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The Value in Uncertainty

(Guest Commentary by Rick Konrad – January 17, 2008)

Dear Subscribers and Readers,

Before I offer our Rick Konrad's guest commentary, I would like to discuss a couple of things.  First of all, the 10-day simple moving average of the NASDAQ high-low differential ratio touched -10.00% at the close yesterday on the reaction to INTC's earnings.  Based on 30 years worth of data, there have only been two other instances when the NASDAQ had been more oversold, based on this measure.  These are: late October 1987 (not surprisingly) and early September 1998 (surprisingly, the aftermath of the tech bubble did not register).

Also, looking at the consumer discretionary and financials sectors, one could argue - based on various measures - that these are more oversold than they were in month-end September 2002 - and are only surpassed by the oversold condition in October 1990, when the market was hammered by $40 oil and the S&L crisis (that was when Buffett acquired his sizable stake in Wells Fargo, to the ridicule of many financial commentators).

Ten years ago, the current sell-off and fear in financial, consumer discretionary, and technology shares would most likely have resulted in a S&P reading of 1,250 or below, if it wasn't for growth in emerging markets and their impact on the materials, energy, and industrial sectors.  The impact of China on raw material prices cannot be overstated.  1/3 of the crude oil demand growth in 2008 is expected to come from China (400,000 barrels/d). Yesterday, I attend an Investors Relation event held by Cemex.  Apparently, the size of the world cement market is now 2.6 mm metric tons.  China's demand makes up 45% of the market, while the US makes up only 5%.

Given the evidence of a Chinese economic slowdown and given the central bank's and the government's continuing policies to tighten growth, my inclination is to overweight US consumer discretionary, financials (to the extent that lower global inflation will allow the ECB and the BoE to ease), and technology in my personal portfolio.  I am not buying any mutual funds (for disclosure purposes, I am long AEO and BBBY in my personal portfolio) but if I was, my inclination would be Bill Miller's Legg Mason Value Trust and Legg Mason Opportunity Trust, based on their historical domestic focus and their historical underweightings in both the energy and materials sectors.

From a foreign market standpoint, I also bought JOF (a Japan small cap closed end fund) and Nomura ADRs (NMR).  In Tuesday's session, the Nikkei closed at 19.55% below its 200-day moving average, an oversold level not seen since mid November 2002.  Unless the Japanese government or central bank makes another policy mistake (you'd think they would have learned by now not to raise taxes in the middle of a slowdown), I will continue to be bullish on Japanese small caps and financials for at least the next six months.  Note that I am not buying any Japanese exporters at this stage.  Now, without further ado:

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.

In this commentary, Rick will be offering his thoughts on the current market uncertainty (understatement) and why this presents a good buying opportunity for certain stocks in the consumer discretionary, and to a lesser extent, in the financials sectors.  Rick will also discuss in more detail about some of his current favorite individual stock ideas in the consumer discretionary sector.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Lessons Learned and Looking Forward” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


The adage about the market hating uncertainty is certainly well founded in today's valuations of some sectors. As Henry has pointed out, two sectors have been significantly affected by investors' qualms and fears, namely the consumer discretionary sector and the financials. Portfolio strategists generally are highlighting the consumer staples and utilities as a place to “hide.” On the other side, their counsel suggests that financials and the retailers are sectors to avoid.

Bertrand Russell said in A History of Western Philosophy: “Uncertainty, in the presence of vivid hopes and fears, is painful, but must be endured if we wish to live without the support of comforting fairy tales.”  

Economic uncertainty abounds. The U.S. consumer is struggling as the economy slows. Today's beige book report indicated that consumers tightened their belts heading into 2008, as manufacturers were hit by weak demand for autos and housing-related goods. This report also noted that the strains from the housing slump and harder-to-get credit are making both individuals and businesses more cautious in their spending.

The housing slump obviously has driven homebuilders, mortgage companies, and building supply companies to the brink, if not beyond. Only the deepest value buyers are willing to delve into these murky waters. Other than buying a few bank stocks, I have yet to put my toe in these troubled waters. On the other hand, as investors we often see relationships where there are none.

Let me highlight Bed, Bath, & Beyond (BBBY). It is a dominant nationwide chain of retail stores that sells a wide assortment of merchandise principally including domestics merchandise and home furnishings. Despite its apparent dominance, the reality is that the firm has merely a single digit sliver of the $120 billion-plus market.

Its major competitor, Linens & Things was LBOed in 2006 and is burdened with significant debt. The latest financials for Linens (Sept 29, 2007) indicate that the company has had an operating loss of $180 million on revenues of $1.8 billion for the trailing 39 week period. Same store sales have declined 4.6%.

Linens' acquisition was funded with $650 million of notes  bearing interest at a per annum rate equal to LIBOR plus 5.625%, which is to be paid every three months on January 15, April 15, July 15 and October 15. The interest rate on the Notes is reset quarterly. The Notes mature on January 15, 2014. As of September 29, 2007 the interest rate on the Notes was 11.0%, based on a LIBOR rate of 5.4%. The firm has recently entered into an interest rate collar agreement to hedge the cash flows associated with the LIBOR component of the interest rate on the Notes and has a one-year forward-starting interest rate cap agreement which took effect on January 15, 2008.

