Geoff Gannon August 24, 2019 Gannon on Investing 0 Comments

Monarch Cement (MCEM): A Cement Company With 97 Straight Years of Dividends Trading at 1.2 Times Book Value

by GEOFF GANNON

This is my initial interest post for Monarch Cement (MCEM). I’m going to do things a little differently this time. My former Singular Diligence co-writer, Quan, emailed me asking my thoughts on Monarch as a stock for his personal portfolio. I emailed him an answer back. I think that answer will probably help you decide whether you’d want to buy this stock for your own portfolio better than a more formal write-up. So, I’ll start by just giving you the email I sent Quan on Monarch Cement and then I’ll transition into a more typical initial interest post.

 

EMAIL BEGINS

I think Monarch is a very, very, VERY safe company. Maybe one of the safest I’ve ever seen. If you’re just looking for better than bond type REAL returns (cement prices inflate long-term as well as anything), I think Monarch offers one of the surest like 30-year returns in a U.S. asset in real dollars.

 

Having said that, I don’t think it’s as cheap or as high return as you or I like as long as the CEO doesn’t sell it. And the CEO very clearly said: “Monarch is not for sale”. 

 

I’m basing a lot of my comments in this email on historical financial data (provided by Monarch’s management) for all years from 1970-2018.

 

In a couple senses: the stock is cheap. It would cost more than Monarch’s enterprise value to build a replacement plant equal to the one in Humboldt, Kansas. And no one in the U.S. is building cement plants when they could buy cement plants instead. The private owner value in cement plants is even higher than the replacement value. An acquirer would pay more to buy an existing plant than he would to build a new plant with equal capacity. The most logical reason for why this is would be that an acquirer is an existing cement producer who wants to keep regional, national, global, etc. supply in cement low because his long-term returns depend on limiting long-term supply growth in the industry he is tied to – and, more importantly, anyone seeking to enter a LOCAL cement market needs to keep supply down because taking Monarch’s current sales level and cutting it into two (by building a new plant near Monarch’s plant) would leave both plants in bad shape (too much local supply for the exact same level of local demand). Fixed costs at a cement plant are too high to enter a local market like the ones Monarch serves by building a new plant. You’d only get an adequate return on equity if you bought an existing plant. Therefore, I believe that it’s usually the case that the price an acquirer would pay for a cement plant – and certainly Monarch’s plant given its location far inland in the U.S. – is greater than what it would cost to replace the existing plant. So: Acquisition Offer > Replacement Cost. And, in this case, Replacement Cost > Enterprise Value. Therefore: Acquisition Offer > Replacement Cost > Monarch’s Current Enterprise Value. In other word, Monarch’s current enterprise value is less than what any acquisition offer would be. So, the stock is definitely cheaper than what a 100% buyer would bid for the plant.

 

So, the stock is cheap. However…

 

This is where things get tricky.

 

Monarch’s stock price is around $60 a share. An acquirer would pay over $100 a share. Like $100 at the low end and $120 at the high end. Replacement value is also quite high.

 

However, I don’t think YOU (or I) would necessarily want to pay more than about $40. Maybe $50. Basically, close to book value. Why not?

 

