Imagine you owned a 10% percent stake in a million-dollar restaurant with nine other people that earned $100,000 per year in profits for thirteen years in a row. Although the amount of profits never grew, the profits that did arrive from operations were used to make some modest dividend returns to owners and modest building improvements. But most of it was used to buy out as many of the fellow owners as possible.
Over the course of those thirteen years, five of the owners got bought out. You’d find yourself now owning 20% of a million-dollar restaurant earning $100,000. Your look through earnings jumped from $10,000 to $20,000 and your net worth in the business climbed from $100,000 to $200,000 without any additional capital on your part. And, other than those modest dividend payments along the way, there were no tax payments required along the way as your share of the profits doubled.
Was this a good investment?
The right answer is a lukewarm shrug of the shoulders and a “Meh.” You got 5.48% compounding. Wealth got built, but you probably would have wished you had more to show for a quarter’s worth of your investing life.
This analogy, while not an identical metaphor, pretty closes tracks the experience of owning the retailer stock The Gap, Inc. over the past thirteen years. There has been absolutely no profit growth and no revenue growth at The Gap over this time frame. It earned around $700 million in profits back in 2003; it earns around $725 million now. It generated about $15.8 billion in revenues back in 2003; it generates about $15.2 billion in revenues now.
What is worrisome is that The Gap opened up 300 stores during this time stretch (taking the store count from 2900 to 3200) and it also launched its online commerce platform. This means that the the 10% store count growth and launch of an e-commerce platform was met by a concurrent decline in sales per existing store by the same amount.
The one nice thing? The Gap had no debt on its balance sheet until 2009, and played out a de minimis dividend constituting 20% of profits or less per year through 2014. Through a combination of profits on hand and a debt load that has gone from zero to $1.7 billion, The Gap has been able to repurchase 55% of its overall stock since 2003 so earnings have actually climbed from $1.09 to $1.85 over the past thirteen years even though the core business has not improved.
I mention all of this to say that long-term investors should ignore the 15% pop that occurred in The Gap’s stock yesterday and not consider this corporation as a long-term holding. Investors had been expecting sales at existing stores to go down by 6%, but they only went down by 3%. Foot traffic has been stagnant this millennium, and The Gap’s dividend payout ratio has climbed from 25% to 50% of earnings in the past three years while the balance sheet has gone from no debt to $1.7 billion in debt. This almost guarantees that the pace of buybacks will slow down.
For thirteen years, The Gap was able to give its shareholders 5-6% annual growth exclusively due to the effects of share repurchases. But those buybacks are almost certain to slow down because of moderately high dividend and debt commitments that did not exist at the beginning of the measuring period. So you’re left with a business seeing foot traffic slowly trickle downward and revenues that have long stagnated. The successful use of share repurchases at The Gap, where the valuation has been low for a long period of time, has been a successful mitigation of the effects of a gradually declining business model. But making the best of a bad situation doesn’t rise to the level of deserving your money. There are 15,000 publicly traded businesses out there. You can do better.