While a teacher at Columbia University, Benjamin Graham would discourage his students from making the blanket statement, “Stock X is a great investment” or the close cousin “Stock Y is a bad investment.” The reason why Graham discouraged this line of thinking is because it ignores the extraordinarily important role that price plays in determining the expected and actual returns that an investment will generate.
If you’ve been at this site for a while, you are already familiar with the foolish habit of saying things like “Coca-Cola is a great investment” because you know that was not true for those investors that paid over 60x earnings to purchase Coca-Cola stock in the summer of 1998. The returns since then have been 2.69% annualized because the starting valuation of the stock was asinine. Some people mistakenly conclude that this is a repudiation of the notion that Coca-Cola is an excellent company, but rather I find it to be a vindication of the company’s strength that it has been able to deliver positive annual returns over an eighteen year period that witnessed the stock transition from 60x earnings to 20x earnings. The valuation is a third of what it once was, and you’re still almost keeping pace with inflation.
As a general principle, it would be much better to say, “Coca-Cola is a solid investment around 20x earnings, a great investment around 15x earnings, and will likely underperform the S&P 500 once the starting valuation exceeds 25x earnings.” Some people may mean something like this implicitly when they shorthand say “Stock X is a great investment” which is fine, but it is important to be deliberately conscious of this leap.
Many investors like the abstract concept of value investing (buying dollar bills for seventy cents) but abandon the principle as soon as the opportunity arises to apply this precept to real-life companies that are out of favor. During the financial crisis, you could have purchased darn near anything and it would fairly have been considered a value investing. Between 2010 and 2012, tech stocks and banks were largely the unfashionable firms. And now, it is the oil and retail sector that offers the greatest margin of safety as a class.
Let’s look at Kohl’s to see what I mean. It made $4.24 in 2014. In early 2015, it traded at a valuation as high as $79 per share. That was a valuation of 18x earnings, right about where I’d consider fair value for the stock (I’d consider the wide band of 16x earnings to 20x earnings to be fair value for a retail brand with moderate debt offering long-term earnings per share growth in the 7% to 10% range. If your inputs are different, your estimates will be different.)
2015 proved to be a challenging year for retail, with most of the big firms in the industry reporting moderate declines in earnings per share. The retail investing index fell 37% compared to 0.7% declines for the S&P 500, exclusive of dividends. With dividends, the performance of each shoots up two points.
Kohl’s was no different from this. After reporting $4.24 per share in 2014, it reported an estimated $3.80 for 2015, for a decline of 10.37%. Yet the price of the stock has fallen to $47. That is a 40% price decline in response to a 10% earnings decline. The reason why you might buy Kohl’s stock isn’t because the company’s earnings are exceptional right now, but rather, because the expectations for the stock are so low that even modest results will create good returns and fair returns will create great returns.
It is worth mentioning that the analyst consensus calls for Kohl’s to make $4.70 in 2016 and over $5.75 by 2019. I quote that not as Gospel but rather to assert the broad agreement that earnings at Kohl’s are expected to perk up by those who study it most. I agree–Kohl’s is exceptionally talented at studying the behavioral characteristics of its customers that strongly prefer sales rather than static pricing, the loyalty database of 35 million customers is expected to send out targeted mail advertising deals in late 2016 at a more robust rate than previously, and the management team has still managed to quadruple earnings since 2000.
What makes this stock so interesting right now is that it is trading at 12.3x earnings. My four-year expectation is that profits will grow from $3.80 to $5.75 over this time frame, and the valuation will improve from 12.3x earnings to 17x earnings. That is a price change from $47 to $97, plus you are collecting a $1.80 dividend currently so that effective change might be $47 to $97+$8 dividends for a total change from $47 to $105. Even if the earnings come in lower, or the valuation only reaches 16x earnings, it’s still an opportunity to do well. Even $5 in earnings against a valuation of 15x earnings will still take the stock to $75+$8 dividends= $83 in total value. It would surprise me if Kohl’s didn’t outperform the S&P 500 over the medium term given the low current valuation.
There are different flavors of investing–the greatest potential returns, and greatest risk, involves companies that are losing money that are expecting a turnaround. I don’t like that approach because the absence of a turnaround can lead to a near 100% capital loss, though I acknowledge that a basket of 100 stocks with distressed characteristics can perform quite well as the quadrupling in stock price of the survivors can overcome the failures.
My preference is for stocks that are still quite profitable and can do all right even if the events that lead to disfavor continue indefinitely. Kohl’s makes $750 million in net profit per year, and only has $760 million in total debt payments over the next five years. Its profits are fine, and its debt load will easily be paid off even if business operations do not pick up. I think Peter Lynch was right when he said that a lot of money can be made looking at companies that are unfairly punished when they experience a temporary hiccup, and the 40% price decline of Kohl’s stock in response to a 10% earnings decline is one current example of the principle.
Originally posted 2016-01-11 07:11:05.