Returns in the cement plant itself are good. But, management here: 1) Doesn’t use leverage (Monarch only uses leverage to fund big cap-ex, then pays down the debt – most public companies around the world borrow constantly to finance cement production). The business here would benefit a lot from continual use of a reasonable amount of long-term, fixed cost debt. The company should carry net debt. It actually carries net cash. You can see that in the results. While Monarch would have reported a net loss if it had debt in the bottom of a deep recession – see 2010 or so as an example – the ROE over time would be higher, because this is a company where you could predictably borrow at like 6% fixed and make 9%+ on whatever investment in the plant you financed at 6%. You could keep doing this. The math is favorable and would drive up after-tax ROE over a full cycle (though you would report losses at the bottom of deep recessions because operating income wouldn’t cover fixed charges in those rare, terrible years). 2) Management has bought ready mix concrete businesses. Without getting into how cement works, basically the input for cement is lime (and other stuff) that is then produced at a cement plant and shipped close to where it will be needed where it is then mixed with aggregates like rock to become concrete. Concrete is then used to build roads, bridges, apartments, offices, warehouses, etc. Anyway, the lime business is as good or better than anything (it is probably a bit more competitive than cement, but it has lower cap-ex needs – so lime may be the best business overall). Cement is the next best business (probably the least competitive, but very high cap-ex spending – because of high economies of scale, desire to reduce labor cost component, and meeting environmental regulations – cement is the most technical part of the chain of production). Ready mix concrete is the worst part of the business. Honestly, I think Monarch just bought out its customers in ready mix concrete in certain markets when they got themselves in trouble. Owning ready mix concrete ensures demand for Monarch’s production. But, it’s not needed. Cement plants only average 80-90% utilization normally, demand is so volatile (much more volatile than price), that even owning the ready mix concrete businesses in an area doesn’t insulate you from the cycle. So, the whole ready mix thing just sucks up a bunch of capital for no return over time. The ready mix concrete business literally returns nothing sometimes. And it’s not small. Finally, Monarch’s CEO just puts the rest of surplus funds into owning other cement stocks (mostly). I think he has a policy of trying to keep roughly similar percents of Monarch’s overall stock portfolio in each of the publicly traded cement companies he buys. He’s not a value investor. He just keeps averaging into these stocks whenever Monarch has extra money after paying the dividend.

 

The CEO said “The dividend is sacred”. And based on the 1970-2018 figures I have – I think that’s true. Monarch will lower the dividend a lot in a total bust in the industry, but then start raising it again the very next year. So, the ROE isn’t going to be leveraged and is going to include investments in ready mix concrete (the CEO knows these are not good investments, but I’m not confident he’ll swear off these purchases entirely) and publicly traded cement stocks. Publicly traded cement stocks are much, much more expensive (usually) on like a P/B ratio compared to Monarch. Some are good businesses long-term. But, Monarch will buy these regardless of price. So, it’s not ideal capital allocation.

 

Because of these capital allocation decisions: I think Monarch as a company will have a long-term ROE of like 8-12% a year. I think the underlying economics of Monarch’s actual cement plant are at the top of that range (12% unleveraged returns on an accrual – not FCF – basis). And I think actual cement plant returns – in the middle of the U.S. – will only be better over the next 30 years compared to the last 30 years (competition has decreased over time, there are fewer and bigger locations, plants are much larger: Monarch’s capacity has probably quadrupled in 50 years at just that one plant, major players in U.S. cement are all bigger and more rational, it’s very similar to what we saw in lime).

 

More accurately I should say: I think ROE will be 5-9% (or maybe like 6-10%) plus inflation. It’s probably easier to calculate real returns and add inflation here.

 

You asked if cement economics are similar to lime as far as transport costs. The answer is yes. You can move cement by ocean going ship, river barge, railroad, or truck. You’ll basically need a cement terminal wherever you take delivery of it. So, if you are shipping across the ocean from East Asia to the U.S. let’s say – you’d have to take delivery at a cement terminal in like Seattle or Los Angeles. And then you could ship by truck. The last leg – shipping by truck – is by far the most expensive per mile. So, the U.S. does import cement from other countries (imported cement is the marginal supply, it can drop like 90% from boom to bust), but imported cement is irrelevant to Monarch. Monarch’s plant is basically dead center in the middle of the country. It can serve about half of each of several states (so, parts of Iowa and Kansas and so on). It’s near the Eastern border of Kansas. So, it can ship to Oklahoma and Arkansas. Cement imports at U.S. ports could never travel far enough inland – due to the high transportation costs per mile once insider the U.S. versus the low value of the cement itself – to ever be worth worrying about foreign competition influencing cement prices in Monarch’s market. Technically, the best way to think of competition would be to imagine supply cascading into adjacent local markets sort of like ripples that dissipate with distance. So, if you can import from Asia into Los Angeles, then ripples of those imports could – through adding supply in the Los Angeles area – also be felt hundred miles inland. But, they wouldn’t be felt a thousand miles inland. Looking at a map of the world – it’s hard to imagine a location for a cement plant that would be more insulated from the risk of chronic oversupply than someplace like Kansas. In fact, looking at margins from 1970-2018, I can see that despite being in the super cyclical industry of cement – Monarch’s variation in margins (0.42 coefficient of variation) and pre-tax return on equity (0.37) is actually lower than many companies experience over 50 years. The only way that can happen in an industry where overall demand is so volatile and fixed costs are so high is if changes in competitive position are much rarer than in less inherently cyclical industries. In other words, you can’t have a lot of new entrants in a cyclical market and have variation that low and you can’t have a lot of changes in who is the low cost producer in a cyclical market and have variation that low. Monarch’s cost position relative to other cement producers in the region must change very, very little over time.

