New Year's Resolutions
(Guest Commentary by Rick Konrad – January 7, 2011)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary. Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick discusses the dangers of following hot trends in stock-picking and asserts that “hidden gems” could typically be found in stocks that underperformed the previous year. One such “hidden gem” strategy is the “Dogs of the Dow” strategy. Rick then discusses in detail the attractiveness in valuations of the grocery industry—specifically SuperValu. Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Flat is Good Enough” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run 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 graded CFA examinations.
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.
When Michelangelo was asked how he carved the statue of David, he said:
“I simply cut away everything that was not David."
Happy New Year to all!
As another new year begins, most of us make lofty promises to ourselves and others about some effort at reformed behavior. Most of us have certainly pledged to improve our diets, to lose weight, to improve communications with spouses, kids, fellow workers, etc. Making a commitment to the “New You” and you will quickly start feeling quite differently about yourself. Staying focused and accountable to others is also an important way to achieve success in portfolio management.
I think the purported Michelangelo quote provides some useful insight into portfolio construction. Find those elements of your portfolio that don't fit, that don't meet your expectations, or that don't fit your style. Chip away at those securities...further analysis may be necessary if your original assumptions are not playing out.
Fundamental analysis, per se, is just the start of analysis, not the conclusion. What is ultimately the most important source of successful investing is judgment that is based on deeper analysis, not just the number crunching and data gathering itself. The whole notion of competitive advantage, the sustainability of that advantage, and an assessment of the competitive threats is where a significant amount of the value add comes from in managing a portfolio.
In today's world, data is everywhere, news is instantaneous, and “information overload” is the prevailing condition. Rarely, can we gain much of an information advantage over others in an environment where access to managements, even by the largest funds, is truly democratic...the same for all of us. Information or data edges are either impossible or illegal thanks to regulation FD that governs managements' dissemination of news.
The beauty of this level playing field is that it changes investing considerably. Nobody possesses a sustainable information edge. Successful investors can only win on judgment, on putting together the information, assembling it into a coherent story and implementing it.
I think one of the prevalent biases that most of us exhibit is to think that actions and decisions require greater justification than inaction, than failing to decide, than leaving things status quo. If our actions do not pan out, or cause us to take a loss, we frequently regret having acted. If, on the other hand, we decide to maintain the status quo and leave things as they are within a portfolio, and our investment does not pan out, we still suffer regret, but for most of us the regret I less.
Don't fall into this trap. Don't let the cost basis of a stock ever influence your decision making. The valuation of the business is a function of future cash flows, not the past. Holding every stock in your portfolio should be justified on this basis…what does the future hold. Anchoring your thinking about a stock based on the price that you paid is illusory. As we say in the business, a stock has no idea what you paid for it. All it “sees” is the voting of market participants, which over the short term determines market price. All you should think about is what Benjamin Graham called the “weighing machine” or in other words, what future cash flows are going to look like and what sort of discount rate one should apply to this cash flow stream. Separating hype from substance and opinion from facts requires a disciplined honesty with yourself.
Stocks with cult-like followings rarely provide exceptional returns over the long run. Lemming-like behavior of investors (I am describing these folk generously) in the rare earth stocks works both ways. Exits will be very crowded when the bubble bursts, when insiders come out of their lock-up period, and when world supply meets demand. Though it seems everyone knows about restricted Chinese exports of rare metals and the effect on commodity prices, few people remember that the Molycorp mine was put out of business in 2002 by the flood of Chinese supply and the inability to be cost competitive. What goes up fast, frequently comes down faster. Be careful out there.
Conversely, some of the worst performers for 2010 may well contain some hidden gems. This sort of thinking is what is behind the Dogs of the Dow strategy. The strategy is very straightforward, simply buying the ten highest yielding Dow stocks. For this year, the list includes the following names:
AT&T, Verizon, Pfizer, Johnson & Johnson, Merck, Kraft, Intel, McDonalds, DuPont and Chevron
The yields here range from just over 3% to about 6%, certainly competitive with Treasuries. Though this strategy is simplistic, it can be quite dangerous. High yields may not be sustainable and frequently dividends might be reduced. Though I see nothing on this year's list that has questionable financial strength, one should be mindful of blind rules like the Dogs of the Dow.
