Dear Clients and Friends of Insight,
In spite of the gloomy sentiment that preoccupied so many investment strategists and commentators for the first few months of the year, the market, once again, surprised the consensus thinkers and reversed its negative course. Although many challenges for a healthy economic environment remain, investors’ moods improved (thank you Chair Yellen), which helped boost the major U.S. indices into slightly positive territory to end the first quarter!
In our last several letters we have advised clients to put more focus on corporate results, and less on emotion. We anticipated a change in stock leadership following the recent market correction. We counseled that the concerns of the negative prognosticators were likely overdone, and we advocated taking a longer-term perspective, as the U.S. economy has an underlying strength to it.
How do we remain confident that current stock holdings will provide a future reward to clients, even during these uncertain and turbulent periods? By striving to maintain our contrarian investment approach – which is to avoid buying the high-flying popular performers of the moment (which are expensively valued) and instead, invest in the slightly-tarnished boring alternatives (which are attractively valued). To be successful, though, requires a strong conviction in our buy and sell decisions. For us, this conviction comes from the application of a disciplined analytical framework to evaluate a prospective investment’s current problems and future opportunities.
Let’s take a more in-depth look at how we investigate a research idea by looking first at the issues which can lead to a stock’s price dropping to attractive levels. It is common for more than one issue to impact a company at the same time, but they generally fall into three categories.
- Macro issues that affect nearly all companies to varying degrees such as slowing global economies, or rising exchange rates.
- Industry issues that affect nearly all companies in an industry or sector to varying degrees such as low oil prices, or the growth in on-line purchasing.
- Company specific issues such as a failed drug trial, or loss of a key customer or supplier.
Once we have identified a company’s relevant issues, we evaluate their impact on a company’s operating results to assess their severity, likely duration and future impact. Of course not all companies are able to manage through their issues in a timely manner, or at all. So, patience is equally important when determining the appropriate entry point. Our research process can be divided into four primary areas of review: Financial Strength, Profitability, Growth and Governance. For each of these we analyze a company’s current situation relative to its history, its peers, and across industries. Let’s review each briefly.
Financial strength characteristics include how much debt there is, whether it has been rising or falling, the amount of interest expense, what the credit rating is, and how much liquidity (cash) is available to operate the business and for how long.
Profitability analysis includes evaluating measures of gross and net profit margins, returns on capital and equity, what affects them, and the trends in each.
Growth measures changes in sales, earnings, book value and dividends.
Governance includes evaluating items such as the capital allocation decisions (reinvest for growth, pay dividends or repurchase stock), the tenure of management, the degree of insider ownership and the composition of other shareholders.
To further our discussion, we’ll look at a stock in which we are currently interested, a retail company.
The issues: Macro… A slowing economy has led to slower sales growth, Industry… Amazon is threatening all retailers, and Company specific… Margins are shrinking as it discounts more items and invests more to beef up its on-line commerce capability.
Wall Street’s response: Earnings estimates are down, there are very few analysts with “Buy Ratings”, and this previous Wall Street darling’s stock price has declined over 35% in the last 12 months.
Our analysis:
Financial strength: Historically they’ve had zero debt, until a recent borrowing raised their debt-to-capital level to about 30%. The company is considered extremely financially sound.
Profitability: Gross profit margins have exceeded 40% in each of the last 10 years, and net profit margins are very strong for a retail company. Current returns on capital are over 20%, consistent with, but slightly lower than long-term averages. The company is very profitable.
Growth: Sales per share have increased every year, including during the Great Recession, leading to a 10- year and 3-year annual growth rate of 14% and 16%, respectively. Earnings and book value have also grown at double-digit rates. The company has demonstrated solid growth.
Governance: Key management has been with the company for more than 15 years. Officers and directors own almost 5% of the company. Many of their shareholders are highly regarded investors. The Company has consistently repurchased its own shares, rather than pay a dividend, and shares outstanding have declined 43% in the last 10 years. The company exhibits responsible governance.
This company is Bed Bath & Beyond. We believe they have the right characteristics to tackle their current issues. They have a proven track record, a strong management team, a commitment to growth and profitability, a shareholder-friendly culture and a good brand. Thus, we view their stock as an attractive opportunity for appreciation over the next few years. Importantly, with the stock price down 35%, we anticipate little downside risk.
We hope this brief review provides you with a better understanding of our investment process and rationales. Perhaps this discussion will spark your interest in some of the other opportunities found in your portfolio. Please let us know, we would enjoy sharing our thoughts with you.
INSIGHT INVESTMENT COUNSEL