In the last two weeks we’ve seen unusual volatility in the stock market coupled with rising interest rates. However, the fundamentals remain strong and our long-term view is positive.
Cabot Benjamin Graham Value Investor 283
Benjamin Graham is called The Father of Value Investing. His influence has inspired many successful investors, including Warren Buffett.
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This month we have seen unusual volatility among our stocks. Gilead Sciences (+11%), Target (+9%), Lowe’s (+7%) and Gentex (+5%) were on the upside while Thor Industries (-15%), Signet Jewelers (-12%) and Toll Brothers (-11%) were on the down side.
Such wild action, of course, is in line and was driven by the overall volatility in the benchmark index S&P 500, which recently plunged more than 9% in less than seven trading days. We will explore more on these unusual volatilities in the section below on Economic and Market Update.
I see this pullback as an opportunity to invest in some fundamentally sound turnaround stocks such as Signet Jewelers. Nothing drastic has happened in the fundamentals, but the market has been extremely bearish. With a long-term view in mind, you can buy more on the dips.
At the same time, stocks such as Gilead Science (GILD), Lowe’s (LOW), Home Depot (HD), Discovery Communications (DISCA) and Gentex (GNTX) are trading close to their fair values. If you are risk averse, I would suggest taking some profit from them and hold the rest for the long term.
As mentioned below in the sell update regarding LCI Industries (LCII), Thor Industries (THO) has plunged from the recent concern on unsustainable RV inventory levels. There is no conclusive proof on the report yet, but we will have to wait until March to get a fair idea on Thor’s future projections. Thor, which was bought in July 2017 for $106 per share, is now trading at about $125 per share even after the recent plunge. If you feel uncomfortable to hold any longer and want to take a quick profit, you may sell Thor. However, I am holding it as I anticipate that any major downturn in RV demand is unlikely in the near term.
“To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” — Benjamin Graham
Economic and Market Update
If we analyze the change in weekly expected volatility from the beginning of 2008, the last week of this January would be the 5th highest in the last 10 years (as indicated in the chart to the right).
What was the reason for the wild swing in VIX (VIX is a Volatility Index by CBOE which measures the expectation of volatility by the S&P 500)? One definite reason is the extremely low volatility of the markets in 2017. According to Bank of America Merrill Lynch, the S&P 500 (with dividends) had 14 consecutive months of gains though January. That was the longest streak since 1928! Thus, a sharp downside movement in the market creates a wild swing in the volatility expectations (VIX).
As a corollary, it’s worth noting that in 1965, the average period for a company to be in the S&P 500 was 33 years, whereas by 1990 it turned out to be a mere 14 years and is expected to shrink further going forward. Very well recognized companies just five years ago, including Yahoo!, Bed, Bath and Beyond and Staples are no longer in the S&P 500 list. Instead, they were replaced by new companies such as Facebook and Illumina.
In this drastically changing environment, the attraction of value investing is that we do not need to worry much about the volatility of stock prices—we worry about the fundamentals. And right now the fundamentals remain great—about half the companies in the S&P 500 have reported Q4 results, and 80% of those have surpassed the analyst’s earning expectations and the economy is showing signs of picking up steam (leading economic indicators continue to strengthen, which is always a plus). With our longer-term methodology, our focus is on the margin of safety of the real economics of the business.
As for valuations, the big thing of note lately has been the rising yield of the 10-year Treasury note; it’s up to 2.88% as of this morning, its highest level in four years. Yet the spread between the earnings yield of the market (earnings divided by price) and this benchmark yield remains wide enough to be a positive for the overall market.
New Buy Recommendation
Nautilus (NLS)
The gym and exercise equipment manufacturing industry is worth $5.5 billion in the U.S., and it’s led by major players such as Brunswick Corporation, Icon Health and Fitness and Amer Sports Corporation. However, the U.S. players are facing stiff competition from low-cost suppliers in China and elsewhere, which has caused the domestic industry to shrink over the past five years. Imports are around 65% of the U.S. demand and that’s expected to grow in the short-term.
