Here’s a quick exercise that I find quite interesting:
Assume that you are looking at a company in 2005 with the following characteristics: it reported revenue of just over $39.5 billion, and net income of $1.07 billion (net margin of 2.7%); now fast forward to 2011, and look at that same company in the heart of a global economic slowdown – sales for the fiscal year came in at $43.6 billion (1.66% CAGR) and net income was up slightly to $1.12 billion (net margin of 2.6%).
You know that this company has been hurt by unemployment (and that key markets are materially worse off in this metric compared to the starting period), but expect that an eventual recovery in certain markets around the globe will act as a tailwind for the business. As far as headwinds go, the company is facing some structural changes and intensified competition, though not from anyone beyond competitors that were ferociously fighting for share in 2005 as well.
With this information, what would you be willing to say about the relative value of this corporation - more attractive in 2005, more attractive in 2011, or just about the same in both periods?
In reality, this isn’t a single company - it’s the collective results of the three main U.S. office supply chains: Staples (SPLS), Office Max (OMX), and Office Depot (ODP). Looking at the results for both years, I would assume the consensus is that while the slight contraction in net margin is concerning, the ability to continue driving sales growth (albeit slowly) in the heart of the worst economic crisis since the Great Depression is a plus; as a result, I would conclude that there’s little to suggest that intrinsic value has moved materially in either direction.
The market, on the other hand, doesn’t seem to agree: in 2005, these companies had a collective market capitalization of $25 billion; Mr. Market was willing to pay 24x earnings for a company facing structural headwinds (the negative impact of computers, email, etc on paper and ink sales was widely anticipated) and intensifying competition from a growing e-commerce industry. Fast forward six years (and into the heart of double digit unemployment around the globe), and it appears that the industry has (collectively) navigated this environment with some success – except now Mr. Market is only willing to pay $8.4 billion, or one-third of the previous amount, for a comparable level of earnings.
This isn’t to conclude that these companies are currently undervalued; all I’m trying to do is point out something that is often overlooked – the threats facing these companies are identical to what they were half a decade ago. Some people believe that this industry is all but dead, that it will not be able to stand up to Wal-Mart (WMT) and Amazon (AMZN) – and they point to a stock price that forecasts disappearing earnings and other troubles ahead as evidence; personally, I think using stock prices as justification for such beliefs rather than the financials (which suggest something quite different) is illogical (particularly if one is active in the markets, and thus by deduction believes inefficiencies do exist).
My point is this: the market was willing to pay a rich premium during the heights on an economic boom (essentially implying that the good times would continue), yet will pay just a third of the previous price for the same dollar amount of earnings in the depths of a recession (essentially implying that the bad times will not only continue, but intensify); for the individual that can keep a level head while others are dancing between bouts of euphoria and despair, I think the fundamentals point to a sweet spot somewhere in the middle.
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.