Investment Activity Review-May 2014

In May I added one new company to my portfolios and added to positions of two other stocks.

ADDED to Short Position in S&P500 Index (via HSD)

I spoke to this a bit more in a previous post about going all-in. So I’m putting my money where my mouth is and I have decided to continue averaging down the position. Nothing has changed. I think the US stock market as a whole is extremely overvalued. Market sentiment is apathetic to risk. Retail investors continue to pour money into equities trying to make up for missing the big bull run. Investors are using margin at record levels. All of this under an economic backdrop that shows interest rates staying low, incomes static, very little capital investment, and tepid consumer spending. These are not usually the ingredients for a sustainable long-term bull market.

OPENED Position in Target Inc (TGT)

Despite my pessimism about the stock market, I still have no qualms about buying good companies that create tangible wealth when they are on sale. Unfortunately these type of companies tend be on sale when the market and equity analysts are spewing venom at them. Right now the company and stock that is being loathed by investors and the Smart Money People is Target. Target has been the pretty sister to Walmart. It is also primarily a discount retailer selling the same basic goods as Walmart, however it has differentiated itself by offering goods that are slightly of higher quality but not at outrageous prices. It has become known especially in the fashion apparel as offering value fashion. Target created a following of customers who were addicted to the concept of finding something stylish at a decent price. Target became known as Tar-jé. Canadians would make pilgrimages across the border just to shop at Target just for the adventure of finding some diamond in the rough piece.

It has had a good run. The Target brand has now become synonymous with adventure value shopping. Then like anything clouds, large dark clouds began to form. In late 2013, Target revealed that its systems had been hacked and almost 70 million customer accounts had been breached including 40 million credit card numbers. The company sat on it for days and their public relations team did not exactly handle the situation as well as it should have. It was revealed that Target’s systems actually detected the infiltration but did nothing about it. Next, the company’s first foray outside the US had not gone well. Initial reviews from its aggressive expansion into Canada were not favourable. Canadian customers complained that the prices were much too high and merchandise selection was limited, often non-existent. We’ve seen the pictures of empty store shelves. Winter then came and with it abnormally bitter cold and snow that apparently kept everyone at home. A perfect storm indeed had descended on the company. In its latest filing, the company reported it had lost almost $1 billion dollars on the Canadian expansion.  

The stock year-over-year has been down almost 19 percent. As a result, every Soothsayer, money manager, and retail pundit has pronounced that Target has lost its way.

When I see this kind of negative pontification by the Smart Money People, especially about a company that has built a strong brand and business and created tangible wealth, I’ll want to take a look.  What I see is a company like most retail stocks right now getting thrown out with the bathwater. Target is a very profitable company. The company generated almost $2 BILLION in profit in 2013. Pretty good considering their main competitor has 8 times the scale it does. It got bit by the hackers. As horrible as that is, it is sadly becoming the norm as we commit ourselves to the Internet for our existence. The fact is Target over the past few years has invested heavily in IT security and that investment did pay off as they were able to detect the intrusion. Many other retailers barely have given lip service to IT security (they are now). Where they failed was in the human element and not reacting to it. That’s a management thing and can be fixed.  The supply chain problems they have had in Canada can also be fixed. Again another management thing. Target completely misread the Canadian market thinking that because they are our neighbour, they will react to the same marketing strategy. Another management thing (hubris) that can be addressed. As we can see, a lot of issues Target faced were very much management related and controllable and I think they are problems that can be fixed. They will want to fix this and fast. Getting rid of the CEO and the Canadian President was the natural first step. Target understands how valuable its brand is and they will not stand idly by and watch it get taken down. They still have a pretty loyal following. If that were to fade then that would be a game changer.

Personally I had never been in a Target store until recently when I needed a few things. I decided to go to one near my parents’ house to look around. If I followed the media reports and the Smart Money People, I should have seen chaos and fixtures hanging from the ceiling. When Target came to Canada, they bought up most of the real estate of a Canadian discount retailer, Zellers, which ironically was branded using red. So when I first walked into a Target, the first impression I got was it looked like a much cleaner, brighter, and warmer Zellers. Those are good impressions to have, no? They pretty much have the same goods as I could find in Walmart. The apparel section had higher quality goods that seemed to be reasonably priced. Because I never went to a Target in the US, I really couldn’t compare whether prices were cheaper or expensive cross-border wise. Pricing wise, there wasn’t much difference between Target and the Walmart down the street. Empty shelves? There were some around, but it wasn’t obscene like the viral pictures. They had the items I wanted to buy including a pad of tracing paper for $2. Next door at Staples they were selling them for $5. They have a Starbucks. Walmart has McD’s. The only thing Target doesn’t have (yet) is fresh produce which is fine. I still like to get groceries from a grocery store, not a department store. I found overall the grocery to be decent and well-presented compared to Walmart where everything looks dark and dank, especially the produce. I really can’t find any reason why I wouldn’t go back to Target.

