Reflections of a Cheapstockhunter

Frontier Market ETF’s May Present More Value vs. Emerging & Developed Markets

A friend of mine recently inquired about the recent run-up of the emerging market BRIC based ETF's and whether we may be able to find more value in some forgotten growth stories in Latin America, Africa, and the Middle East.  This encouraged me to revisit the fundamental work we typically do when making tactical adjustments to our portfolios and I made some actionable observations. Over the past year, if you had the stomach to actually hold on to your typical emerging Market ETF such as EEM, although it was a roller coaster, you are now actually are up 10%. A newer set of ETF's that are focused the emerging markets of tomorrow, or the emerging, emerging market countries, have not fared as well, and are still down about 15-20% from a year ago. You could argue that the traditional MSCI index of emerging market countries, includes many countries which given their stature in the world economy, should not be characterized as "emerging" as the OECD would define the term. Countries such as South Korea, China, and Brazil are global powerhouses, that although do have fast growth rates and may not have the infrastructure that the developed world enjoys, are borderline. This is not the case with the Frontier Market ETF's which, in the case of Claymore/BNY's Frontier Market ETF (FRN), which includes Chile, Poland, Egypt, Kazakhstan, Peru, Nigeria, Vietnam, Czech, Pakistan, & Qatar in its top holdings. Granted, these ETF's do have greater exposure to many countries, particularly eastern Europe, that are not as financially stable as the other more "developed" emerging markets, but nevertheless, given a rise in oil prices and heavy exposure to many very natural resource rich geographies, these ETF's may present an opportunity. Also, using the MSCI Emerging Europe, Africa, & Middle East Index as a proxy for the Frontier markets, they appear more discounted than their more developed counterparts. This index doesn't include Chile, Peru, and Colombia, which make up almost 40% of the Claymore ETF, but those individual countries would actually enhance the growth/valuation characteristics of the Frontier Index.

As the following charts indicate, as revisions have finally begun to turn, P/E ratios have followed. Analysts on average, have sufficiently lowered the bar on earnings estimates and are now beginning the process of upwardly revising numbers. The developed and emerging market ETF's reflect this trend, the frontier markets, have not yet followed suit, but in my opinion, they should be next.

*barbells represent 1 standard deviation above and below the "mean" P/E ratio

 

GDP Falls 1%.....Could be worse, all things considered

Actually, this is a pretty good number considering we are rebounding from a negative 6.4% number last quarter. Strong government spending, and an improving trade balance are appearing to dampen the slowdown, but corporate reluctance to make new investments coupled with dramatic inventory reductions, and obviously the cutbacks in consumer discretionary spending (remember that consumer spending is over 70% of GDP) continue to limit growth. As a consumer, it is becoming increasingly noticeable how much less "stuff" is on the shelves, which seems appropriate given the decrease in traffic.  I enjoy checking out the latest gadgets at Best Buy, and cant remember a time when it was so easy to get the attention of one of their in-house sales "geeks".

I am reminded of John Mauldin's frequently referenced chart illustrating the contribution of mortgage equity withdrawals to GDP.  This continues to worry me that this will be a very long "muddle through" economy.  On a brighter note, even as home values have declined, some consumers do have access to home equity, and credit is beginning to flow again. Hopefully some American ingenuity, hard work, and optimism will return the country to growth.

Here are some excerpts from the release:

Real gross domestic product -- the output of goods and services produced by labor and property
located in the United States -- decreased at an annual rate of 1.0 percent in the second quarter of 2009,(that is, from the first quarter to the second), according to the "advance" estimate released by the Bureau

of Economic Analysis. In the first quarter, real GDP decreased 6.4 percent.The decrease in real GDP in the second quarter primarily reflected negative contributions from nonresidential fixed investment, personal consumption expenditures (PCE), residential fixed investment,private inventory investment, and exports that were partly offset by positive contributions from federal government spending and state and local government spending. Imports, which are a subtraction in the

calculation of GDP, decreased. The much smaller decrease in real GDP in the second quarter than in the first primarily reflected much smaller decreases in nonresidential fixed investment, in exports, and in private inventory investment, upturns in federal government spending and in state and local government spending, and a smaller decrease in residential fixed investment that were partly offset by a much smaller decrease in imports and a downturn in PCE.