 

When shipping direct to the customer, you don’t ship cement further than you’d ship lime. Lime is an input for cement. Monarch owns lime deposits at its cement plant to supply it for 50+ years. Lime isn’t a huge part of the cost of cement. But, it’s always a plus to have this low value/weight resource without having to worry about transport costs. I think the plant and lime deposits are on like 5,000 owned acres. However, I don’t think land in Humboldt, Kansas is worth much of anything if it wasn’t being used to produce cement. In Iowa: they also own a 250 acre cement terminal and a 400 acre (nearly depleted) quarry.

 

Nonetheless, the replacement cost and acquisition prices I suggested don’t explicitly include any value for the land, the lime deposits, etc. For example, I don’t think someone in the U.S. – if they were building new cement plants, which on a net basis they certainly aren’t – would really plan to spend less than about $300 million. Less than that and the plant wouldn’t have sufficient economies of scale. Monarch’s plant isn’t super small or anything. I’d say the plant is worth more than $300 million but maybe not more than $450 million (the plant’s capacity is 1.3 million tons a year). Remember, an acquirer depends on utilization to drive economics – so, the reason you don’t build (you buy) is that the buyer is a cement industry participant (usually a huge global cement company with big U.S. market share). They don’t want to add national capacity if possible. And certainly don’t want to add local capacity. So, it’s almost always the case in cement that acquisition prices look a lot higher than replacement cost. Also, I think I underestimated Monarch’s replacement cost if I suggest it’s close to $300 million. It’s more than that. I’m not sure how much more.

 

At tangible book value, you might like Monarch a lot.

 

At the current price – which is like 1.25 or 1.3 times book or something – it might be a little too expensive, because the upside is so limited.

 

Long-term, I think you could hold MCEM indefinitely (literally forever) and do as well as the S&P 500 did in the 1900s as a century. I think that’s possible. The S&P 500 is a lot more expensive now than it was throughout the 1900s. So, maybe you’d outperform in MCEM if bought today and held for 15, 30, or 45 years. Maybe. The volatility will probably be lower. It’s a hugely cyclical industry in terms of demand. But MCEM’s margin volatility is actually lower than most public companies (and I think this is typical for a leading cement plant in the U.S. interior – coasts could be different, I’d avoid coastal cement plants). Also, as an illiquid stock that doesn’t file with the SEC, etc. – I’m pretty sure the stock will always have a beta well below 1. Some websites say the stock has a beta of 0.3. That sounds about right. It’ll always pay a dividend. The stock is almost certainly to be less volatile than the business and the business isn’t really more volatile than most public companies. So, you should – even at today’s price – get returns equal to or higher than the S&P 500 with volatility equal to or lower than the S&P 500 if you buy the stock today and hold it forever.

 

But, I think you’re looking to outperform the S&P 500. That probably requires paying closer to book value and selling the stock quicker – not holding it forever. Another reason you might consider focusing on buying at book value…

 

Monarch will buy back its own stock below book value. One thing the CEO made clear is that he knows the stock has historically traded around book and he thinks it’s never a good idea to buy back stock above book – but, that it is a good idea to buy back stock below book. Even when buying out members of the families that have owned a lot of Monarch for 50 plus years, the rule has been to only buy back stock below book.

 

Monarch might be a stock that – especially if you could ever get it at book – you could just buy and forget about pretty much forever. I can’t think of a more durable industry or industry position than being a cement plant in the middle of the United States. You can see dividends since 1970. That’s as far as my data goes back. However, I think they’ve paid a dividend for 100 years or so. I also think that most of the major shareholders are descendants of people who bought the stock 60-100 years ago. It’s durable.

