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Woodlock House 2019 Q4 Investor Letter

Woodlock House is a small new private fund and recently published its 2019Q4 investor letter on its website. We’d like to bring two stocks to your attention from this letter and share what we think about them. The first stock is Air Lease Corporation (NYSE:AL). Here is the excerpt from the Woodlock House’s investor letter:

“I significantly reduced our exposure to Air Lease (AL). We bought Air Lease initially at $33 per share – a deep discount to book value of $48 per share. Today, that valuation gap has closed. The stock was up about 45% for us in 2019. Since it is no longer as compelling, I cut its weight in our portfolio by half from roughly 11% to 5.5%.

With AL, we successfully took advantage of a wide gap between price and value. But ideally we wouldn’t own businesses like AL. It is very capital intensive, earns single-digit returns on its assets and is reliant on debt to finance new aircraft and grow.

Granted, AL does this safely by securing long-term leasing contracts for these aircraft and manages a mid-teens return on equity. The point I want to make, however, is that AL is a capital guzzler compared to the other businesses profiled in this letter. Over a longer period of time, such businesses generally do not perform as well as capital-light businesses that generate more free cash flow and earn far higher returns on their assets.”

We looked into aircraft leasing companies recently. David Einhorn has been pitching AerCap (AER) for a very long time and the stock underperformed the market. Air Lease Corporation isn’t much different. These are indeed leveraged, capital intensive companies. Investors shouldn’t be deceived by their low PE ratios. Hedge funds recently increased their holdings of AL but the overall sentiment is below its historical averages. You can check out the hedge fund sentiment towards this stock in this article.

The second stock we are going to talk about is A. O. Smith Corporation (NYSE:AOS). Here is what Woodlock House said about it:

“Lastly, we added A.O. Smith, a leading manufacturer of water heaters, boilers and filtration products. AOS has nearly 40% of the residential market in North America and over 50% of the commercial market. Founded in 1874, it’s another family owned firm. The Smith family owns about 14% of the stock. AOS is another excellent business generating returns on equity of 20%+ with zero net debt and strong free cash flows.

The stock has been a winner up almost 7x in the last decade. But it recently fell over 30% from its high and we built a small position near the lows with an average cost of about $47.

The reason for the selloff was a sharp decline in sales in China. Over the past ten years, business in China has increased at a 21% clip to over $1 billion in sales. It now makes up one-third of overall sales. That growth came to a halt in 2019 and the market bailed. AOS still has room to grow in China, though, and I would expect growth to resume at some point.

AO Smith has taken that same game plan to India, where water treatment needs are acute. Though small now, this could be another huge business for AOS in the future.

The business produces lots of free cash flow and I like AOS’s discipline in how they allocate that cash. They’ve returned cash to shareholders via buybacks and dividends. In fact, the dividend has increased at a 30% rate over the last 5 years. Meanwhile, the shares outstanding have shrunk by 8% during that time.”

We like conservative companies, however AOS is trading at a forward PE ratio of 19 which isn’t very cheap. Its topline hasn’t gone anywhere since 2017, so this isn’t a high growth stock at all. Last April we recommended a better stock that’s growing its topline 20% annually and was trading for the same PE ratio of 19. Ultra low interest rates have been pushing investors towards dividend stocks like AOS. AOS isn’t a bad dividend stock but there are definitely better dividend stocks than AOS. We recommended a 3% dividend stock last month and the stock already appreciated by 20%. That stock had no debt, $130 million in the bank, and a market cap of only $135 million. You can subscribe to our free daily newsletter and get similar recommendations in your inbox before we publish these analysis articles on our site or elsewhere.

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Hedge fund interest in AOS peaked during the summer of 2018 when the stock’s price was around $60. Today AOS shares are 20% lower and hedge fund sentiment towards the stock is at its all time low (see here).

Disclosure: None.

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