 

Stocks look fairly valued here -

According to author and renowned Yale Economics Professor Robert Shiller's most recent update of his version of the Fed Model, which uses cyclically adjusted earnings, stocks in the S&P 500 are looking fairly valued at current prices.   This model has one great advantage, it removes cyclicality and the short term "noise" found in the market by using a ten year rolling average of S&P operating earnings.  It is a fairly long data set so I have found it to be the best fundamental indicators of the broad market.  Using this model toward the end of the 1990's bull run, would have very reliable signal that prices were becoming unsustainable. 

That said, one major drawback of this methodology, is that it looks at the P/E yield in isolation, rather than comparing it with the opportunity cost of our funds, or interest rate yields.  In the early 1980's stocks looked very cheap, but relative to the high-teen rates being earned in debt market, perhaps stocks would look less attractive.  Currently interest rates are lower than long term historical averages so the 15.8x multiple on earnings that the S&P is trading at, actually may be much more more compelling when looked at relative to other places to park our cash.

Google's Secret Sauce

Secret of Googlenomics: Data-Fueled Recipe Brews Profitability

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Weak US Recovery?

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In light of today’s revised GDP data, let’s go to Unigroup CAIB to see what the likely course of the US recovery will look like. The conclusion they draw: The recovery will not be as strong as is already priced into the market . . .

>

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Article
Title: Weak US Recovery?
Link: http://feedproxy.google.com/~r/TheBigPicture/~3/vmV4RMNZWA8/
Author: Barry Ritholtz
Publication Date: 5/29/2009 12:03:48 PM

Source
Feed Title: The Big Picture
Feed URL: http://feeds.feedburner.com/TheBigPicture