 

EMAIL ENDS

 

Monarch Cement (MCEM) is an illiquid microcap. The company does not file with the SEC. But, it does report financials publicly.

There are two classes of stock. Many websites do not reflect this fact. So, a lot of sites show a lower market cap for Monarch than it really has. For this reason, you should never rely on any secondary data from financial websites when analyzing Monarch. Always make sure your research on MCEM uses only the company’s own reports:

https://monarchcement.com/investors/

From these reports, we can see that Monarch had 3.86 million shares outstanding at the end of last year. The class of stock you’d be interested in buying – the one that trades over-the-counter under the ticker “MCEM” – has a last trade price of $60 a share. So, Monarch’s market cap is $60 * 3.86 million = $232 million. Of course, this is not the price at which someone could actually acquire all of Monarch. I believe descendants of 5 families – Monarch was founded 106 years ago – control around 50% of the company:

“Of the eleven members of our Board of Directors, nine are descendants of five families who invested in and have guided our Company for over 60 years. Two of these five families’ ownerships date back to the purchase of the bankrupt Monarch Portland Cement Company and its reorganization as The Monarch Cement Company in 1913. The descendants of these five families continue to own a significant share of the outstanding stock of our Company.” (2019 Proxy)

And Monarch’s CEO is quite clear that “Monarch is not for sale”. Also, as I’ll explain later, Monarch’s enterprise value is actually lower than its market cap.

But first…

…The business.

Monarch’s key asset is a cement plant in Humboldt, Kansas with the capacity to produce 1.3 million tons of cement per year. So, let’s start by talking about cement and that other word that’s probably already on your mind: concrete.

 

Cement and Concrete

You are probably most familiar with cement through the product it’s an input for: concrete. Basically, concrete is cement with stuff like gravel mixed into it. The cement part is the paste. Concrete has been used as a building material for probably around 2,500 to 3,000 years. It’s best known historical use is in major Roman building projects that survive to this day. If you’ve ever visited sites like the Pantheon, the Baths of Caracalla, the Pont Du Gard aqueduct, the Colosseum, etc. – the reason they’re still standing over 1,500 years later is because they were all built from concrete. If we know Roman concrete structures are still standing nearly 2,000 years later – we can probably guess that whatever technological innovations there have been in the concrete (and thus cement) industry since then haven’t just been about making the material more durable. In fact, Ancient Roman concrete could withstand compressive forces (“pushing” forces) even better than modern concrete does. However, modern reinforced concrete has better tensile strength (“pulling” force resistance) than Ancient Roman concrete – mainly because it often includes something inside the concrete that the Romans didn’t know how to make: steel rebar.

Concrete is the world’s most important building material. Each year, the world uses more concrete by weight than wood, plastic, aluminum, and steel combined. The “by weight” part is super important – as we’ll see when we discuss the economics of the cement industry. For now: just remember this – cement is cheap, heavy, and durable.

 

Using Andrew’s 4 Point Initial Checklist

The word “durable” brings me to our initial checklist.

My Focused Compounding co-founder, Andrew Kuhn, did a YouTube video where he outlined the 4 things we look for in a stock when first sitting down to research it:

https://www.youtube.com/watch?v=rqw6KzhSvvE

Those 4 things are:

  • Is the stock overlooked?
  • Is the business high quality?
  • Has the stock’s CAGR worked over time?
  • Is it cheap?

 

Has Monarch’s CAGR Worked Over Time?

I’m going to give you the answer to #3 (what Monarch’s long-term CAGR has been) in a second. But, before unveiling that number – I’d like to discuss why a publicly traded cement stock may or may not have made its buy and hold owners rich.

Let’s start with the past. But, not just the 30 or 50 year past. Let’s start with the industry’s entire past.

What does the history of cement (and concrete) tell us about the durability of Monarch as a business?

Cement has been one of the key inputs – and certainly the key technological input (quarrying aggregates is a low tech business) – in producing one of the most durable building products (concrete) used in large scale public infrastructure (like roads), private homes (like apartment blocks), and commercial and industrial buildings for around 2,000 years now. Technology in this industry has progressed by making cement (and thus concrete) something that can be produced at greater and greater scale using less and less labor. The Romans may have had the technology needed to build the Colosseum out of concrete. But, they didn’t have the scale to produce 1.3 million tons of cement at a single plant (and there are cement plants much, much bigger than the one Monarch owns in Humboldt, Kansas).

