This year, unlike most of the recent decade, picking value stocks for the final class project was like picking lilies in the valley for my students at Ivey Business School. The market correction enabled them to find and write a report on undervalued stocks, not only among the Graham type of stocks, but also among Buffett-type stocks – something that I have not seen for years.
It is much easier to find smaller, less liquid stocks that Ben Graham, the father of value investing, would have liked, and I profiled such a stock (Fonar Corp.) in a recent article. It is much more difficult to find stocks that would appeal to the different value style of Warren Buffett. But because of the market disruption that accompanied COVID-19, my students did: Douglas Dynamics Inc. (PLOW-NYSE).
Douglas Dynamics met some of the Graham value investing criteria – with a price-to-earnings ratio of 13 and market capitalization of US$641-million at the time of the student report – but missed the price-to-book ratio, which was over the required Graham benchmark. This was not too surprising considering that this was a stock that Mr. Buffett may have considered and so despite violating the P/B requirement, students felt the stock could still be potentially undervalued and worth exploring further.
Core operations for one of two founding companies behind Douglas started in 1948, the other started in 1950; the companies came together in the early 1980s. Douglas was bought by Aurora Group and Ares Management in 2004, which then took the company public in 2010. Douglas operates two segments: work truck attachments (WTA), accounting for 51.4 per cent of revenues as of the end of 2019, and work truck solutions (WTS), accounting for the rest. The end users of the first segment are professional snowplow operators who remove snow and ice from commercial and residential areas. The attachments are sold through a distribution network with more than 1,900 points of sale. The company says it has built customer loyalty, with more than 600,000 of its attachments now in use. The need for constant upgrade, repair and maintenance incentivize dealers to support existing customers to avoid losing revenue and this affords Douglas pricing power and a degree of competitive advantage.
Douglas is a clear leader in the WTA segment with 55-per-cent market share, well ahead of its two largest competitors, Meyer Products LLC (plows and salt spreaders) and Swenson Spreader LLC (salt spreaders).
The WTS segment operates in two areas: uplift and custom manufacturing. The uplift operation focuses on task-specific work vehicle configurations and has high levels of customization that affords the company another competitive advantage, derived from high search costs associated with finding an alternative supplier. More than 50 per cent of revenue in this segment is derived from contracts with local municipalities and departments of transportation, which create a more predictable business model. While the market in this segment is more fragmented, Douglas is still the industry leader.
Douglas has been operating for about 70 years, allowing it to develop customer loyalty and brand equity. It enjoys high barriers to entry because of product customization, customer relations, search costs, economies of scale and distribution network effects. This has led to a stable operating margin that has been fluctuating at around 17.2 per cent over the past five years.
One potential risk is that its future sales are out of their hands as the company’s profitability is heavily dependent on third-party vendors/retailers opening and selling the company’s products. If small vendors went bankrupt (e.g., owing to the pandemic), this would decrease the number of places offering Douglas products.
The company’s total debt to capital has fluctuated around 45.9 per cent for years – which is close to the debt level of other companies in the same business risk group. Because of that, students assigned to the company medium financial risk. The adjusted return on invested capital (ROIC) was estimated to be 7.9 per cent compared with a cost of capital of 5.9 per cent. The magnitude and stability over time of the difference between ROIC and cost of capital reinforced students’ belief that Douglas has a sustainable competitive advantage. This is important as it allows the students to value the company as a growth company.
The company’s minimum intrinsic value was estimated to be US$62.55, while its entry price was pegged at US$41.70. As at the time of student valuation (March 25), the stock price was US$28.16, making the company a strong buy. Even at Friday’s closing price of US$36.17, the stock is still a buy.
Buffett-type stocks are hardly ever undervalued, but owing in part to COVID-19, from the students’ analysis Douglas Dynamics fits the bill.
George Athanassakos is a professor of finance and holds the Ben Graham chair in value investing at the Ivey School of Business, Western University.
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