Gap Stores (GPS) is an example of a stock surrounded by apathy and disgust which was recently added to our portfolio. GPS has similar characteristics to McDonald’s and Hasbro when we purchased these companies many years ago. Apathy and investor disgust created by consistent earnings and sales disappointments have resulted in the stock selling at the same price it traded at in 1997. Yet, between 1997 and 2005, earnings and sales have more than doubled. The stock peaked in the late 1990’s near $50.00 a share when the company earned $1.26 a share. We believe prospects are better now than they were in the late 1990’s, although we are not projecting a move back to $50.00 a share in the next few years. The company has adopted a back-to-basics strategy, consisting of closing down unprofitable stores, simplifying the product line, and de-leveraging the balance sheet (all actions focused on improving operating margins and generating excess cash.) In addition, over the past three years, GPS has moved from a net debt position to a net cash position of approximately $3.00 per share. The excess cash provides management with the leeway to fully execute their strategy, repurchase the company’s stock, or return capital to shareholders. GPS’s operating and financial changes appear to be gaining traction, with reports of increasing consumer traffic and a moderation in the decline in comparative same store sales. Over the next 18 months, we believe the company’s operating leverage should kick in, resulting in earnings power of better than $1.50 which should result in a higher stock price.
The Strategy of Ben Graham – Warren Buffett’s Mentor
From 1923 to 1957 Warren Buffett’s mentor, Ben Graham, followed a strategy of investing in net-nets. He said: “It always seemed, and still seems ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the...net current assets alone…the results should be quite satisfactory. They were so in our experience, for more than 30 years.”
Today net-nets are rare. They are collected under GuruFocus’ Net-Net Screener. GuruFocus also publishes a monthly newsletter which recommends the safest net-nets. All of these are included in GuruFocus Premium Membership.
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