The statement of cash flows for Linens also presents some concern. Net cash used (as opposed to generated) in operating activities for the thirty-nine weeks ended September 29, 2007 was $261.3 million. Needless to say, Linens will likely have its hands full in dealing with the burden of these financial obligations when cash flows have been negative, even before general economic malaise hits.

Let's contrast that with the case of Bed Bath & Beyond. The company has generated operating earnings of $579 million over the comparable period on revenues that came in a $5.1 billion, almost three times Linens scale. Cash flow from operations was $240 million. BBBY has zero long term debt.

Obviously the sector has caused great concern because of the weakness in housing. Purportedly, new homeowners are the major purchasers of household-related products. Yet, having tested the correlation statistics for the last four years, there should be very little concern for BBBY sales being hampered by the housing situation. The correlation of BBBY sales on a quarterly basis with housing starts or sales is very poor, in fact, it is negative.

In early January, the company announced that it forecasts Q4 EPS of 64c-67c, compared with analysts' consensus estimate of 78c. For Q3, the company reported EPS of 52c, exactly in line with the consensus estimate. Two research firms lowered their targets for Bed Bath & Beyond after the company released its guidance and results. Credit Suisse lowered their target to $25 from $43, and wrote that they have no confidence that the company's margins will rebound in the near future. Deutsche Bank reduced their target to $24 from $26, and wrote that the home goods sector is experiencing a supply-demand mismatch.

I'm not so sure that I see much evidence of great weakening. The return on assets for the last four quarters has averaged 24.4%. The most recent quarter came in at 21.67% versus the comparable quarter's year ago 23.09% down but far from dismal. Here's a look at historic valuations:

Bed Bath & Beyond Valuations

(TTM)

 
 

P/E

P/Book

P/Sales

P/CF

         

1998

66.2

16.0

4.6

101.0

1999

51.0

9.6

3.6

61.4

2000

49.3

8.8

3.4

47.4

2001

57.5

9.9

4.1

50.3

2002

46.7

7.6

3.5

30.5

2003

43.3

7.2

3.6

31.2

2004

30.4

5.1

2.7

22.1

2005

21.9

4.1

2.2

18.0

2006

18.8

4.0

1.8

19.3

2007

13.7

3.2

1.2

12.6

2008

11.9

2.7

1.0

11.4

At the end of December, BBBY authorized another $1 billion buyback program having completed a previous $400 million buyback. The buybacks have reduced the share count and have been effective. Current fully diluted shares outstanding is 265 million shares versus the count two years ago of 293.9 million.

What else do I find attractive in the consumer discretionary sector. Foot Locker (FL) was the subject of a new Goldman Sachs sale recommendation yesterday. Goldman, with recession in sight reduced its sales forecasts and earnings estimates for several companies in the sector. Strangely, it predicated its sales forecasts on a recession and the effect on personal consumption (PCE), yet, the report also indicated that “Historically, Real PCE and footwear spending have been only loosely correlated, with an R2 of just 0.37.”

Similarly, Foot Locker with 3,896 stores faces a troubled competitor Finish Line that has a total of 797 stores. Back in June, Finish Line agreed to buy Genesco (GCO), based in Nashville, Tenn., but it then sued to get out of the deal after the company reported a second-quarter loss and sharply lower third-quarter earnings. A judge ruled last week that Finish Line must complete the acquisition, an acquisition that will likely result in severe financial trauma. Foot Locker sells at 2.8 times trailing twelve months EBITDA, merely $520 million for about 4000 stores. There is more cash than debt on the balance sheet.

In addition, insiders at FL have started to step up to the plate. The CEO just recently purchased $1.25 million of stock at $12.74 in addition to purchases by two division presidents and one outside director. As Peter Lynch once said, “Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise." Other apparel stores' insiders have been purchasers of stock. These include American Eagle (AEO), Ann Taylor (ANN), Chicos FAS (CHS), Nordstrom (JWN), Limited (LTD), Mothers Work (MWRK), Stein Mart (SMRT), Wilsons the Leather Experts (WLSN), and Wet Seal (WTSLA)

I also have been a buyer of Dress Barn (DBRN) which sells at EV of $532 million. This is just slightly above its 2001 recession valuation of $430 million. Back then, the firm operated 720 DBRN stores. Today, it operates 822 plus 638 Maurices stores. Back then, the company had a return on invested capital of about 11%. Last fiscal year the company returned about 19% on capital At today's price, the company is selling at a decade low in price to cash flow, price/earnings and price/sales as well as price/book value. The company is selling at what I consider a ridiculous 2.8 times trailing EBITDA. The company has just instituted a $100 million buyback program.

Street estimates have adjusted downward after yesterday's announced revision to earnings guidelines. Never flashy, never pricey, DBRN avoids the extremes of the fickle fashion world and tends to play it safe. Currently, Dress Barn's inventory is 98 percent private label as opposed to its history of buying off-price. Markdowns of slow merchandise are swift and inventory control seems excellent.

Harold Geneen of ITT fame (if not infamy) used to say that “Uncertainty will always be part of the taking charge process.” Investors often have a history of cowering when markets get ugly. Uncertainty has always created bargains. Panics, fear, and buying “strikes” in sectors deemed to be troubled bring opportunities to the courageous. There is value in uncertainty.

I, my family, or clients own a current position in BBBY, FL, and DBRN.

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