performance than what most shareholders have after they get a brokerage statement showing a 20% drop in the share price.
I see no reason to be worried about the company’s medium- and long-term prospects. The balance sheet is healthy, new products and recent acquisitions are gaining traction, and the competitive gap is widening in Armstrong’s favor. This is among the most favorable competitive situations I’ve ever seen, and Armstrong is likely to continue to dominate the North American ceilings industry.
As the economy reopens and recovers, commercial spaces of all kinds will need to be retrofitted or redesigned to accommodate a post-COVID world.22 Less density is a trend that could persist for some time, both as a response to the virus and as a reversion from the recent trends toward clustered, shared workspaces. (Average square footage per office employee decreased from 211 in 2009 to 194 in recent years.)23 Armstrong’s repair and remodel revenue comes with high incremental margins and returns on capital. The company gets a further boost when many buildings use a remodel to improve the quality of their ceilings.
Investments in the product line are paying off as well. New products introduced within the last five years – those with improved acoustical performance, light reflection and diffusion, aesthetics, fire suppression, and environmental sustainability – come with higher prices and better margins. These new products are now more than 40% of total sales, up from only 9% in 2010.
A multi-year investment in digitalization has also made the company more responsive and efficient. Before and during the pandemic the company played a good mix of offense and defense – safe operations and a strong balance sheet were prioritized, but there was no need to stop investing in the business or making sensible acquisitions.
On the negative side of the ledger, new construction of commercial office space – the area that seems to get the most attention – is actually a small part of Armstrong’s business and it fared relatively well in 2020. The bigger headwind was discretionary repair and remodel projects, particularly for smaller and midsize projects. And the question there is more “when” than “if.”24
The pre-pandemic concern about Armstrong focused on the lack of growth in the core market for Armstrong’s legacy mineral fiber ceilings. In most years demand will be up or down with the broader economy, but it is not a big secular growth story. There is real pricing power, however, and that combines with favorable mix from new products and the double-digit growth in the Architectural Specialties segment to produce total top line growth that should average at least 4-6% per year over the next decade. There is no doubt, however, that given Armstrong’s high incremental margins and returns on capital it would be better if the company grew at 25% instead of 5%.
The debate over the return to work is a new wrinkle arising from the pandemic, and it is legitimate. No one knows how things will look in a few years. It seems rash to predict drastic and permanent changes, but they are possible. There will be some lasting effects, but any changes that put Armstrong at a permanent disadvantage seem very unlikely. People will again value the ability to come together, businesses will reopen, and life will continue. The workplace will evolve, with some portion of workers gaining added flexibility in work location. A day or two per week of at-home or remote work may be an enduring change from Covid-19 just as the five-day work week was an enduring change from the Great Depression. Time will tell what sticks and what does not as we recover from the pandemic, but there is plenty of reason to expect Armstrong to persist in generating attractive economic returns.”
Vadym Andrushchenko/Shutterstock.com
In Q3 2020, the number of bullish hedge fund positions on Armstrong World Industries Inc (NYSE:AWI) stock decreased by about 12% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t believe in AWI’s growth potential. Our calculations showed that Armstrong World Industries Inc (NYSE:AWI) isn’t ranked among the 30 most popular stocks among hedge funds.
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Video: Top 5 Stocks Among Hedge Funds
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Disclosure: None. This article is originally published at Insider Monkey.
