Investing in the 21st century can be a difficult task: It can be hard to focus on long-term fundamentals of a business when every talking head is focused on this quarter’s earnings or last month’s unemployment data. One of the ways I attempt to disregard the endless noise is by rereading Warren Buffett’s annual letters to shareholders: It seems that every time I peruse the Oracle’s writing, I’m even more enamored with Berkshire’s investment philosophy and the merit it holds in the transaction-based market environment we are all surrounded by.
One company I’ve wrote about lately, Staples (SPLS), has been in the crosshairs of the talking heads; it’s pretty funny to see how people react on both extremes to the endless flow of information, soaking in that which confirms with their thesis and proclaiming (no matter how irrelevant it may be to the long term result) how it foreshadows what lies ahead.
Unfortunately, this isn’t all fun and games: if you spend enough time listening to these discussions, there’s a good chance that it will eventually influence your decision making; for the investor, this constant battle between noise and relevant information can be just as critical as the investment thesis itself — particularly in real time, when what may eventually prove to be inconsequential can seem critical (with market volatility imploring you to act).
This brings me to Warren’s 1987 shareholder letter, when he said the following:
“Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, ‘If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy’.”
Warren has talked endless about one’s circle of competence over the past few decades, but rarely puts it in these words: “Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game.”
I think this statement is profoundly important: Most people wade into investments based on a “Mad Money” interview (and a thumbs up from Cramer) or due to an analyst upgrade without a second thought. It’s only when the stock starts heading lower that people worry about risk.
Unfortunately, even after they have lost 20-30%, they are still focusing on the wrong thing: Most individuals will wonder about the potential for further downside in the stock price, rather than looking at the underlying business and determining its intrinsic value. The reason why is clear: They don’t read 10-Ks, they don’t understanding the underlying economics of the business, they don’t want to put in the necessary time to make an informed decision, and they are not focusing on the long term-viability of the business model. In a word, they’re the patsy of the game.
The usual response is to sell the stock, call the CEO an idiot (by title, they most likely don’t know his name) and move on to the next ticker symbol; the path less traveled is to be honest with yourself and admit that if you don’t like a stock more when its price declines (assuming no fundamental changes), then you’re not investing – you are gambling.
This brings us back to Staples. The company got obliterated on the release of the second-quarter report and has dropped more than 15% over the past five trading days. While this is what everybody focuses on (and draws their conclusions from), let’s instead look at what really matters: the fundamentals of the underlying business.
As I noted in my contest submission, the international picture is weak; this continued through the second quarter. As I also noted in my contest submission, Staples has the financial flexibility to ride out this storm (more than $1 billion in FCF generation and a current ratio north of 1.5x) while smaller competitors are forced to pull back on the reigns; management will discuss potential changes in this business segment on the third quarter call, at which point I will add my two cents.
In the North American Delivery business, which I highlighted as a key strength for Staples, sales declined 0.8% in the quarter (coming off of a 3.1% sales increase in the prior year), and 0.4% in local currency; as management noted on the call, two large contracts were not renewed due to inadequate expected returns, which was a 70-basis-point headwind. Through the first six months of the year, sales in the segment have increased by 0.5%, on top of a 2.5% increase in the first six months of 2011; considering the macroenviornment and the figures posted by SPLS’ closest competitors, I’m satisfied with these results.
North American Retail was off 2% in the quarter (on a comp basis), compared to a 1.8% slide at Office Max and a 4.0% decline at Office Depot; many have pointed to this data and drawn the conclusion that the outperformance by OMX in the quarter is an indication of trouble at SPLS — as I noted above (and based on other occasions where OMX/ODP have etched out short-term share gains), I think this is little more than noise, and blind to the trend of the past decade. My continued focus is on store closures/downsizing, with the belief that the trend will increase in the coming quarters — although my valuation is not dependent upon this by any means.
To clarify, I’m just as happy owning Staples as I was a week ago (particularly at less than 8x free cash flow, which conservatively assumes all capex is for maintenance). I’m willfully ignoring the market’s opinion of SPLS common stock, only because I do not believe it accurately reflects the fundamentals – but I’m more than happy to hear what Mr. Market has to say, particularly if it means buying Staples for less and less with each passing day.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.