Black Swan Hunting

In my years as an investor and a professional in the financial services industry, I have not yet been able to find anyone who can accurately and consistently forecast future market events with any degree of accuracy. In my view, any and all forecasts are, at best, educated guesses. Many brokerage houses and investment banks have literally dozens of in-house economists that dedicate their careers to identifying changes in the economy before they happen, when in reality we have found that, no one truly knows what tomorrow will bring. In a survey of Wall St. economists taken one year ago, the "consensus" view was that the likelihood of recession was less that 40%. One problem with these forecasts is known as the "Black Swan Theory", popularized in a book by Nassim Nicholas Taleb, that recounts a 17th century scientific experiment as a metaphor for a deeper philosophical question about human behavior. In the book he argues that we place too much weight on the odds that past events will repeat, using statistics and the scientific method. Instead, the most impactful events are those that are rare and unpredictable. Aside from their obvious human tragedy, events occurring in the last decade such as the tech/telecom bust, 9/11, hurricanes of 2004, and the current credit crisis have been powerful examples of highly improbable events that have had a profound impact on history and our portfolios. While I would agree with his conclusion, I would argue that there are 2 kinds of predictions that, when applied consistently, have some value to investors and should be considered in the investment process: One is opportunity-based, and the other is risk-based. Risk based forecasts are applied extensively in the asset allocation process. First and foremost, when constructing and maintaining portfolios I believe that by applying a consistent and disciplined strategy balancing growth, income, and alternative asset classes you can successfully reduce exposure to inflation, currency devaluation, credit risks, and declines in corporate and consumer spending. While we can add value by tilting these beta exposures in response to cyclical and fundamental changes, anchoring the portfolio from these risks increases the likelihood of long term success of the strategy. One tool used in determining these allocations is known as "Monte Carlo" analysis, in which a computer effectively recreates over 10,000 portfolio outcomes or "rolls of the dice" in order to effectively determine which weightings are most appropriate, Because a "black swan" can have such a large impact on our portfolios, and are so as hard to predict, we should continue to embrace diversification. Probability assessments are typically based upon historical comparisons of prior markets with similar characteristics: The more variables that align, the higher the likelihood that a given scenario plays out in a similar fashion. While I admittedly did not anticipate the magnitude and depth of the current crisis, I have been, and continue to strategically position assets away from financial, consumer discretionary, and cyclical industries, in favor of increased weighting toward healthcare, staples, and utility stocks, which are generally a safe haven during periods of market duress. Many times these types of comparisons require going back in time, to make a thoughtful judgement about the future. A recent decision to sell a position in Schlumberger (SLB) was based on an analysis of the oil services industry and its sensitivity to economic events that happened in 1974 and 1981. Another way to improve the likely outcome of the portfolio can be seen within the research process itself. As access to credit and free flowing spigot of the capital markets becomes sealed temporarily, I have rigorously approached each holding as "credit analyst" would, rather than simply an equity analyst. Reviewing debt covenants, credit facilities, and near-term spending needs for each company owned has become routine. I am highly confident that these actions have minimized risk, and recent additions to the portfolio like Alcon, Stryker, and Google, further improve quality of the portfolio with their pristine balance sheets and strong cash generating ability. Probability assessments are not only used as a defensive mechanism, but also as tool used in search for opportunities within your investment universe. To illustrate this concept consider an investor with the following investment opportunities presented to him/her: Opportunity A) a $1mm investment that offers a 20% return, with an 80% likelihood of success. Opportunity B) a $1mm initial investment with a payoff of 50%, but only a 50% likelihood of success. At first glance, most people would pick opportunity A, because if its relative certainty, but a more informed investor would actually pick the second opportunity, because the probability weighted expected value is actually higher (250k vs. 160k). This type of analysis is used extensively when evaluating an E&P company with a portfolio of oil or gas reserves, with differing levels of profitability and probability of drilling project success. When thinking about constructing your portfolio in a way that is aligned with your view of the world, it is important to have an investment paradigm or framework in place to guide decision making in a disciplined and consistent manner. Mohammed El-Erian, former manager of the Harvard Endowment, and currently a bond portfolio manager at Pimco, uses the analogy of a 6 lane highway, to illustrate how to benefit from our perceived systemic changes to the investment landscape. He believes that investors can benefit by identifying a handful of growth themes (lanes of highway) in a portfolio, that may take several years to materialize, but investor can shift vehicle to avoid traffic (risk exposures) but needs to stay within the highway barriers (investment process). Within the framework of an investment process, we can add value in a similar fashion. In the near term I anticipate weak consumer and corporate spending environment, however, recently announced government stimulus programs around the world may offset some of this weakness. President Obama recently announced a $700B program designed much like the "New Deal" with huge investments in transportation, telecommunications, healthcare, and power grid infrastructure, are likely to benefit many of our holdings. Norfolk Southern should benefit from improvements to the nations rail network; companies like Cisco Systems, Citrix, and Google will benefit from the "networking" of America's schools and institutions, and names like ABB and ITT will surely benefit from increased spending on infrastructure and energy efficiency. While none of us has a clear “crystal ball” to foretell the outcome of current economic situation, history tells us that it is likely to be longer and more complex than most people anticipate, and controlling risk needs to remain the top priority in your portfolio. That said, with risk comes opportunity. Many of the darkest, most uncertain times in our history, were times that presented the greatest opportunities for investors. We continue to strive to find those opportunities without taking unnecessary or excessive risk.

If a tree falls in the woods, does Wall St. hear it?

  How Mother Nature Can Grow Your Portfolio

If a tree falls in the woods, does Wall Street hear it? Clearly not, judging by the wide discounts to intrinsic value being awarded to names in the Timber REIT sector. Based on my analysis of private market value, the three largest timber REITs, Plum Creek, Rayonier, and particularly Potlatch Corp. offer investors a wide margin of safety, relatively stable cash flows, and a healthy dividend yield.

