How We Define Sustainable Quality Compounding (Part 4)
Pool Corporation: navigating the recent COVID cyclicality that led to poor ROIICs
In this fourth and last part of “Sustainable Quality Compounding”, we’ll break down Pool Corporation’s pre-COVID, COVID, and post-COVID performance. This stock has been flagged by some of our premium members as a potential play adjacent to a core position in Harvia, so we thought it would be a good idea to compare their investment cases (acknowledging they’re not directly comparable). It’s significantly off its highs, and, in fact, trades below the 2020-end level.
As mentioned previously, there’s a lot to learn from investment cases that didn’t pan out as expected, or where cyclicality makes it impossible to consistently achieve attractive returns/model the business.
We Often Know Very Little
This article will serve as a good reminder of the one biggest lessons we’ve learned over the years: we cannot predict the future. Through hindsight analysis, anyone could look like a real genius.
The more you dive into more cyclical companies where an external factor led to a completely unexpected and thesis-changing outcome (i.e., COVID boom, temporary margin expansion because of inflation), the more you’ll face the following conclusion: it’s difficult to fully grasp the concepts of valuation and the drivers of shareholder value creation.
It’s quite daunting to be honest with yourself and acknowledge that, from the outside, it’s often not easy to see the true core strengths of these businesses and/or companies with borderline ROIC/ROIICs.
M&A - Risk of Looking at Blended ROIICs
Let’s give you a practical example. Company X with a 30% rolling operating ROIC and a 20% operating ROIIC acquires company Y which has a 20% rolling ROIC and an 8% ROIIC. That 8% ROIIC is close to its cost of capital. Both companies generate the same NOPAT and are focused on growing their business through capacity investments (e.g., a typical industrial or consumer-goods company).
On a blended basis, the merged company XY now has a 25% rolling ROIC and a 14% ROIIC. These returns are based on a normal pricing/inflation environment. A 14% ROIIC isn’t that exciting, but it’s fairly acceptable. As you might have guessed already, the two companies’ average ROIIC shouldn’t really be our focus here.
The question becomes: what will the newly combined entity’s growth strategy look like? Company X should be focused on investing in new capacity and growing its top-line; company Y should put all efforts into drastically optimizing its profitability and/or asset turnover (maybe it’s carrying too much inventory?).
If the management team simply considers the company’s average ROIIC to make investment decisions, then company X will generate true incremental economic value. Conversely, company Y wouldn’t generate additional value, since it’s reinvesting at an incremental return equal to its cost of capital. Frankly, company Y should just be “milked”, with generated free cash flow being used to finance growth for company X.
This may help explain why acquisitions often fall short of expectations: a clash can arise between a performance-driven culture focused on the right metrics and one that isn’t.
In the 2023 interview with InPractise, Fredrik Karlsson (CEO of Röko) stated:
Entrepreneurs are passionate about growing their businesses, but they don’t prioritize high margins as much as we do, because lower margins can reduce cash flow. We still have some work to do to help them understand this.
Portfolio Construction - Coffee Can?
From a portfolio construction point of view, you want to own companies that are led by executives who understand the above. Still, even the best executives can fail and fall victim to short-term optimization, e.g., maximizing margins at the expense of revenue growth which leads to a lower terminal company value. The fact that the corporate lifecycle has never been shorter makes it increasingly difficult to stick to a buy-and-hold-forever mentality.
Still, some might argue that a closed coffee-can type portfolio should still yield strong returns. You simply buy a handful of high-conviction names: some will fail, some will be a wash, and some will compensate for all the losers you’ve had.
The problem is that investors typically add and withdraw capital to and from their account. Naturally, from time to time, they’ll reassess what’s going on in their portfolio and think the laggards (seemingly undervalued names) are likely to make a comeback.
Paying Up For Quality
There was an interesting table on valuations for quality businesses, shared on X by John Huber from
.
Paying up for quality has been a clear winner over the past decade, riding strong momentum in earnings growth and positive investor expectations. In many cases, it’s led to annualized returns of 7-10% from multiple expansion alone. Many business have enjoyed very sizable tailwinds that allowed them to transition from a rolling 15% ROIC to 25-30% (Old Dominion Freight Line is a good example), implying much higher ROIICs.
However, without consistent growth (i.e., post-COVID normalization) and a return to more typical incremental returns, it becomes difficult to justify significant premiums.
For us, it's not about timing when there will be a reversal to the mean (simply impossible to predict when and how rapidly), but understand that paying up for a business only makes logical sense when there’s no alternative readily available, and when the combined outlook for ROIIC, reinvestment rate, and excess cash returns to shareholders is fairly stable.
We’ve talked about valuation vs. ROIIC vs. durability/longevity in last week’s blog.
Harvia’s starting valuation was about 12-13x NOPAT in FY19, and today it’s at 23x FY25 and 19x FY26 steady-state NOPAT (based on recurring depreciation, but not eliminating growth OPEX). That rerating has been a clear tailwind, but is it about to reverse, or could the multiple expand even more considering the much higher ROIIC, organic growth opportunities in emerging sauna markets (which weren’t there in FY19)?
Rather than getting the multiple right - it’s nice to enjoy the twin engine of growth and multiple expansion, a process that takes time to compound - we focus on real shareholder value creation excluding favorable inflationary pricing tailwinds. We’re not looking for companies that will eventually transition from quality growth to just quality over a short period of time.
Pool Corporation - Post-COVID Hangover?
This fairly well-known company makes money primarily by distributing swimming pool supplies and related outdoor living products. Their core business model is similar to a wholesaler or distributor, rather than a manufacturer or retailer.
It buys wide variety of products - like pool chemicals, equipment (pumps, filters, heaters), replacement parts, maintenance tools, and accessories - from manufacturers, and sells them to pool builders, contractors, service companies, and some retailers. They rarely sell directly to consumers.
Pool Corp. also sell related items like grills, lighting, outdoor kitchens, patio furniture, and irrigation products. This has become a growing revenue stream as backyard renovation and outdoor living have gained popularity.
Besides, they offer technical support, delivery logistics, and inventory management to their customers, which is aimed at building customer loyalty and justifies some of the margin despite the low markup on goods sold.
The fact that Pool doesn’t have in-house production/is a distributor leads to three things:
potentially large mismatch between inventory management and changes in revenue;
gross margin expansion is relatively limited;
relatively low invested capital besides working capital, some ordinary property, plant, and equipment, and a relevant portion of leased assets (sales centers).
Now, outsourcing production or being a distributor essentially implies someone else has to fill the gap for this lower invested capital. Being capital-light should therefore be contextualized. Let’s take a closer look at this inventory management versus revenues, cash flow volatility, and capital allocation and compare these factors to Harvia’s operating model.
It’s worth noting that COVID has presented tough comparisons for both Pool and Harvia, and our high conviction around the latter has grown over time. For instance, in 2022, we thought Harvia’s profitability would collapse as it drastically returned to more typical order book patterns. That didn’t happen, nor did it in 2023.
Still, until late 2023, its post-COVID sales performance was pretty much in line with the trends described by Home Depot and Pool Corp. It just took a little more time to digest post-COVID headwinds and deviate from continued softness in other consumer discretionary segments. Put another way, we’ve long waited for confirmation around our thesis that Harvia is a truly different and unique consumer speciality player.