The Warren Buffett Approach
Two Undervalued Retail Stocks
I dislike politics--partly because I shy away from anything that's controversial. I enjoy a good discussion, but I am not the combative type. And I don't like watching politicians and others who jump at the chance to get in front of a camera and lash out at their opponents. Good things seldom come from a negative approach.
Many Americans, including yours truly, are fed up with the political bickering in Washington, which has produced mayhem and gridlock. Of course, everyone from politicos to professors to reporters have offered up suggestions to resolve the gridlock: Rewrite our 224-year-old Constitution, enact term limits on Congressmen and women and "throw the bums out" by electing a new team.
Even Warren Buffett got in on the act and offered a solution: "I could end the deficit in five minutes," he told CNBC. "You just pass a law that says that anytime there is a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election." I like that one, even though it probably wouldn't get any votes.
What is the solution to the nation's problems? (By the way, there are several other nations with exactly the same problems.) In my opinion, there is no short-term solution. But there could be a long-term solution on the way.
According to a recent PBS Newshour report, a behavioral change is about to occur in the United States and other countries. Leaders who are combative, egotistical, greedy and question authority will phase out over time. New leadership is coming of age and will influence political outcomes within the next decade. Why does this matter?
According to recent surveys, as summarized by PBS Newshour, money is not so important to these new leaders. They prefer to compromise rather than to fight. They would prefer to work as a team, rather than seek power for themselves.
These new leaders grew up in divorced households, saw unsettling demonstrations against the Vietnam War, experienced the AIDS epidemic, and feel the effects of global warming and the War on Drugs. They are destined to become the agents of change.
As the current combative, egotistical, greedy leaders move on, and the shepherds of our future take over, the change will be refreshing; we'll compromise, work as a team, and the U.S. will once again function better than other countries. We will all prosper.
While I am on a roll, I want to touch on another, related subject: value versus growth. I have always advised most investors to divide the stock portion of their portfolio into 50% value stocks and 50% growth stocks. I find, though, that many investors prefer growth stocks and disregard those slow-moving value stocks that have to be held "forever."
Poppycock! Value stocks belong in everyone's portfolio. Now is a great time to transition money into conservative, dividend-paying, undervalued companies. The current stock market offers you an excellent opportunity to buy stocks at bargain prices.
If the stock market continues to move in 100-point increments, you can take advantage at both ends of the spectrum. Buy when it dives and sell when it soars. One last point I need to make before I jump off my soapbox ... most growth stock analysis methods are way over-used.
Everyone--well almost everyone--is looking at the same charts and making the same decisions. As Benjamin Graham eloquently stated on many occasions, when a methodology becomes overused, it loses its effectiveness. But you don't need to completely switch from growth to value, you just need to diversify a bit more.
I often write about Benjamin Graham, because he is considered the father of value investing. His clear teachings of how to analyze stocks and bonds using formulas and restrictive conditions make sense to me and are easy to follow. His book, The Intelligent Investor, first published in 1949, provides all of the information needed to become a successful value investor.
Benjamin Graham taught investment courses at Columbia University in addition to running his Graham-Newman Partnership, investment advisors, for many years. Many of his students at Columbia became successful investors, including Warren Buffett.
Want to invest like Warren Buffett? Here are seven guidelines to get you started in the right direction.
Buy Companies at Bargain Prices. Warren Buffett is a true value investor. Buying companies cheap is what being a value investor is all about. Purchase stocks below their intrinsic value and fill your portfolio with these companies. Pay less attention to earnings per share. Look for solid return on equity, high operating margins and low debt. In addition, look for companies that generate lots of cash and have a consistent operating history during the past 10 years.
Be Patient. Wait for the right time to buy. Patient investors are the best prepared when opportunities emerge. Because of market turbulence, stocks of great companies become available to trade at very cheap valuations. This doesn't mean buy stocks and forget about them! Tracking performance is key and so is getting out when necessary (when your stock is overvalued or trouble is on the horizon). Invest only in companies that will outperform for decades. Follow this approach and you will gradually develop an outstanding stock portfolio like Warren Buffett.
Go Against Conventional Wisdom. Attempt to be fearful when others are greedy and to be aggressive when others are fearful. Going against the crowd can be an effective way to make money.
Stick with What You Know. Stay within your circle of confidence. If you don't understand what a company does or how it makes money, avoid it.
Be Self-Confident. You must be able to act without affirmation from others (or the market) on your investment decisions.
Buy Companies with Competitive Advantages. Warren Buffett calls this an "economic moat" which gives a company barriers or protection from its competition. Examples of competitive advantages include high capital costs for rival companies to enter a business, a strong brand identity or patent protection.
Believe in America. Warren Buffett has faith in the long-term prosperity of U.S. companies. This allows him to make investment decisions that are not based on where we are in economic cycles.
For this Cabot Wealth Advisory, I combined Warren Buffett's and Benjamin Graham's criteria for choosing stocks. To find investment opportunities for you, I looked for stocks with:
1) Free cash flow more than $20 million--cash needs include dividends, operating expenses, capital improvements, and research.
2) Net profit margin more than 15%--a good indicator of growth sustainability.
3) Return on equity more than 15%--a barometer of future appreciation.
4) Discounted cash flow value higher than current price--Standard & Poor's is a good source to find discounted cash flow estimates.
5) Market capitalization more than $1 billion--small companies not allowed.
6) Standard & Poor's rating of B+ or better--indicates financial stability and steady growth of earnings and dividends.
7) Positive earnings growth during the past five years with no deficits--very important to adhere to.
8) Dividends currently paid--always important and helps your return, too.
I screened my Benjamin Graham Common Stock Database and found two high-quality companies that fit my criteria. Both companies are leaders in the retail store sector, and both have excellent future prospects.
Coach (COH) is a designer, maker and marketer of high-quality leather goods for men and women. Products are sold in department stores, specialty shops and the company's own Coach stores. Coach expects to expand its retail space by 12% during the next 12 months including opening 30 new stores in China.
COH's stock price slipped in August due to weak quarterly earnings brought about by store closings in Japan and higher raw material prices. Conditions have improved in Japan, and raw material prices should abate in 2012.
We expect sales and EPS growth of 15% during the next 12 months and beyond. Coach's stock price has partially recovered from its August swoon, but continues to stand out as a high-quality opportunity at a very reasonable price. The current dividend provides an attractive 1.5% yield.
Ross Stores (ROST) operates 1,091 stores in 27 states and Guam featuring apparel, shoes, jewelry and home furnishings. Ross is able to offer brand-name merchandise at 20% to 60% below department and specialty store prices by buying manufacturers' cancellations and overruns. The company keeps low in-store inventories to increase turnover and to reduce the need for discounts.
Consumers continue to seek Ross's low-priced products during the current economic malaise. The company will enter Arkansas and Illinois with an initial 15 new stores. These will jump-start Ross's presence and provide noticeable growth in the near future. We forecast sales and earnings growth of 12% during the next 12 months. The current dividend is meager but provides a 1.0% yield that will continue to grow.
I will continue to follow Coach and Ross and other blue-chip, high-quality companies in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will focus on undervalued stocks with low price to book value ratios. I hope you won't miss it!
Until next time--be kind and friendly to everyone you meet.
J. Royden Ward
Editor of Cabot Benjamin Graham Value Letter
Editor's Note: You can find additional stocks selling at bargain prices in the Cabot Benjamin Graham Value Letter. In every issue, you'll find my legendary Maximum Buy and Minimum Sell Prices for over 250 stocks. Click here to get started today!