Most investors would prefer to plunk their money down when the sun is shining—witness the great rushes into the market when a boom is underway. For a value investor, though, the best time to invest is during storms. In that sense, Peter Lynch was a value investor.
As he wrote in his 1993 book, “Beating the Street,” “Digging where the surroundings are tranquil and pleasurable may prove to be as unrewarding as doing detective work from a stuffed chair.”
At the end of 1991, after he had retired from running the Fidelity Magellan Fund and was collecting investment ideas for Barron’s magazine, the housing and real estate businesses were said to have been unraveling. Common wisdom had it that commercial real estate was collapsing and pulling down residential real estate as well.
However, Lynch discovered some “quiet facts” that got his attention; specifically, the National Association of Realtors reported that the median price of a house was going up in 1991, as it had in 1989 and 1990—and every year since it had begun tracking this metric in 1968.
Following quiet facts led him to Toll Brothers (TOL, Financial), a prominent home-building company; in October 1991, it was selling for about $2.35 per share, down from $12.65, a “five-bagger in reverse.” While the market had soured on the stock, Lynch said he remembered it as a strong company with the financial wherewithal to sustain itself in tough times.
What’s more, he said, “You can imagine my excitement at finding a company with very little debt and enough new orders to keep it busy for two years, its competitors dropping by the wayside, and its stock selling for one fifth its 1991 high.” It was a good call on his part: The stock rebounded back into the $12 range within a few months.
If there was quiet strength in the housing market, then it should also benefit related markets. In this case, Lynch reasoned that if people were moving into new or used houses, they would need lamps, room dividers, placemats and similar goods. This brought to mind Pier 1 (PIR, Financial), which sold such products at affordable prices (and where his wife Carolyn liked to shop).
The stock had been a star during the 1970s, then bumped up and down, taking big hits with both The Great Correction and the “Saddam Sell-Off.” At the time Lynch began looking at it, Pier 1 was selling for $7, about half its market value before The Great Correction of 1987. That would have made it undervalued if the housing market was recovering.
Discussions with the CEO in 1991 led to several quiet facts: The company was making money that year, despite a tough economic environment; it was growing by 25 to 40 new stores a year; it had only 500 stores, so it had a lot of room to grow; and it also had reduced its expenses. As a backstop to those facts, Lynch checked the company’s inventory, which was growing in line with the growth in its store count.
And, there was a bonus behind the good news: It had sold 50.5% of its subsidiary Sunbelt Nursery, which brought in $31 million. It used $21 million of that to reduce its debt, leaving it with a stronger balance sheet and making it very unlikely the company would go bankrupt. Lynch called it “a valuable hidden asset to the company.”
Sunbelt was also a public company, spun out of Tandy Leather Factory (TLF, Financial) at the same time as Pier 1, and the author’s discussion gives us more insight into the way he thought about investing. That started with the connection to the growing housing industry since Sunbelt was in the retail lawn and garden business. All new homes would need lawns, trees, flowers and the like. In addition, the industry was dominated by mom-and-pop businesses, so Sunbelt might become an aggregator.
When it went public, its initial price was $8.50 per share, and with the sale of stock in the initial public offering, the company started out with no debt and $2 per share in cash. The latter would be used to renovate and upgrade most of its lawn and garden centers. Lynch was also attracted because Pier 1, with extensive retail experience, was staying invested in Sunbelt, and the management of both companies held significant stakes.
Using what he called “the home buyer’s technique of comparing it to similar properties that recently have been sold,” he compared Sunbelt with competitor Calloway Golf Co. (ELY, Financial). Based on Calloway’s valuation, he estimated Sunbelt would be worth some $200 million, or more than $30 per share. The stock was selling for about $5 at the time he did his analysis.
General Host also came up in the same investigation because it had once owned Calloway’s, before the latter was spun off as a public company. Now, though, there was another company to consider, General Host. In the early 1990s, the one-time conglomerate had sold off all its other businesses to focus on Frank’s Nursery, a company with 280 outlets in 17 states.
When he began researching it, Lynch discovered it had a long-term buyback program, and had recently bought back shares for $10 each. He added:
“When a company buys back shares that once paid a dividend and borrows the money to do it, it enjoys a double advantage. The interest on the loan is tax-deductible, and the company is reducing its outlay for dividend checks, which it had to pay in after-tax dollars. dollars. A few years ago, Exxon’s stock was so depressed that it was yielding 8–9 percent. At the time, Exxon was able to borrow money at 8–9 percent to buy back millions of these dividend-paying shares. Since the interest on the loan was tax-deductible, Exxon was really paying only about 5 percent to save 8–9 percent on dividends.”
At the time of the buyback at $10 per share, the company had a book value of $9 per share and the market price was $7 per share. Purchasers of the stock would get assets worth $9 for just $7. The company was also attractive because of a relatively strong balance sheet and cost-cutting measures, as shown in the selling, general and administrative expenses section of the financials.
Using comparative valuations again, Lynch estimated the company’s net value ($420 million in assets, minus debt of $167 million) at $253 million, or $14 per share—twice what the shares were selling for when he did the analysis.
Conclusion
In chapter nine of “Beating the Street,” Lynch showed how research in one area could lead to robust opportunities in related areas. In this case, an investigation of one homebuilder led to three other potential opportunities.
In each of the cases, we see a familiar Lynch research pattern. First, he finds a fact that is at odds with the common wisdom, looks into the story behind the “quiet facts” and, if he likes the story, does a thorough review of the fundamentals. It’s the process behind all those great returns for 13 years at Magellan.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Beating the Street: Insights Into Retail Stocks
- Beating the Street: The Art, Science and Legwork of Investing
- Beating the Street: Lynch's Mature Years at Magellan
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