Perhaps the most compelling argument for an investment in timber lies in the risk reduction benefits that timber can add to a growth focused portfolio. Backtesting 20 years of data from the NAREIT Timberland Index, in addition to a portfolio of US stocks, intl developed, emerging markets, and bonds reveals remarkably low correlation, while generating long term returns of almost 14%. The correlation with equities was less than 10%, providing "bond-like" diversification, with returns that would be expected from smallcap or emerging markets. As these risk/return characteristics continue to improve the opportunities along theefficient frontier, the optimization models that institutional investors base their asset allocation on will continue to overweight this asset class. Many highly regarded asset allocation gurus, such as David Swensen, who manages the Yale endowment, have been long time proponents of adding real assets, such as timber, to a well diversified portfolio. That said, as of this past Decemeber, the average institutional portfolio only held about 1% of their assets in timber, a far lower allocation than the efficient frontier would suggest as optimal.

Within the Timber REIT sector, one of the more attractive companies is Potlatch Indstries. Potlatch owns about 1.7mm acres of timberland in Arkansas, Minnesota, and Idaho. The company is vertically integrated with higher margin businesses such as resources (timber harvesting) and real estate sales, offset by its lower margin, downstream businesses such as wood products (lumber), pulp/paperboard manufacturing, and consumer products (off-label tissues). This provides the company with numerous growth levers and allows them to more effectively manage volatility in its business. For example if timber pricing is weak, the company may delay its harvesting activities, choosing instead to generate cash with its manufacturing operations and real estate sales. Importantly, there is minimal opportunity cost when the company delays its timber harvest as trees continue to grow biologically. On average, trees grow between 3-6% per year.

After recently filling the CFO post with Eric Cremers, who recently orchestrated the splitup of Albertsons, it is clear that the company is focused on creating value for shareholders. Based on my analysis, there is plenty of value that can be monetized. Using data from 30 of the largest private market transactions over the last 5 years, US timberlands have been sold at roughly $800 per acre. The most recent data, published by industry journal, Timber Mart South, indicates timberland transactions have been averaging $1400 per acre. Lets be conservative, and use the 5 year average. The company also has 225k acres of HBU land (or higher or better use land) that the company conservatively believes can be sold at $2000 to $4000. After conferring with industry sources, and considering that competitors Plum Creek and Rayonier value their comparable HBU land at $4000 to $10000, using $2000 per acre as a base-case scenario should provide a margin a safety in the analysis. Assigning these values to the 1.5mm timberland acres and the 225k HBU acres, subtracting debt, and applying a trough 6x EBITDA multiple to the the manufacturing businesses implies a total enterprise value of about $56 per share for Potlatch. At its current $40 stock price, the risk reward is quite favorable. Furthermore, a dividend yield of 5% should offer investors a healthy stream of income as we patiently await for catalyst to develop and the intrinsic value to be realized.

Labels: asset allocation, potlatch, timber

Long Case for ABB, Ltd. (NYSE:ABB)

One exciting investment opportunity identified through a fundamental/earnings quality screen that I run periodically is ABB Ltd. ABB is a Swiss conglomerate that provides a wide range of products and services to the power and automation markets. A recent earnings warning from Siemens, another European conglomerate that competes in similar markets, dragged the stock down in sympathy, and now trades at an earnings multiple slightly less than its long term growth rate. I felt the problems at Siemens were company specific, and the market reaction of ABB was unwarranted, creating an opportunity for long term investors to own a great business at a reasonable price.

