Intense Bargain or Value Trap?
- By Smead Capital Management
As value managers, we are often asked if a company whose stock price is down substantially is a value trap. This is especially true when we are auditioning new holdings. We like to buy a company with a long history of success when it falls deeply out of favor for one reason or another. We approach this subject with a great deal of humility since it is impossible to avoid owning some value traps over the years in the process of finding your biggest winners. How do you tell the difference between an intense bargain stock and a value trap suicide mission?
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The intrinsic value of JPM
First, we rely on our eight criteria for stock selection listed below:
Over the entire holding period, each holding is required to:
Meet an economic need.
Boast a strong competitive advantage (wide moats or barriers to entry).
Have a long history of profitability and strong operating metrics.
Generate high levels of free cash flow.
Be available at a low price in relation to its intrinsic value.
Favored, but not required, criteria include:
Management's history of shareholder friendliness.
Strong balance sheet.
Strong insider ownership (preferably with recent purchases).
Our experience is that strong balance sheets and high free cash flow allows companies with long histories of success to recover from stumbles. Every company hits a bad stretch over the decades. A few examples of these historical stumbles will be helpful.
In the early 1980s, Coca-Cola (KO) diversified into the movie business by buying Columbia Pictures. Management thought that a movie with popcorn and a Coca-Cola was a wonderful vertical integration. It was a dismal failure. Coca-Cola bottomed at six times earnings and was paying a 5% dividend in 1982. Peter Lynch coined the term "diworsification" around that time. Warren Buffett (Trades, Portfolio) bought shares of Coca-Cola stock in 1988 at 18 times earnings. Coca-Cola divested Columbia Pictures in 1989, and the stock appreciated tenfold in the following years.
When the U.S. was attacked on Sept. 11, 2001, most investors were sure that nobody would want to travel. Disney's (DIS) stock plummeted to a low around $15 per share, which it once again reached in March 2003 at the bottom of the 2000-2003 bear market. Whoever put the time in has been well rewarded.
Starbucks (SBUX) hit the wall in 2007 as Howard Schultz had his attention drawn away by owning the Seattle Supersonics NBA team. It had overdeveloped stores in the U.S. and needed to improve its delivery methods. The stock fell from well over $35 per share to $8 at the low in 2009. Schultz came back to work, closing poorly performing stores and reworking the delivery methods. Ironically, as it slowed store growth, the free cash flow started gushing, and it initiated a dividend that has grown immensely since then.
Second, those who know the business the best (the company's officers and directors) must believe the stock is undervalued. We can see this through the insider trading statistics provided by the Securities and Exchange Commission. The regulations give insiders two business days to report their buys and sells.
JPMorgan (JPM) had a big stumble on the "whale" trade in 2012 and a rough go in the stock market selloff of February 2016. The CEO, Jamie Dimon, and a director, James Crown, stood ready to buy up shares at favorable prices induced by those fears. I will never forget all the insider buys of IBM (IBM) shares in 1995 when Lou Gerstner and his executive cohorts took over. By 1999 the stock had gone up tenfold.
Despite all the good things that have happened using our eight criteria to look for bargains, we have had our share of duds. Polaroid had heavy insider buying and a good balance sheet in 1999, but the digital camera and then the cellphone camera came along and eliminated the economic need that Polaroid met.
Numerous formerly successful financial service companies met our eight criteria in 2008. Insiders backed up the truck on Wachovia Bank and MBIA (MBI), but that didn't stop them from getting clobbered in the worst bear market since the mid-1930s. Wells Fargo (WFC) bought Wachovia for a song in 2008, and MBIA has never regained its mojo.
Why run the risk of value traps?
We are more than willing to take the risk on our eight criteria because of the sell discipline we practice and the mathematics that are associated with long duration common stock ownership. When a stock declines 15% to 20% from our purchase price, we re-examine it as if we didn't own it. If we like the company, we buy more and if we don't, we sell. Those circumstances can happen anytime in the first three years we own a stock. Also, if a company ruins its balance sheet, if its moat has been permanently damaged or its free cash flow has been interrupted, we can say goodbye to the shares.
The mathematics of common stock ownership are both beautiful and simple. If you buy a stock and pay cash, the worst thing that can happen is you lose your entire investment. If you buy a successful common stock investment and hold it for decades, you may make as much as 10 times your money - or more. The Bible says, "Love covers a multitude of sins." In long-duration common stock investing, stocks that go up many times your original investment cover a multitude of holdings that have 20% to 40% declines!
What do we own today that investors might consider a potential value trap? Most market participants are avoiding traditional media, health care and retailing. The clear majority of investors believe that the FANG companies - Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOG)(GOOGL) - will change entertainment delivery, prescription sales and crush brick-and-mortar retailers.
Tegna (TGNA) owns 46 network-affiliated TV stations in many of the most attractive markets in the U.S. It has yet to figure out how to convert its proprietary content into revenue via Facebook and Google. At nine times earnings with copious free cash flow generation, it still looks attractive and worth a shot to us.
Investors in AmerisourceBergen (ABC) and Walgreens (WBA) got spooked when Amazon announced that it is considering entering the distribution and sales of prescription pharmaceuticals. Among staple companies, these stocks are very cheap on both a price-earnings (P/E) and free cash flow basis. The CEO of Walgreens bought $160 million of its shares at a price below today's level, and Walgreens owns 30% of AmerisourceBergen.
Last, it is our opinion that investors have gone way overboard on fleeing Target (TGT) and Nordstrom (JWN) in retailing. When all the dust settles, shoppers will be attracted to great service experiences and brands that resonate with millions of Americans. These two companies own many of their stores, have great balance sheets and gush high amounts of free cash flow. Insiders have been buying at Target, and the Nordstrom family has said it is considering buying the whole company from public shareholders.
John Templeton said to buy stocks "at the point of maximum pessimism." These industries look like they are somewhere close to "maximum pessimism," and the companies we own meet our eight criteria. Therefore, we like to put the mathematics of investing to work in these areas of the U.S. stock market.
The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Bill Smead wrote this article. Smead Capital Management holds positions in Disney, Starbucks, Wells Fargo, Tegna, AmerisourceBergen, Walgreens, Target and Nordstrom. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past 12-month period is available upon request.
(C)2017 Smead Capital Management Inc. All rights reserved.
This article first appeared on GuruFocus.
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The intrinsic value of JPM
