As the 2016 Christmas season nears, several consumer cyclical companies offer strong value potential to investors based on backtesting results. Four retail companies, Amazon.com Inc. (AMZN, Financial), Home Depot Inc. (HD, Financial), Nike Inc. (NKE, Financial) and Walt Disney Co. (DIS, Financial), generally had strong financial strength and business predictability during the backtesting period from 2006 to 2016.
Sector overview
The consumer cyclical sector, also referred to as “consumer discretionary,” contains companies offering goods and services that are generally nonessential to consumers. As the term “discretionary” implies, the consumer can elect to purchase such goods and services based on their income levels. Consumer discretionary companies include apparel stores, travel and entertainment companies.
GuruFocus names this sector “consumer cyclical” as companies in this sector fluctuate based on the current state of the economy. As Peter Lynch observed, cyclical companies usually have unpredictable revenue and margin trends. These companies outperform other companies during expansions and underperform during recessions. However, some cyclical companies, especially those with durable competitive advantage, can generate value even during a recession.
Amazon.com Inc.
Specialty retail company Amazon.com sells goods and services through the company’s website, which provides advertizing services and credit card agreements. The Washington-based company also offers Kindle, a well-known e-reader tablet. As of Dec. 16, the company has a predictability rank of five stars, the strongest predictability rank. As mentioned in the research article, five-star companies realized an average annualized median gain of 12.1% during the backtesting period from 1998 to 2008.
Figure 1 summarizes Amazon’s historical trend of profit margins while Figure 2 summarizes the company’s historical trend of financial strength scores.
Figure 1
Figure 2
Even though the company’s operating margin generally declined during 2006 to 2016, Amazon had increasing gross margins during the 10-year period. The company’s gross margin increased about 8.5% per year during the past five years. As illustrated in Figure 2, Amazon generally has strong Altman Z-scores, which ranged between 4 and 10 during the 10-year period. This suggests that the company seldom faced financial distress during the past 10 years.
Figure 3 summarizes the historical trend of Amazon’s financial strength rank, profitability rank and predictability rank. While Amazon’s financial strength slightly decreased during the past three years, the company’s financial strength rank ranged from 6 to 10 throughout the 10-year period. Amazon’s profitability rank, which is currently 7 out of 10, has a narrower range than its financial strength rank. This suggests that Amazon has a strong business outlook with high growth and value potential.
Figure 3
Finally, Amazon’s predictability rank sharply increased from one star to 4.5 stars during the second half of 2013. The company maintained a five-star predictability rank since 2014.
Home Depot
Home Depot, the “world’s largest home improvement retailer,” sells an eclectic variety of building materials, lawn products and garden supplies. The Atlanta-based company also provides various home maintenance services, including painting walls and installing lights.
Figure 4 summarizes Home Depot’s historical trend of operating and gross margins. The company had expanding operating margins since 2009, growing from about 6% to 14% during the past seven years.
Figure 4
As discussed in the company’s third-quarter earnings report, Home Depot reported $23.2 billion in total revenue, outperforming third-quarter 2015 revenue by 6.1%. Diluted earnings per share climbed 25 cents, about 18.5% higher from the prior-year quarter. CEO Craig Menear praised the company’s “balanced sales growth” in the third-quarter, with productivity driving double-digit EPS growth. During the past three years, Home Depot’s earnings per share grew 22.1% per year, outperforming 82% of global home improvement stores.
Home Depot’s increasing operating revenues likely contributed to increasing Altman Z-scores, as the Altman scores soared higher than 4 since 2011. Figure 5 illustrates the company’s increasing Piotroski and Altman scores, implying a strengthening business operation.
Figure 5
Despite having relatively low predictability, Home Depot generally had strong financial strength, likely due to high Piotroski and Altman scores. The company’s financial strength ranked 9 out of 10 from 2010 to 2013. Even though the company’s financial strength ranked dropped to 6, the company maintained a profitability rank of 8: Home Depot’s margins and returns are currently near a 10-year high, with a return on equity of 128.28% as of October 2016. Figure 6 summarizes the company’s historical financial strength, profitability and predictability rank trends.
Figure 6
As Home Depot presents high growth and value potential, Ken Fisher (Trades, Portfolio) and Spiros Segalas (Trades, Portfolio) both increased their holdings in the company stock. Fisher owns 8,480,515 shares, the largest stake among Home Depot guru owners.
