Learning to say "no"
Cement companies and their drawbacks
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Hi reader,
A couple of weeks ago, I wrote an article on two industries I liked which were somewhat unconventional. These industries are those of cement and aggregates and I used that article to lay out some of their attractive attributes. I highlighted their durability and high entry barriers above all other attributes.
After further research, I decided to “discard” (at least for the meantime) one of these industries and focus my research efforts on the other. This article aims to explain why I made this decision. Note that one of the most challenging parts of investing is not deciding what to own or buy but rather learning to say “no” and to knowing when to sell. Saying “yes” and making a purchase decision is arguably a much simpler than deciding the latter.
But, why is this the case? In my opinion, saying “no” to a given company after doing work on it is very tough because one might think this constitutes “lost time.” If I have spent 50 hours analyzing a given company or industry, I might be inclined to take action on my work because the alternative is to discard it and maybe think that all those hours of analysis have not resulted in any tangible outcome. This is how many people view it, but the truth is that doing work on any company or industry is not “lost time” even if we don’t take action on it; quite the contrary, actually.
Over my years of investing and analyzing companies, I have had to say “no” to many companies after extensive research. Sometimes one will only spend 3 hours researching something to conclude that they don’t want to own it. Other times, the time spent on research will be much more considerable, and it’s here where saying “no” becomes really tough. So, why is it not lost time? The answer lies in pattern recognition. Studying tens or hundreds of companies eventually gives an investor the tools to identify good or bad patterns earlier in the research process. This pattern recognition helps a lot with productivity and in identifying opportunities early on (and also discarding companies early on). This means we should consider “unfruitful” research as an investment more than lost time.
With this out of the way, let me explain what makes me stay away from cement companies for the time being.
What makes me stay away from cement companies
Several things make me stay away from cement companies (at least for the meantime), although the source of all these is the same: environmental considerations. Cement production accounts for roughly 7-8% of human-made carbon emissions. For context, the aviation industry accounts for less than 3%. There’s no denying that cement production is very carbon emission intensive:
Carbon emissions come from two sources throughout the cement production process:
The energy required to heat the kilns where cement is manufactured.
The chemical process required to manufacture cement.
Cement is produced by heating limestone until this material makes a chemical reaction, of which a by-product is CO2. According to some sources, around 20% of CO2 emissions during the process come from the heating of the kiln, whereas the remaining 80% comes from the chemical process per se. The former will probably be substituted with a green energy source in due time, but the latter is expected to be with us for a longer time.
But, why is this important if I explained in my last article that environmental considerations should not worry investors? Just to recap, the reason why I said these should not be too worrying is because cement has no substitute and it’s mission-critical for society. This means cement will be with us for a long time despite its carbon emissions, but under what conditions it will be among us also matters.
With society more focused on the environment, cement companies are suffering increasing levels of unproductive Capex spending. I call it unproductive Capex because these companies are spending significant Capex to comply with regulations, and these investments don’t really offer any tangible return. This regulatory Capex is not an investment but rather an expense.
Let’s look at the case of The Monarch Cement Company (OTCPK:MCEM). In one of its shareholder letters, management mentions that the company needs to invest around $12 to $15 million in Capex every year to maintain its current operations. This is what is commonly known as maintenance Capex. However, if we look at the company’s Capex through the years, we can see that Capex has been considerably higher than this number for quite some time now (part of this is obviously attributable to inflation). These higher investments have not resulted in a surge in capacity, which is where one would think they should go:
We must not, however, take for granted that this Capex is not going to productive sources just because supply is not increasing. The company might be investing aggressively in productivity initiatives, which do yield a return on investment. However, when we dig deeper into its annual reports, we can start seeing that the use of these “investments” might not be very productive.
This is what the company said in its 2014 annual report:
We are also pleased to report that the Company is currently completing the installation of the final pollution control equipment necessary to comply with the Environmental Protection Agency’s NESHAP regulations.
More recently, in the 2022 annual report, management stated the following:
In 2021 we reported that we were planning to produce a new product, Portland Limestone Cement (PLC) in an effort to reduce our carbon dioxide emissions.