In other words: concrete – as a product – and cement (as an input) has perfect economic durability. It isn’t going to be obsoleted. Someone is going to be producing a lot of cement each year. The two questions we need to answer are: 1) Is this someone going to be making enough money over an entire cycle to successfully compound their wealth over time? 2) Is Monarch going to be in a position to stay in business forever and earn an acceptable rate of return relative to its competitors.

Now we can look at Monarch’s long-term returns. I have actual stock returns for a shorter period of time (about 25 years) and I have summary financials from Monarch for a longer period of time (about 48 years). The summary financials don’t allow me to calculate the stock’s actual return over close to 50 years. But, aside from price multiple expansion or contraction (changes in the stock’s P/B ratio, P/E, ratio etc. from the 1970 start point till today’s 2019 end point) – I have all the data I need to calculate what a buy and hold investor’s return would be. Over the last 25 years, the stock’s price has compounded at about 7% per year. Monarch also pays a dividend. The dividend is usually quite meaningful (today it’s 3% of the stock price). It’s often been a 3-6% yield on the stock’s book value (which is not necessarily the price at which an investor actually bought the stock). The nearly 50-year history of the company shows a 2.6% compounding of Monarch’s REAL book value per share. Nominal compounding of book value has been about 6.1% a year (remember, inflation was quite high in the 1970s and 1980s). The dividend has grown a bit slower at 4.8% a year for 50 years. This points to a nominal per share growth rate somewhere between 4.8% and 6.1% a year. So, basically, 5.5% a year. On top of this, you have a dividend yield on book value in like the 3-6% range. It started the period (back in 1970) as a 6.8% dividend yield on book value and ended the period – in 2018 – at a 3.9% dividend yield on book value. Keeping it simple enough to do here instead of in Excel – we could just take the average of 3.9% and 6.8% and assume that the average dividend yield on book value is about 5.4% of book value. Again, we’re close to 5.5% (meaning half your gains as a buy and hold investor in Monarch cement would come from dividends and half from stock price appreciation). If we added 5.5% and 5.4% – we’d get 10.9%. If we rounded both numbers down we get 10%. If we rounded both number up, we get 12%. Is that really the kind of return Monarch cement stock has produced: 10-12% a year?

Maybe.

Two issues here are stock multiples and inflation rates. The period from 1970-1995 (where I have financial data from Monarch but not stock price data) was most likely a better period for a cement stock (though not necessarily for a cement business). Why? Because inflation rates were high throughout much of the period and yet interest rates – and therefore, stock price multiples – ended the period in 1995 much higher than in 1970. In other words, I’m just warning you that if you use the most recent 20-25 year CAGR you see for Monarch stock – I think it’s possible you might be underestimating the 50-year record here. The stock has actually been around – and the company claims, paying dividends – for over 100 years. Like I said, I can see the year-by-year dividend record. And Monarch has certainly paid a dividend every year for the last 50 years (and, I suspect more like every year for the last 100+ years). Monarch has sometimes lowered the dividend in a recession. However, after any lowering of the dividend, Monarch has always started annual dividend hikes again the very next year. For example, I can’t find any situation where the dividend actually declined over a full 10-year period.

So, what does that ultimately mean for returns in Monarch cement?

Historically, I’d say the stock would have returned 8-12% a year if you bought it in some year and held it till the day you died. The dividend would usually have been a big part of that return: maybe 50/50 between the dividend and the capital gains. The S&P 500 obviously doesn’t return more than 8-12% a year to buy and hold investors. So, yes: Monarch Cement’s CAGR works. One caveat here: I expect Monarch’s REAL total return to be more reliable than most stocks. So, it may be easier to predict that Monarch stock often returns 4% to 8% a year plus inflation than to predict it will return 8% to 12% a year in plain old dollars. Investors aren’t used to thinking in real terms. But, here it might be better to take a 4% to 8% real rate of return and then add your expected rate of inflation to the returns to compare it with other stocks.

