Investment Activity Review - January 2016 Part 2

In Part 1 of my Investment Activity Review for January, I went over investment decisions I made to sell stocks and decisions I made to buy and stocks to my existing position. In this and the next few posts, I will review my decision process on some new stocks I added to my portfolios. Like always, I ask myself the standard 8 questions I use to evaluate a company and their stock.

As you should know by now if you have been following my musings, I always keep a list of stocks that I would love to aspire to buy but haven’t because they are simply too expensive for my liking. I call it The List. The premise of having The List is when stock markets pull back significantly, chances are that some of these stocks will fall in price and suddenly fall within a price range that may make me more comfortable buying.  It’s like a Black Friday sale.  Often in major pullbacks, there often isn’t any discrimination between quality blue chip stocks and bad stocks. They all get thrown out with the bathwater.  It’s at these moments where opportunities to buy these great companies on the cheap present themselves. In January a few opportunities came up and I decided to jump in an open up some small positions. The key here is small positions, just because the stock goes on sale, does it mean you adopt gluttony and buy everything in sight. I personally use these moments to start off buying a small position and building slowly over time. The reality of a stock market correction is prices could fall further so going all-in doesn’t make much sense. I’d rather slowly build up and average the costs down. At the end I may not be buying the stock at the rock bottom price, but it will be a lot lower than the peak and likely there will be more upside than down.

In January I added 4 new stocks to my portfolio. 3 of them were in the same sector so in this post I’m going to speak to these stocks as a group and save the other stock for another post.

Opened positions Tiffany (TIF), Nordstrom (JWN) and Williams Sonoma (WSM).

 

1)     What do they sell

TIF, JWN, and WSM are luxury retailers that sell the nicer things in life. They are retailers of all things bling. Tiffany sells jewelry (real bling). Nordstrom’s is a department store that sells all kinds of apparel and jewelry bling, and finally Williams Sonoma sells home and kitchen bling. All of their product offerings are of high quality and of course high price.

2)     Who do they compete with?

In some ways TIF, JWN, and WSM compete with each other for the high income consumer’s discretionary income, however they do operate in different segments. Tiffany is in the fashion and jewelry segment that will compete with other brands such as Birks or Blue Nile, while Sonoma is catering to the home and kitchen segment and competing with retailers such as Pottery Barn. Meanwhile Nordstrom’s as a department store are competing with similar broad category stores like a Saks or Holt Renfrew.  All of these brands offer the same value proposition which is involves an elevated status in society.

3)     Who buys their products and services

Their primary customers are those in the high-income, high net worth, professionals with a lot of disposable income. They also cater to the wannabe cross over group that is upper-middle class and want aspire to a higher standard of living.

4)     Will they buy it over and over again

Customers who frequent these brands tend to be very loyal and will return when they have that need to remind people where they stand in the world.

5)     Do they make any money?

The products that these companies sell are often high margin products because of their exclusivity and high quality that goes into the design and construction.

When we dive into their financial performance, all three companies have demonstrated that they can create tangible wealth. Tiffany’s Return on Invested Capital (ROIC) ranged from 16.8 to 17.9 percent between 2013 to 2015 which was above 10 percent. Nordstrom’s ROIC fell from 21.8 percent in 2013 to 18.4 percent in 2015 but were well above its 9.4 percent cost of capital. All three companies in their recent calendar year posted returns on invested capital that ranged from x to x percent and were well above their costs of capital. Finally Williams Sonoma’s ROIC ranged from 29.6 percent to 31.8 percent again well above its 10.8 percent cost of capital.

6)     What do they own and who do they owe money to?

All three companies have pretty strong balance sheets and carry very manageable amounts of debt.  Tiffany’s debt/equity ratio tracked at 0.28 which is very manageable. Nordstrom’s debt/equity was on the high side tracking at 1.3 while Williams Sonoma had no debt.  In terms of liquidity all three companies had current ratios well above the 1 level indicating they had more than enough cash flow coming in to meet short term obligations.  Finally in terms of quality of assets, all three companies have very little in the way of goodwill or other intangible assets so the quality of the balance sheets are pretty strong.

7)     How risky is the business?