The investment thesis on ABB is relatively straightforward. ABB has smartly positioned itself as an “energy efficiency” solution provider. Its products & services can be found at every node of the energy value spectrum, resource production, transportation, por generation, por transmission & distribution, and even consumption. Here is a sampling of the types of solutions that ABB offers:

• motors that efficiently por deep-sea drilling rigs
  
  
• marine propulsion systems that transport the oil
  
  
• substations, circuit breakers, capacitors used in electricity generation
  
  
• high, medium, low voltage transformers used to transmit and distribute energy across
  
  
• power grid automation, robotics, and variable speed drives/motors that drastically reduce industrial consumption

ABB is well positioned competitively to maintain its leadership status in most of the markets it serves. An enormous installed base, economies of scale, and a core competency in efficiency solutions provides the company with an enviable competitive moat. It's industry leading R&D budget that has generated a voluminous portfolio of intellectual property and innovative new products has galvanized this edge over the competition. Lastly its global footprint positions ABB favorably to benefit from rapidly growing emerging markets. Only 15% of revenues are generated in the US, and almost 40% from fast growing emerging markets. Interestingly, its leading market share in Asia is likely remain firm, as customers in that part of the world place greater emphasis on business relationships, and are more likely to award new contracts to their existing network of suppliers, a Chinese social custom known as Guanxi.

New Infrastructure needs to be built to support electricity demand in emerging markets-
As a provider of infrastructure & energy efficiency, ABB finds itself in a “perfect storm” of end-market demand. Emerging market electricity demand is expected to grow from 8B kilowatts per hour to 16B kw/h over the next 20 years. As population and GDP grows in these parts of the world, new infrastructure will be required to provide the energy to fuel that growth.



Existing Infrastructure in developed markets needs to be replaced -
Wall St. as ll as the entire northeastern US remember the summer of 2005 por outage in that left more than 20% of the US population in the dark for nearly 24 hours. A huge capital investment cycle in the 1960’s and 1970’s follod by a long period of neglect has left the US por grid in brittle condition, and as the head of the EIA describes, “one or two heat waves” away from crisis. The average US transformer is over 40 years old, ll beyond the average life expectancy for that type of equipment.

Energy Efficiency – The low hanging fruit of the green movement. While less “sexy” than other green investment opportunities, efficiency improvements are the low hanging fruit of the energy problem. 65% of energy use and CO2 pollution can be attributed to motors and engines. ABB’s variable speed drives and motors can significantly lor energy consumption and pollutants, yet in the US are used marginally (only 5% penetration). For perspective, consider that the installed base of these drives/motors in Europe has reduced annual consumption of energy to a level equivalent to 32mm households (1/3 US households!) and reduced yearly CO2 tonnage by the amount that the entire country of Ireland emits on an annual basis. Throughout the energy value chain, ABB believes it can reduce waste by about 20%, generating low-risk, high return on investment opportunities that businesses and governments will find hard to walk away from.

Renewable Momentum – Remote energy sources (solar/wind) will require transmission
Renewables – Public & legislative momentum as ll economic parity with traditional coal, gas, & nuclear fired por plants, is stimulating demand for renewable energy sources around the globe. While wind and solar por have become a meaningful part of the European por grid, the US still only generates about 2% of its electricity needs from such sources. Because renewable por sources are often great distances from the population centers that they serve (think Arizona!), infrastructure such as high voltage transformers must be used to effectively distribute the energy. ABB is the #1 player in this type of equipment.

Catalysts & Low Expectations may drive upside surprise for investors
In addition to these growth drivers, ABB has a great balance sheet, which could be a catalyst for the stock. The company has paid off most of its debt and now boasts a net cash position of over $6B, which can be used as competitive ammunition, for strategic M&A, or simply can be returned to shareholders through dividend or share buybacks. Expectations are modest relative to recent results, and believe the 10% earnings growth that Wall St. is anticipating will be easily surpassed. A closer look at the company backlog reveals a visible stream of high margin revenue yet to be realized.

Fundamentals & Valuation very attractive – Price target of $43
Returns for the company have been strong. Margins have grown from 5% to almost 12%, and the company sees 18% margins down the road as internal goals are met. Return on invested capital is ll over 20% highlighting quality management and focus on creating shareholder value.

Valuation is reasonable. For a company growing earnings at a 20% rate over the long term, a P/E of 18 represents a fair value in our opinion. This is a 20% premium to the market, but would argue growth prospects and profitability deserve an even greater premium. I am also comforted by the free cash flow yield of just over 4%, and annual free cash flow generation of about $4B. Using relatively modest assumptions (about 10% long term growth) and a 8% discount rate, I arrived at an intrinsic value of about $43 for the shares.