The biggest losers of Wall Street for 2010 are not unlike the Biggest Losers television program. Public attitudes about fat have never been more judgmental; stigmatizing fat people has become not just acceptable but, in some circles, de rigueur. There are many people who wouldn't dream of disparaging anyone's color, sex, economic status or general attractiveness, yet feel free to comment witheringly on a person's weight. Derision on Wall Street for many companies that were poor performers also stigmatizes these have-nots and may provide attractive buying opportunities.
A high profile bankruptcy can often take apart an entire industry sector. For example, last year, A&P went chapter 11, a result of many years of mismanagement, poor cost controls, a unionized workforce with restrictive rules, and an acquisition that stretched the balance sheet. The continued success of WalMart and Costco in the grocery business as well as the incursion of Target in this space makes this a highly competitive industry. Needless to say, the grocery store stocks in general did not win many friends last year.
SuperValu (SVU) is one of the largest grocers in the US. The stock was a miserable performer, dropping about 26% for the year and so far this year, more of the same, down about 4%. The company operates in two segments with 75% of revenue coming from food retailing through 2,370 stores with about two thirds operated by SVU and about one third licensed to third parties. One half of the stores sell “hard-discount” food under the Save-A-Lot brand. The company markets under a wide number of local brands including Jewel, Lucky, Shaws, Albertsons, and Cub Foods. The other 25% of the business is a wholesale food distribution business supplying SVU's own stores as well as some 2,500 independent retailers.
The hidden jewel in SVU is significant ownership of its real estate owning about 25 million square feet of stores (about 40% of the total store footage) and about 9 million square feet of warehouse space.
There is almost $7 billion in net debt including capital leases or roughly 3.5 years of EBITDA. About half a billion is due in 2011. The company recently extended $2.0 billion in debt to 2015. SVU also is partially unionized and has an underfunded pension liability of about $900 million. There are also operating lease obligations of about $3.5 billion.
The company is showing negative operating earnings for the last two years. Cash flow from operations has been positive and is running at $1.4 billion for the trailing twelve months. In addition, for the most recent quarter, cash flow from operations was up almost 25% versus last year.
What also encourages me is that the company has opportunities to monetize its real estate holdings. It has a distribution business producing around $300 million in EBIT. In addition, it receives licensing income from its licensed SuperValu stores. The grocery wholesale distribution business appears to be in decline for SVU, for example, Target, which had been a customer, has gone to self-distribution.
Insider buying has been evident in the last year, though still remains fairly modest.
The integration of Albertsons and the centralization of buying are high priorities for this company. The escalation of the Save-A-Lot brand also makes a great deal of sense. Save-A-Lot is the largest limited-assortment chain and stands to benefit from consumers seeking value in a difficult economy. Save-A-Lot offers low price points in a no-frills shopping environment.
SVU is led by Craig R. Herkert who was appointed Chief Executive Officer in May 2009 and President in August 2009. Prior to joining SUPERVALU, Mr. Herkert served from 2004 to 2009 as the President and Chief Executive Officer of the Americas for Wal-Mart. Insiders own only about 1% of the stock. Herkert's position of about 340,000 shares represents a $5 million investment.
Though this is a fairly risky bet, given its somewhat stretched balance sheet, I do like the restructuring efforts both operationally and with respect to the balance sheet. With estimates that still incorporate about a 5% same store sale decline, a turn in this business could take the stock into the high teens.
Disclaimer: Neither I, my family or clients own a position in SVU at present. However, positions in T, VZ, JNJ, MRK, INTC, and CVX are currently held by me, my family, or clients.