Unlike mid-level retailer like the Gap and Abercrombie and Fitch,  luxury retail has benefited from the recent global redistribution of wealth. As new millionaires are being raised in Asia, the Middle East and in Silicon Valley, their demand for high quality products has benefited luxury retail brands and should this trend continue they should continue to benefit for the long term. However, short term clouds exist. China’s crackdown on corruption and displays of opulence has put a dent in demand for luxury goods. Members of the elite are less likely to flash things with fancy logos, however that doesn’t mean they don’t want nice things. Retailers are catching on to this and in their latest product iterations have developed goods that are still high quality but emphasize the logo per se.  Another risk facing these companies is currency risk. The US$ has been surging the last 18 months and it has made their products more expensive and it appears it is cutting into their sales. Should the US$ stay at these levels or even go higher, this will have a negative impact on their earnings. The other risk that luxury retailers face is trying resist the temptation to go down market and appeal to a broader consumer. Coach tried to do it with its Factory Outlets which were a hit at first but eventually diluted the brand. When a luxury brand tries to down market it often becomes harder to regain that exclusivity factor. Tiffany and Sonoma have so far resisted while Nordstrom’s has been deploying it’s Nordstrom Rack discount stores which have been popular but it remains to be seen how much the stores dilute and cannibalize the brand.

8)     Is the stock cheap?

Luxury retail stocks have pulled back quite a bit in last 6 months. Tiffany is down 30 percent. Nordstrom down 37 percent and Williams Sonoma down 35 percent.  Based on current valuations, Tiffany is valued in between $58 and $86. Nordstrom between $49 and $73 and Sonoma between $50 and $74. On a relative basis and forward earnings multiple basis, Tiffany is trading at about 17.6 times forward earnings which is slightly above the median of its peer group. Nordstrom’s is at 15.5 which is well above its peer group multiple only because it is one of the few department stores out there that is still profitable. Finally Sonoma is trading at about 15.2 times forward earnings which is in line with its peer group median.  With the recent pullbacks in January, it appears that these stocks are now trading at a discount.

One of my favorite themes I’ve been exploring the past few years is luxury retail. To me the whole consumer retail sector has changed dramatically. Because of the nature of our economies we are seeing a hollowing out of the middle class in North America and the result is a very polar class of consumers that are in a high income bracket or in a low income bracket. This translates into a retail segment that is catering less to middle class consumers and to the extremes. We are seeing that luxury retailers like a Tiffany or Ralph Lauren as well uber discount retailers like Walmart, Ross Store thrive while those positioned in the middle like a Gap struggle.  Some describe this as a barbell distribution of the retail industry.  If we expand the lens globally we see that emerging markets are seeing a new generation of nouveau riche consumers and are seeking the finer things in life.

From an investing perspective I see luxury retail as an appealing sector because often sell higher margin goods to consumers who have a greater brand loyalty. There’s less competition and prices don’t suffer from intense discounting.  From a stock perspective, while they will suffer shocks like any other sector, they seem to bounce back from those shocks faster. In this sense I’ve always tried to keep one eye on the luxury retail stocks and tried to buy in when they go out of favour or when the market pulls back severely.  As the graph here shows, luxury retail has had a good run but it appears that that they are having some tough times as sales have been falling meaningfully the last few years. The big reason has been China, which has been the big growth area for luxury goods has slowed down due to a combination of a government crackdown on corruption and consumption of in your face bling to an overall slowing of the economy that reduced demand for said bling. With this in mind, Nordstrom and Sonoma are appealing because they don’t do business in China. Their brands reach out primarily to North America and Europe. Tiffany is more of a global brand and so is more susceptible to global gyrations, however Tiffany is considered a best of breed and iconic brand when it comes to fine jewelry. There are a lot of people out there that aspire to acquire something in a blue box.

Based on this and the pullback in January, I thought it was a decent time to jump in open some small positions in all three stocks. Tiffany I bought in at $61 (it was as high as $90), Nordstrom at $45 (it was as high as in the $80’s) and Sonoma at $50 (again it was in the $80’s). They can very much go lower from here. Right now they are out of favour by the market but these are high quality businesses selling products that cater to a growing segment. They are established brands that are so well entrenched in their respective niches that I think if they do fall, it won’t be for long. They are still creating tangible wealth in a weak business cycle so I can see there being more upside in the long term.

Update:

Since I penned this article, all three stocks have ramped up higher as the market started to calm down. Tiffany is in the mid $60’s, Sonoma in the high $50’s and Nordstrom back over $50.