Is Watsco (WSO) A Smart Long-Term Buy?
LRT Capital Management, an investment manager, has published its investor letter for the second quarter of 2021 – a copy of which may include: downloaded here. A return of +29.68% was recorded by the LRT Economic Moat strategy for the second quarter of 2021, extending the 12-month return to +42.18%. You can check out the fund’s top 5 positions to get an idea of their top bets for 2021.
In LRT Capital’s Q2 2021 investor letter, the fund mentioned Watsco, Inc. (NYSE: WSO), and discussed his stance on the company. Watsco, Inc. is an HVAC company based in Coconut Grove, Miami, Florida, with a market capitalization of $10.8 billion. WSO has delivered a return of 22.54% since the beginning of the year, extending its 12-month return to 17.15%. The stock closed on August 9, 2021 at $277.16 per share.
Here’s what LRT Capital has to say about Watsco, Inc. in its investor letter for the second quarter of 2021:
“Watsco is a long-standing holding of our fund that recently made the top ten. The company distributes heating, ventilation and air conditioning (HVAC) equipment. The HVAC distribution company consists of approximately 80% replacement / 20% new construction. This is a great venture because of its fragmented supplier base (seven major HVAC manufacturers) and fragmented buyers (thousands of HVAC contractors). This limits the bargaining power of both buyers and suppliers. In addition, while homeowners end up footing the bill, in most cases it is the contractor who makes the purchase decision. Parts availability, speed of delivery and ease of installation play a major role in the purchase decision, with price being only a secondary consideration. Most HVAC equipment is bulky and difficult to ship, limiting competition from online players. Simply put, when your HVAC unit breaks down on a hot summer weekend, you don’t have to spend time shopping for the lowest price — repairing the AC unit becomes a priority, no matter the cost. The company’s revenues are also extremely predictable, as the majority of sales are tied to replacement demand, which itself is a function of installed base.
Watsco is the largest player in a highly fragmented industry. The company achieves returns on invested capital in the mid-teens and pays out most of its profits in the form of dividends. The company also expands over time through acquisitions, buying up smaller independent HVAC distributors. They recently acquired Temperature Equipment, a Chicago-based distributor53. Watsco also has the most unique long-term senior executive compensation policy we’ve ever encountered in corporate America – all stock awards become final at retirement or after 10 years, whichever comes later. This makes managers extremely focused on the long term, which we believe is a real advantage for a company that grows primarily through acquisitions.
Watsco last reported gains on July 22, beating both the top (EPS +64% YoY) and bottom-line estimates. The company also increased its dividend in conjunction with earnings reporting. We believe the stock is attractive at current valuations, given the extremely predictable profits the company enjoys, the product’s recession-proof nature and long-term growth trajectory. GAAP earnings have been understated due to the amortization of intangible assets related to prior acquisitions.
Shares are +27.37% year-to-date and +24% over the past twelve months.”
Based on our calculations, Watsco, Inc. (NYSE: WSO) failed to earn a place in our list of the 30 Most Popular Stocks Among Hedge Funds. WSO participated 22 hedge fund portfolios at the end of the first quarter of 2021, compared to 24 funds in the fourth quarter of 2020. Watsco, Inc. (NYSE: WSO) has returned -7.31% over the past 3 months.
The reputation of hedge funds as savvy investors has been tarnished over the past decade as their hedged returns failed to keep up with the unhedged returns of the market indices. Our research found that hedge funds’ small-cap stock selections beat the market by double digits between 1999 and 2016, but the margin of outperformance has narrowed in recent years. Nevertheless, we were still able to pre-identify a select group of hedge fund investments that outperformed the S&P 500 ETFs by 115 percentage points since March 2017 (see the details here). We were also able to pre-identify a select group of hedge fund investments that underperformed the market by 10 percentage points annually between 2006 and 2017. Interestingly, the margin of underperformance of these stocks has increased in recent years. Investors who are long in the market and short on these stocks are said to have yielded more than 27% annually between 2015 and 2017. We have been tracking and sharing the list of these stocks since February 2017 in our quarterly newsletter.
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