Both of these investments seem “forced” by the regulatory landscape rather than productive investments that management was willing to make. With regulators increasingly pushing environmental regulations, it’s hard to argue against this trend continuing in the future. Note that unproductive Capex can put a significant strain on returns. This has not happened to date due to the favorable pricing dynamics created by scarce supply, but the future might be different:
The capacity and pricing dynamics of the industry
Regulatory constraints also mean it will be challenging for cement companies to expand capacity organically. This has further implications for the industry because imports (mainly from Turkey and South America) are growing and allowing for capacity expansion without the need for domestic capacity expansion. This is not necessarily bad but does limit the price increases these companies can enjoy going forward. It’s evident that cement companies enjoy local monopolies thanks to their low value-to-weight ratio, but if prices keep rising, there might be a point where it might be more profitable to just ship it from abroad where environmental regulations do not increase costs, at least not to the same extent. Note that shipping cement by boat is the cheapest transport option and the reason why Turkey is one of the largest exporters to the US. It’s also true, though, that these imports might make sense for States close to a port, not so much for States in the middle of the US.
Another reason to believe that price increases might be limited is that, despite being mission-critical, cement makes up a significant portion of a project’s costs, especially in infrastructure projects. The capped supply would be great if price increases could go on “forever,” but it’s hard to see how that is the case here when exports have been growing markedly while domestic capacity has not expanded materially:
In my most recent annual recap, I shared that one of the main lessons I learned this year was that while demand determines the growth of a given industry, supply determines its profitability. I still believe this is true and applies to cement; the only problem is that imports might put a ceiling on how far prices can go, while regulations might harm profitability. We must not forget that cement is a commodity and customers ultimately make decisions based solely on price.
The good news for cement companies and investors
So, is there any good news for cement companies and investors? The answer is a resounding yes. For starters, the regulatory landscape is the same for the entire cement industry, meaning that all companies will probably suffer higher capital spending to adapt to new regulations. This eventually means domestic cement prices should rise and benefit all players as they will all play under the same rules. The only caveat here is what I just commented on about imports putting a ceiling on these price increases due to environmental regulations not having the same applicability in Turkey than in the US.
The second good news is that despite cement companies enjoying average (but still value-generating) returns, we should also consider their durability. There’s almost always a tradeoff between how high returns are and their defensibility. For example, a company might enjoy very high returns, but those will not compound shareholder value if entry barriers are low or if they can be disrupted over the long term. Another company (like a cement producer) might enjoy average returns, but there might be a case to be made about the defensibility of those returns. Capacity has not expanded much over the last decade despite a rise in demand (a clear sign of high barriers to entry), and it’s highly likely we will still be using cement 100 years from now.
This said, the best scenario will always be finding a company with high and very defensible returns, which is what I aim to do for my portfolio. I also believe, for example, that Copart’s returns are highly defensible and substantially higher than those of cement companies. The only caveat here is that while I am pretty sure that cement will be around 50 years from now, Copart has more uncertainties. As said earlier, there’s a tradeoff between durability and the return level in most cases. In those cases where there isn’t, one should seriously consider adding such a company when it’s out of favor and holding it for a long time.
The good news for investors is the fact that the market might not only acknowledge these concerns but might even go too far as to consider these businesses in terminal decline. This would be great because it…
Would allow investors to buy them very cheap.
Would allow cement companies to buy back their stock at cheap prices.
Both of these characteristics are already present in industries such as tobacco, with the only caveat being that tobacco might indeed be in terminal decline. It’s hard to think about a scenario where cement is in terminal decline, especially after the Infrastructure Act has recently been signed into law. This is why I don’t think I am saying “no” to cement companies forever, as I feel there will always be a price when it makes a lot of sense to purchase such durable companies.
What about aggregates?
I also wrote about the aggregates industry in the article I discussed the cement industry. This industry enjoys similar characteristics to cement due to its low value-to-weight ratio and has the added benefit of not being responsible for such a large portion of CO2 emissions. The only caveat is that the market seems to be aware of this benefit, and these companies trade at significantly higher multiples than cement companies.
I must say that even after considering the potential risks, The Monarch Cement Company does seem cheap enough to consider it as an investment (this is not investment advice). Its PE can potentially be extremely misleading due to the company’s equity portfolio, but the company also seems cheap if we look at its EV/EBIT multiple. This is not the case when we look at it from a cash flow lens, primarily due to the increased investments the company has had to make in the past years:
It’s the cash flow that worries me…As discussed throughout this article, if Capex keeps increasing to comply with regulations, it’s tough to envision a scenario where more of the company’s operating cash flow belongs to shareholders.
Conclusion
I hope this article helped you understand why I’ll pass on cement companies, at least for now. These businesses are a 10 out of 10 for durability, but they are good, not great, businesses. Sometimes, we have to make such a decision (even after doing some work) to not compromise our quality standards. This said, at a cheap price I absolutely think these are businesses worth owning.
In the meantime, keep growing!
EXP. Superior capital allocation