One of the things that makes investing so interesting is that there is a tension between the abstract principles that value investors advocate compared to their actual ability to execute on the strategy.
Take something like this: Most people agree with the notion that they like to buy stocks on sale. As a general rule, though, absent 1973 or 2009 type of market conditions, the types of stocks that are on sale tend to have something going wrong with them at the time—as I’ve discussed with previously, companies like Brown-Forman, Hershey, and Colgate-Palmolive are swimming along, and that’s why their stocks aren’t on sale.
On the other hand, when people encounter companies with something going wrong—think IBM’s slow adjustments to the cloud, McDonald’s any time same-store sales stagnate for a bit, or Johnson & Johnson after experiencing significant product recalls in the late 2000s and early 2010s, many people prefer abandonment to actually buying additional shares because recency bias is a very strong cognitive bias that can make your economic life much more profitable if you’re able to successfully remove it from your analysis.
Because I’ve been trying lately to give in-the-moment examples of the value investment principles we discuss, I thought I’d talk to you about Target.
Target has fallen 4-5% today to under $59 per share because the company reduced its quarterly guidance from $0.91 per share to $0.78 per share, noting the data-breach costs.
What people are leaving out of the discussion is this: Target is currently in the midst of growing its annual profits. In 2013, Target reported profits of $3.21 per share. Even with the reduced guidance, Target should still make $3.70 or so in profits this year. Talking about the data breach and trying to scare customers might be good for ratings and pageviews, but it ignores the quality of the business. Last year, Target generated $2.0 billion in profit. This year, even factoring in the reduced guidance, Target should generate $2.3 billion in profit.
The need to be scared isn’t justified by the market fundamentals, especially when you figure:
#1. The concern about the data-breach will dissipate with time, in much the same that people have gotten over Wal-Mart’s bribery scandal in Mexico or Royal Dutch Shell’s accounting scandal of almost a decade ago. Time heals this kind of stuff pretty thoroughly, leaving people to look back and wonder, “Gee, I wish I would have bought some of that stock when the price got so cheap.” How many people do you think wish they bought BP stock at $27 per share after the oil spill? (My note: Target’s cheapness is milder than the severe cheapness seen in BP stock immediately after the oil spill, as the projected costs of litigation were so substantial that BP had to temporarily freeze its dividend, something you haven’t seen with Target).
#2. This year should be the worst of it for Target, and if the company can grow its profits even in the aftermath of the data-breach, imagine what it will be able to do several years down the line as this problem fades even more into the rearview mirror.
If you figure Target is going to make $3.70 in profits for 2014 and the current price is $59 per share, you’re looking at a P/E ratio of 15.95x earnings. In the 1990s, you could never buy the stock that cheap. In the 2000s before the financial crisis, the stock had a brief bout of unpopularity in parts of 2005 into 2006 when the Board was being exceptionally stingy with the dividend (raising it only from $0.38 annually to $0.42 even as profits were growing and only 15% of the profits were going to the dividend). During the financial crisis when the stock fell to $25 per share, you were able to buy the stock cheaper than today, as the valuation fell to 11-12x profits.
Target has been raising its dividend every year for decades. It’s a stock that, in normal times, trades at 19-20x earnings. Over the past ten years, earnings per share have grown at a rate of 1.0% annually. The company recently raised its dividend 21%, from $0.43 to $0.52 quarterly, signaling to investors, “Hey, this business is of much higher quality than the press is currently giving us credit for.” When you study the company’s financial statements, profits are actually growing on an annual basis (so that you don’t have to make any long-term projections about Target’s future earnings power), further highlighting the disparity between Target’s actual business operations and the public perception of the company. Therein lies the opportunity.