In conclusion, I found it difficult to poke holes in this investment case. While the world adjusts to $130 oil, terrorism, and a rapidly growing population, ABB’s products and services address some very real problems. We may not be able to find more energy, and it may take several years to find alternatives, ABB offers solutions to get much more out of what have, today.

Syngenta - Planting the seeds of growth....

Currently there is a compelling argument for a sustained period of growth in the agriculture markets as demand from bio-fuels such as ethanol, and feed exports to emerging markets overwhelm current supplies. The widely followed “stock-to-use” metric suggests that ending inventories of corn will be less than 10% of annual consumption, a level not seen in over 40 years. In 1996, the stock-to-use ratio declined below 20%, causing a nearly 200% increase in corn prices. In fact, if we were to assume flat demand next year, and yields were to improve at the same rate they have been improving (about 8% year trend), we would end the year with a shortage of corn bushels, forcing the U.S. to become a net importer. What’s troubling is that most of the data suggests demand will actually increase next year, making continued grain price rallies more likely. Currently there are approximately 100 ethanol plants in operation in the US. Over the 2007-2008 time period, about 85 additional ethanol facilities are expected to complete construction, and begin operation, further increasing demand for agricultural inputs. Furthermore, emerging economies are becoming more and more dependent on corn feed as their populations demand more protein in their diets. As more acreage is planted for corn, less is planted of other crops, driving up their prices as well. It is likely that as more and more technological advancements in cellulosic ethanol and other bio-fuels are made, the role of agribusiness and improving yields will be increasingly higher on the value chain.

These exciting developments in agriculture encouraged me to focus my screening efforts within this industry. Importantly, I sought to find a company with exposure to these trends, but one that would fit within my disciplined investment process and met my fundamentally based criterion, which led me to Syngenta (SYT). Syngenta is a Swiss- based company that manufactures and markets crop protection and agricultural seed products. The company was formed in 2000, when the agri-business segments of Novartis and AstraZeneca, where spun-out and merged together to more effectively compete with DuPont and Monsanto.
Here are some of the main points of this thesis
1. Crop protection business is a “cash cow” that can be used to fund growth
Today, Syngenta is the global leader in crop protection (insecticides, fungicides) with about 20% global market share (market size is roughly $30billion). This segment accounts for about 80% of the company’s current sales mix. The primary reason that the stock trades at a discount is because of its exposure to this slower growth business. Most analysts believe that about 5-10% of the crop protection market is at risk from new seed technologies, which limits the growth attributable to acreage growth and new products to only 1-2% per year. In my view, while this is a slower growth business, it still offers very strong margins and cash flow to fund other growth initiatives within the business. Furthermore, I expect the introduction of several new products to allow the company to charge higher prices and generate stronger profits, even if the top-line growth moderates.
2. 2007 and 2008 product introductions in bio-tech (GM) seeds can significantly accelerate profit growth
The company also has a significant presence in seeds, where it is the #3 player globally, with about 10% market share of the $15B world seed market, and about 15% of the U.S. market. In the seeds business the primary competition is from Monsanto, which has about 30% of the market, and DuPont, the #2 player with about 25% share. The seed market is therefore highly oligopolistic, and has significant barriers to entry and reasonable pricing power. The primary knock on Syngenta is that it is late to the game in the faster growing biotech (genetically modified) seed market. Currently, it takes about 4 years for a seed to be developed and to sufficiently breed enough quantities of it to distribute. While DuPont and Monsanto have debuted their “double” and “triple stack traits” recently (double-stack is seed with two significant biotech traits), Syngenta was somewhat late, and won’t offer a double stack trait until mid-2007 and a triple stack in 2008 (just recently approved by U.S. agencies). That said, if Syngenta migrate only a small % of its conventional seed customers toward its new products, it will generate significant profits. The double and triple stack products generate nearly twice the profitability as conventional seeds and will have a powerful impact on net income.
3. Syngenta has the best business fundamentals in the peer group. Syngenta has stronger return on equity trends (evidence of well managed company), a better balance sheet, and generates more free cash flow than peers.