Checklist Item #3: Has the stock’s CAGR worked over time? Check.

 

Is the Business High Quality?

First of all, I want to explain something that should be obvious – but, that most investors overlook. If a stock’s CAGR has worked over a really, really long period of time (like 50 years) we pretty much know that the business at least was high quality during this period. Stock prices can diverge from intrinsic value by a lot. And they can stay diverged for a long time. But, because of the way compounding works – changes in the stock’s price multiples are unlikely to overwhelm actual business performance over half a century. Basically, a good business makes a good stock over a 50-year holding period almost regardless of the price you buy and sell at. And, a bad business makes a bad stock over a 50-year holding period almost regardless of the price you buy and sell at.

Consider this example. You pay 25 times earnings for a stock today. You hold the stock for 50 years. The stock compounds its earnings per share at 12% a year for those 50 years. You then sell the stock at a P/E of 5. Obviously, paying 25 times earnings for a stock is a higher price than an investor should ever be willing to buy at. Just as obviously, selling a stock at a P/E of 5 is a lower price than an investor should ever be willing to sell at. Nonetheless, because the stock compounded its earnings per share at 12% a year for 50 years – your total return over that half century holding period would still be 8.5% a year. Basically, you could afford to over buy (P/E of 25) to start and under sell (P/E of 5) to end your holding period and still match the 8-9% type annual return you’d get in an index fund. Conversely, even if you buy a stock at a P/E of 5 and then hold that stock for 50 years and sell at a P/E of 25 – if the stock only compounds its earnings per share at 6% a year while you hold the stock, your CAGR over that half century holding period will only be 9.5% a year. In both cases, we are talking about a 9% a year annual return plus or minus 0.5% a year. And those are very, very extreme P/E buy and sell assumptions. If you were just randomly picking when to buy and sell a stock – without basing your decision on the P/E multiple at all – it’s likely the stock’s P/E when you bought and sold would be somewhere between 5 and 25. So, I’m not exaggerating how small a factor buy and sell prices are over a 50-year holding period. A good business – reinvesting 100% of its earnings at 12% a year – is pulling your returns up toward that 12% a year level while you own it. A bad business – reinvesting 100% of its earnings at 6% a year – is dragging your returns down toward that 6% a year level while you own it. I need to stress here that it isn’t the stock’s per share growth rate alone that matters (and it’s definitely not the company’s overall growth rate). Three factors matter. 1) How long is the stock held for? 2) How big a portion of earnings are being reinvested in the business? 3) How high is the return on reinvestment? Monarch has often paid out 40% to 75% of its earnings in dividends (40% in 2018 and 75% back in 1970). So, the business’s return on equity is only driving the other portion (100% minus 40% equals 60% of earnings in 2018) that the company is retaining. Whether a company has an ROE of 6% or 12% – a dollar of dividends is worth a dollar of dividends. Who pays the dividend doesn’t matter. But, a dollar of retained earnings driving a 6% ROE is worth less than a dollar of retained earnings driving a 12% ROE. Most companies – and certainly a cap-ex heavy company like Monarch – end up retaining a good portion of their earnings. So, their return on equity (really, their return on retained earnings) drives about half of their total stock return.

