Stock Market Irrationality in a Bull Market

A reason why index funds that track things like the S&P 500 have become popular in recent years is that each investor is shielded from seeing the volatility of individual components that can promote irrational selling. If someone owned Visa and Chevron outright over the past year, he might discount the excellent performance of Visa and fret over the fluctuation in Chevron that took the price of the stock from over $130 to under $70 at some point in the past few months. And yet, if someone owned an S&P 500 that contained Chevron, they would never actually see the Chevron stock individually swing in stock price because its performance would get blended in with hundreds of other companies. It’s all irrational, yet Dalbar studies show that the typical investor churns over individual stocks at almost triple the rate of S&P 500 index funds.

There are circumstances, however, when it is the individual stock picker that has an advantage over someone pursuing an index strategy. When the general collection of companies that make up an index are, on balance, overvalued, then you are putting in a position to earn less than the 10% annual returns that the S&P 500 typically delivers over long periods of time.

The advantage of the stock picker is that you can find companies that offer better total return potential than the S&P 500 as a whole. There are a few ways to find these types of companies, but my favorite is to look for companies that are doing well but not currently meeting lofty expectations.

One such company is Whole Foods (WFM). The organic food grocer traded at a high of $57.60 earlier this year, but came down after delivering only same store sales growth of only 3.6% in the previous quarter. I see the price decline as an overreaction because Whole Foods is adding 43 stores per year, and a little over 20 of them have been built near existing locations in Orlando and Chicago. So you have a situation where people are starting to have two nearby Whole Foods to choose from, instead of just one in the area.

Whole Foods isn’t a company like Wal-Mart where it can just open and sell Kale Waldorf Salad to anyone. There’s a trendiness meets affluence to each location. It’s a nice business model that gives way to 9% operating margins, and explains why Whole Foods has been able to grow profits from $0.13 in 2000 to an estimated $1.70 by the end of this year. With only the 2007-2008 year as an exception, Whole Foods has grown its annual profits every year since 2000.

And one of my favorite parts? Whole Foods has been able to roll out new stores by using retained profits to fund it, which is unusual for a retailer that is trying to roll out across the nation. It only has $63 million in long-term debt on the balance sheet, and the company makes $620 million per year in profits. Basically, the total debt on the entire balance sheet is equal to 37 days worth of profit.

Earnings are growing at 13% annualized, and the 3.6 percentage points come from same-store sales growth and 9.4 percentage points come from the addition of new stores to the company. For a current valuation of 19.5x earnings, that’s not a bad price to pay for that kind of growth.
The current media attention that Whole Foods is receiving has to do with the new investment into Mendocino Farms, which is being billed as a new avenue for additional growth. This may well prove important with time, but I think the biggest to come at Whole Foods will be the result of increased bargaining power as its store count increases.

Even with Whole Foods has 9% operating margins, the figure is somewhat low considering that it works in the field of high-end groceries. In order to make $620 million in profit, Whole Foods has to sell $15.6 billion in groceries. That means only 4% of sales are directly into profits.

The issue is that Whole Foods still only has a little over 400 stores in existence. This gives Whole Foods limited bargaining power with its food suppliers–the suppliers don’t currently have a strong reliance on Whole Foods to generate a high totality of their own sales, and that makes it difficult for Whole Foods to wring out price concessions.

Contrast that to something like the relationship between Wal-Mart and Smucker. Wal-Mart is so huge that it accounts for 30% of the sales that J.M. Smucker will generate on behalf of its shareowners this year. When Wal-Mart executives barter with Smucker executives over price, the Wal-Mart executives clearly have the upper hand. If no agreement is reached, Wal-Mart could find it tolerable to not stock the jams, jellies, ice cream toppings, and coffee on their shelves. The absence of Uncrustables is not going to have a material effect on the Wal-Mart business model.

But it would absolutely crush Smucker’s to report 30% lower profits as the result of not reaching a deal with Wal-Mart. This, in turn, makes a national behemoth like Smucker’s desperate for the business of Wal-Mart, and that puts Wal-Mart in a strong position to receive price concessions from Smucker’s.

But Whole Foods isn’t quite at that point yet. This is the first year that Whole Foods has over 400 stores to its corporate name, and I don’t think it will start exhibiting WalMart-like negotiation power until it hits close to 2,000 stores in operations.

Over the long term, there will be countervailing forces at play–yes, Whole Foods may build some locations near others that bring down the same stores sales growth rate, but it should also see improvements in its supply chain economics that lead to an improving relationship in the profits-to-sales figures.

Whole Foods is fine. Even at the stores that are in close proximity to each other, the sales are growing at a low single digit rate. Earnings at existing stores are growing at a mid single digit rate. And when you include the new store rollouts, you get a company that is achieving double-digit earnings per share figure. And it is doing this with $770 million in cash on hand, only a bit over $60 million in debt, and a low dividend payout ratio of only 30% that permits retained earnings to self-fund future store rollouts. This current decline from $57 per share to $33 per share is an example of specific stock irrationality even in a market that is generally a bit overvalued.