Nike
Nike, one of several well-known sports brands, designs and markets footwear, athletic and equipment products for a wide variety of sports. The Oregon-based apparel company has seven good investing signs, including consistent per-share revenue growth, expanding operating margins and strong interest coverage. As of August 2016, Nike’s interest coverage is 175.14, which outperforms 65% of competitors and is significantly above Ben Graham’s required threshold of 5. Figures 7 and 8 summarize the company’s historical profit margin trends and financial strength score trends respectively.
Figure 7
Figure 8
Nike’s operating margin of 13.05% outperforms 84% of global footwear and accessories companies and its net margin is close to a 10-year high of 11.61%. As discussed in a previous article, Nike reported robust third-quarter performance, including a 9% increase in diluted earnings. Likely due to strong growth potential , Nike’s board of directors announced a 13% increase in its quarterly dividend payable Jan. 3, 2017, in a Nov. 17 press release. The company’s trailing dividend yield is currently near a three-year high.
Despite having a low Piotroski score of 3, Nike’s Altman Z-scores exceeded double-digit figures July 2014 and remain a robust 8.71 as of December 2016. The company’s Altman scores seldom dropped below 4, suggesting almost no distress during the past 10 years. Likely due to strong Altman scores and interest coverage, Nike has a financial strength rank of 8. Figure 9 summarizes the historical trend of Nike’s financial strength, profitability and business predictability.
Figure 9
Nike’s predictability rank seldom dropped below three stars during the past 10 years. Additionally, the company maintained at least a four-star predictability rank since August 2008. As the company provides strong value potential, John Griffin (Trades, Portfolio) purchased 2.6 million Nike shares during the third quarter.
Walt Disney
Diversified entertainment company Walt Disney operates in five business segments, including media networks like ESPN, parks and resorts like Walt Disney World, studio entertainment, consumer products and Disney Interactive. The Burbank entertainment company has a 3.5 star predictability rank, and its profitability ranks a strong 8 out of 10.
Figure 10 illustrates Disney’s historical margin trends while Figure 11 summarizes the company’s historical F and Z score trends. The company’s operating margin and return on equity are near a 10-year high, with the former outperforming 90% of global entertainment companies. As discussed in its latest earnings release, Disney increased its diluted earnings per share by 16% from fiscal fourth-quarter 2015 to fiscal fourth-quarter 2016. Chairman and CEO Robert Iger praised the company’s record-setting performance, delivering top revenue, net income and EPS in the company’s history. Disney’s gross margin sharply increased from about 22% in January 2015 to over 60% by July 2015.
Figure 10
Figure 11
Although Disney had a five-star predictability rank in 2015, its predictability dropped to 3.5 stars as of December 2016. The company’s financial strength rank dropped from 8 to 6 as Disney issued some long-term debt. Despite this, the company maintained a profitability rank of at least 7 during the past 10 years, occasionally reaching 9 out of 10. Figure 12 summarizes the historical trend of financial strength rank, profitability rank and predictability rank for the “magical company.”
Figure 12
As the company has high value potential, Ken Fisher (Trades, Portfolio) and Pioneer Investments (Trades, Portfolio) boosted their stakes in Disney. The latter increased his holdings by about 7.08% while the former owns 8,722,317 shares, the largest among gurus.
Conclusions and see also
These four companies suggest that even though consumer cyclical companies usually depend on business cycles, several retail companies have robust value potential based on historical financial trends. The Christmas season likely increases short-term value potential in retail companies like Nike and Home Depot.
Other retail companies like Hibbett Sports Inc. (HIBB, Financial) and Winmark Corp. (WINA, Financial) appear on Warren Buffett (Trades, Portfolio)’s “nice” list, companies that meet the Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) manager’s four-criterion approach to value investing. Such companies have high value potential in a booming but significantly overvalued stock market. As discussed in a previous article, gurus are shopping for good Christmas deals in consumer cyclical companies.
Premium members can also find good retail companies to invest in using the All-in-one Guru Screener, which offers over 150 filters. The premium membership also grants access to over 150 gurus’ portfolios, including the aggregated portfolio of gurus. If you are not a premium member, we invite you to a free seven-day trial.
Disclosure: The author has no position in the stocks mentioned in this article.
Start a free 7-day trial of Premium Membership to GuruFocus.
