Royce Investment Partners Commentary: What Is a Quality Compounder?
In the Small-Cap Premier Strategy that we use in Royce Premier Fund, we look for small-cap companies with high returns on invested capital that we believe can compound value by reinvesting their current earnings back into the business at high rates of return over the long run. A company with consistently high returns on invested capital (ROIC)and consistency is criticaltypically means that the management team is effectively allocating capital.
We would define UFP Industries (NASDAQ:UFPI) as one of these quality compounders, though the company may not appear that way at first glance. UFPI is the largest pressure treated lumber manufacturer in the U.S. The company was founded in Michigan in 1955 as a lumber supplier to the manufactured housing industry. Today, UFP has a multibillion-dollar business with subsidiaries around the globe that serve three markets: retail, packaging, and construction. Headquartered in Grand Rapids, Michigan and publicly traded since 1993, the company has 219 affiliated operations that supply tens of thousands of products to its three markets and employs more than 15,800 people.
What makes a pressure-treated lumber manufacturer a high-quality premier' company? UFPI is a relatively recent addition to Premier, though we have owned the company in other Royce portfolios for several years. The company realigned its management teams in 2019 to focus on business segments rather than geography, which the company believed would better highlight the breadth of its product offerings and allow for quicker introductions of new products. The ensuing boost to its ROIC helped make it a particularly attractive candidate for Premier's portfolio.
Equally important through the lens of the Strategy's search for high-quality companies with discernible competitive advantages, UFPI benefits from both formidable supply side advantages and differentiated demand side advantages. On the supply side, UFPI has relationships with roughly 90 lumber mills where it accounts for a majority of the offtake at each mill. In light of this leverage on purchasing, the company has managed vendor programs with these mills whereby it only takes lumber when needed. The upshot is that one of the world's largest soft wood lumber owners is largely an asset light business.
On the demand side, UFPI has a scaled processing plant network with more than 200 locations that have attractive proximity to big box retailers. This network and its proximity to UFPI's customers gives it differentiating pricing benefits compared to its competitorswho tend to have two-step distributions serving these same customers. UFP can thus use the benefit of one less margin stack as it pleasesby augmenting its own margins or passing the benefit on to its customer. This benefit gives UFPI a dominant market share at the big box retailers in the product categories it supplies. The company's scaled supply advantages and demand advantages allow it to leverage its buying position in serving commodity channels at lower prices while strategically increasing the value-added mix of its products in higher-margin, non-commodity merchandise such as decking products, roof trusses, floor systems, and engineered wood products for national builders. It's a unique model in this market structure.
UFPI has enjoyed more than 60 consecutive years of profitability and has a cash-rich balance sheet. Its durable business model has given the company differentiated advantages by structurally transforming its business mix to the higher value-add products mentioned above. Meanwhile, the market continues to see it as a commodity manufacturerwhich has so far kept its valuation in what we regard as a highly attractive range.
Mr. McBoyle's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
This article first appeared on GuruFocus.