Here’s my point. If you think an industry is a bad industry, or a business is a bad business – look for a stock that performed well over the 50 years or so. If you find such a stock, chances are you’ve just disproved your bad business theory. The same test – by the way – can be applied to self-made millionaires and billionaires. Someone who is super rich today and who you know founded a company and owes almost all their wealth to an ownership stake in that business is pretty strong evidence for that business being a good one at least for many years in the past. There are some fluke ways that a business owner can get rich (they could sell out in a massive bubble, they could use massive amounts of debt, they could cheat their partners, they could pay themselves a lot from the company’s till, they could have perfect market timing of when to start up and when to sell a business). But, these fluke ways are rare. If someone entered a business without being at least somewhat rich to start and then they ended up being famously rich – the business they were in (and also probably the industry they were in) was almost certainly a “high quality business” for many of the years they were invested in it. If you don’t know what the long-term ROE of Carnival (CCL) was, but you do know that Micky Arison is worth $8 billion and was CEO from Carnival from 1979-2013, odds are you’re going to find Carnival had a good CAGR from 1979-2013. The same is true for long ago industrialists. Steel and railroads and oil and so on could be low ROE industries whenever you started researching them. But, if you find that some of the richest Americans of an era made their money in steel and railroads and oil and so on – you’ll find that the companies they owned had good ROEs compared to other businesses around at that time. This is sort of the iron rule of long-term compounding. If the owners of an asset compounded their money at high rates while invested in an asset – for a long time – then, the asset itself must have been high quality (at least while those people owned it). Over short periods of time, this rule does not hold. If you buy a stock at 5 times earnings today and sell at 25 times earnings next year while your neighbor buys another stock at 25 times earnings today and sells at 5 times earnings next year – you will get rich and your neighbor will get poor, almost regardless of the underlying business performance of either of those stocks. In the short-run, cheapness overwhelms quality. In the long-run, quality overwhelms cheapness.

We know Monarch Cement has had a 25-50 year record that suggests a buy and hold owner of the stock wouldn’t have done much worse than if they’d owned the S&P 500, and (depending on their timing) may have done better.

However, I know what an 8-12% long-term rate of compounding sounds like to most investors. They hear that and they yawn. It sounds typical.

Actually, it’s not.

The overall stock market may return 8% a year over the long-term. However, fewer individual stocks than you might imagine actually achieve this level of compounding over a period like 50 years. A small number of stocks start out very small and get very big by compounding at incredibly high rates of returns. This small number of very successful compounders creates a lot of the returns you see in the S&P 500. So, the average stock chosen from among U.S. public companies is unlikely to still be around several decades from now and to have compounded at around 10% a year.

Nonetheless, you could buy the index instead of Monarch. The index is able to capture the home runs enough to offset the strike outs. So, it’s okay to have a high strike out rate in an index, because the home runs more than offset the strikeouts. Therefore, it might not be a good idea to prefer a stock like Monarch that is probably safer, more predictable, etc. in its very long-term returns than the individual stocks that make up the index – because you could just use Vanguard or something to buy the whole index and thus eliminate the risks of owning specific stocks.

In reality, I think Monarch will be less volatile than the S&P 500 over time. I think the beta of Monarch will be below 1. And I think the alpha will be zilch or somewhat positive – not negative. So, actually, I do believe that if Monarch is never sold to an acquirer – it stays public forever, and you keep owning it forever – you will get the same or higher return as in the S&P 500 with lower volatility. But, that’s not a bet I really want to make in the accounts I manage. I don’t want to target the same returns as the S&P 500 – just with lower volatility. The goal isn’t to reduce volatility. It’s just to increase long-term compounding.

At today’s price, I’m not sure Monarch clears the threshold of the kind of future return potential I’d like to see. Certainly, if the company is sold to an acquirer in the next 5, 10, or maybe even 15 years – it’ll hit that target. And it may even outperform the S&P 500 with less volatility. But, I don’t like to buy a stock unless I see a realistic way to 10%+ returns over the next 10+ years.

I think I see that path for Monarch at tangible book value. I’m not sure I see it at today’s price. I think this is a business that is very unlikely to give you inadequate returns if bought today and held long-term. However, I also think it’s a business that’s unlikely to ever give you far above market level returns if bought today and held forever. The stock is already selling for less than it would be worth to an acquirer. It’s maybe somewhat cheap in today’s world of pretty high prices for stocks, businesses, etc. I think it’d be decisively cheap at book value. Last I checked that was about $49 a share.

Today, the stock is trading at $60 a share. You might not want to buy it above $50 a share – or whatever book value has risen to by then.

The reason for that is you have to be very, very careful about price when you are buying a business with a long-term return on retained earnings (while you own the stock) that you know will be very close to the market’s own return. If Monarch reinvests a lot of its earnings at between 8-12% a year, your long-term return in the stock will be dragged down closer and closer to 8-12% a year over time even if you pay a low price today. So, it’s often important to not just pay a low price – but, to pay a very low price. I think book value at Monarch would be a very low price. So, that’s a good price to aim to buy it at.

Geoff’s Initial Interest: 70%

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