4. Syngenta, because it is slightly late to the “bio-tech party”, and has some slower growth segments trades at a significant (and undeserved) discount to Monsanto.
This disconnect will be likely be narrowed if the company can show just moderate amount of success with new product introductions, and others begin to see the relative value in this name. In fact, assuming just moderate margin expansion and EPS growth of about 14% over the next 5 years, a discounted cash flow analysis yields value 30% higher than the current price. Monsanto trades at over 34 times earnings, while Syngenta trades just slightly above the market multiple at 17.5X (almost 50% of Monsanto’s valuation!!). DuPont trades at about 15X, but has about 50% of its business tied to highly cyclical housing and automotive markets. In my view, this is a “safer” way to play this trend in agriculture.

Labels: Agriculture, Corn, Monsanto, Seeds, Syngenta

TJX, a high quality retailer in the bargain bin....


The recent credit card breach at TJMaxx has evoked loud criticism from all corners of the investment and political spectrum over the company's lax security measures. Some have gone as far as to equate the companies actions as those of the criminals themselves. In a recent Lightening Round on Cramers Mad Money, when asked his view of the stock, Jim declared that TJX is a "mismanaged" company. Perhaps had he given more than the 12 allotted seconds to deliberate each stock idea, he may have constructed a more thoughtful position.

While I am concerned that more stringent controls were not in place before the breach, I view TJX as more a victim than culprit in this situation. I love when short term issues like this give us the opportunity as long term investors to buy and hold great companies until the market lets them out of the penalty box. I must say, I have to respectfully disagree with Cramer’s conclusion however that TJX is a “mismanaged” company. Having done significant work on the drivers of outperformance in the retailing space, I have concluded that the winners are usually the companies that #1 can generate the highest return on shareholders capital & #2 can sustain strong “same store sales”

Because TJX employs a unique business model that emphasizes operating highly efficient stores and delivering value to the consumer and focuses less on developing fancy store layouts and concepts, they consistently earn higher return on invested capital than their peer group. TJX turns its inventory much faster than most peers, which creates value in three important ways. The faster inventory turnover enables TJMaxx to generate higher levels of cash flow as less working capital is needed to finance the inventory. Capital expenditures also tend to be lower as store concepts are lower priority, and stores do not need to be renovated every three years to remain "trendy", As the chart below illustrates, TJX has one of the highest levels of free cash flow earning power in the retailing sector, a financial metric which is typically associated with higher valuations and stock prices. Secondly, the brisk turnover model creates huge value proposition for its suppliers, providing the clothing manufacturers and department stores an additional channel of distribution and allows them to optimize their merchandising. Finally, the model lowers the financial risk profile for TJX as fashion risks are minimized.

It is difficult, in the long run, to make money on stocks that have high fashion risk, companies that can often be victim to consumers rapidly changing tastes, i.e. the Gap, Krispy Kreme, and Cramer’s favorites like Crocs and Under-Armor. Sure, some will succeed, but getting the merchandise strategy right is another uncontrollable variable in the mix.

TJX has much less risk because if it makes a fashion blunder, it has much shorter lead-times and can quickly adjust its merchandising. Other companies could have several quarters of earnings misses if it makes poor merchandising decisions as purchasing decisions are made several months in advance.

In terms of growth, TJX has strong unit growth potential in some of its newer concepts, but more importantly it grows its “same store sales” much more consistently than most retailers. The attached charts show how TJX has a very loyal customer base (we call them “treasure hunters”) and in fact in slowing periods TJX tends to attract marginal customers that trade down from higher-end retail.


These are signs of very solid management and I remain confident that over our longer frame investment time horizon, this thesis should materialize and we will see a solid return.

Labels: inventory, retail, TJX