When you dig into the numbers, we can see that despite an initial drop-off in customer visits after the credit card breach, it appears that consumers are slowly warming back up to Target and coming back into the stores, even in Canada. Maybe it’s the weather? Returns on invested capital are still greater than its cost of capital. Revenue growth is picking up in the Canadian segment from $86 million in 2013 to $393 million so far in 2014. Margins have fallen slightly but in a bad market it is not the disaster Wall Street is making it out to be. The stock from a discounted cash flow analysis is priced at $68-$72 based on a pretty conservative growth rate (3.6% average revenue growth rate over 5 years) so it is trading at a healthy discount. On a forward P/E basis, Target trades at 14.7 which is lower than its peers. The balance sheet is relatively clean with very little Goodwill/Intangibles. Overall I just don’t think the company is in peril the way the media and the Smart Money People think it is so I decided to take the other side of the trade and open a position. Compared to Walmart, I think there is more upside on the stock in the long term.

 

ADDED to Position in Whole Foods (WFM)

Another once darling of the Smart Money People, the stock has fallen on hard times. Whole Foods, the leading retailer of natural and organic foods in North America has brought upscale eating to the masses. The company seeks out the finest natural and organic foods available and maintains the strictest quality standards in the industry. It operates more than 350 stores, averaging over 7 million customer visits each week. It’s in essence a luxury retailer, which is one of my favorite sectors as the world appears to be becoming more polarized and the middle class is sadly getting squeezed out. The company because of its niche position was able to enjoy much higher margins than traditional grocery retailers. So anytime I see a luxury brand taking a hit, I want to have a look. 

The company has been growing at a hectic rate, however the sales have not caught up. In addition, it is not the only upscale grocery store in town anymore. Traditional grocery retailers are upping their game. Walmart just recently announced a huge deal to source more organic produce in its stores. Greater competition means lower prices, lower margins, and lower profits and that has spooked Wall Street. Ironic that free market completion is viewed as bad thing in financial circles. Recent evidence has shown that other competitors are slowly eating into Whole Foods market share. Its most recent earnings report was quite dismal and the leadership essentially did a mea culpa saying they didn’t take the oncoming competition seriously.

The stock took a major falling as much as 20 percent after its last earnings announcement. The stock is trading at a discount to its intrinsic value which comes in at about $48 to $50. Their balance sheet is very clean (very little debt and intangible assets). Even with the recent pullback the stock is pretty rich relative to earnings. The Smart Money People believe that Whole Foods will not be able to handle the competition especially from the Walmarts, but history has shown that specialized, niche oriented companies can more than hold their own against the behemoth’s. Whole Foods really hasn’t done anything wrong except be really good at what it does. It’s a victim of its own success. The creative competencies and leadership are still there and I think can more than match or even exceed the value offered compared to other grocery retailers. The only concern I would have is if they start to chisel away at the brand by going more down market and trying to match prices. That may work in the short term but the long term effect is that their differentiation will be lost. I think management knows this and if anything they may move more prudently in their expansion plans.

The stock is very much out of favour in the market but it is still the dominant high end grocery retailer that despite the increased competition is still generating tangible wealth. I decided to add to the position to lower my cost base significantly. It will probably tread water for a while but I’m willing to wait. Should the story remain the same, I would not hesitate to add more to the position.

 

What is common in all of these positions is that they involve companies that are very much out of favour with investors and especially Wall Street, yet however they are dominant brands that have established themselves as leaders in their segment and despite the current issues, are still creating tangible wealth. If they were not publicly traded companies, you wouldn’t have even noticed their challenges. Because they are out of favour, they are trading at meaningful discounts which if they can right the ship could lead to some meaningful gains in the future. As individual investors, this is our best chance to exploit the market to our advantage, not going with the herd and buying what’s sexy.