Nautilus is one of the smaller players in the group, though it owns major brands including Bowflex, Octane Fitness, Universal and Schwinn, includes treadmills, ellipticals, cardio, strength products and exercise bikes. Around 85% of 2016 revenue came from consumer cardio products. Nautilus was founded in 1986 and mostly sells through direct channels, with the remainder via retail channels.
The company (which was once called Direct Focus) has gone through drastic changes in the last 20 years. The company started its business as a direct marketing business, marketing its Bowflex fitness equipment and Nautilus Sleep Systems. It’s been diversifying itself into various new products such as cardiovascular, apparel and nutritional products.
In 2003, the founder and CEO Brian Cook voluntarily resigned after 17 years and was replaced by Gregg Hammann. Hammann came up with a new strategy named FIT #1. After thorough market research, he found that 80% of their target consumer market buys fitness products through the retail channel and 60% of those dollars are spent on cardiovascular products. Unfortunately, Gregg Hammann could not improve the sales, and overall profitability eroded resulting in his termination in 2007. In 2007 Robert S. Falcone was elected as the interim CEO and was replaced by active investor Edward Bramson in April 2008. Under the leadership of Edward Bramson, Nautilus went through a major restructuring in 2008 and 2009.
In 2008 the company closed its manufacturing facility in the U.S., becoming one of the first fitness equipment manufacturers who entirely moved its production to Asia. Most of the firm’s products are manufactured by third-party manufacturers, while the company is focused on the designing and marketing of the product (you could compare this to the business model of Nike—interestingly, Falcone was the former Nike CFO). The company also sold its apparel business and closed its call centers in Canada. In September 2009, Nautilus decided to complete the divestiture of its commercial business and cut more than half its staff.
Edward Bramson, handed over the CEO position to Bruce Cazenave in 2011. Cazenave brought the company back to profitability and has been leading a growth revival since, as you can see in the chart below. The stock has soared from $2 per share to $20 per share in 2016, during Cazenave’s term.
Nautilus re-entered the commercial business (to supply gyms and health clubs) with the acquisition of Octane Fitness for $115 million in December 2015. Analysts were perplexed at the decision given that the company had exited this area during the 2008-2009 restructuring period. However, Cazenave highlights that Octane’s business model is quite different from the old Nautilus’s commercial business. Octane is asset light and gets 22% of its revenues from overseas—this will create good synergy with Nautilus, which has only 2% international exposure.
Revenues did flatten in 2016, and the trend continued in 2017; revenues are expected to have totaled about $405 million last year, basically flat with 2016. Because of the worries and flattening growth, the stock has taken a dive in recent months, with the recent market correction driving prices down to nearly 11 before bouncing a bit.
How should you approach the stock from here? The stock could certainly see lower prices in the near-term, partially due to its own downward momentum and the previously mentioned worries and competition. Plus, of course, the market remains iffy—after a big, multi-month advance, stocks could certainly cool off for more than just two weeks, which could drive NLS (and everything else) down more.
But, from a long-term view nothing drastic has happened to the company. Bruce Cazenave continues to show excellent management skills with swift changes in strategies and focus.
There are three basic challenges that Nautilus has to overcome: 1) Get the right price point for their new product, HVT, and improve the ad conversion rate, 2) improve the sales of declining TreadClimber and, 3) improve synergy with Octane. It will likely take some time for growth to kick into gear.
However, as we focus on the margin of safety of the company, I am assuming a conservative long-term growth estimate of 5% per year. Even with such a forecast, the company looks around 20% undervalued (more financial metrics are in the Prudent Portfolio below). I think you can buy a small position in NLS around here, and look to piece your way into the stock should it remain under pressure.
Another reason to start slow: Q4 results which are likely to be released later in February, which is always a risk, especially with relatively poor results on the way. You may buy partially now and add further exposure after the Q4 earnings report. BUY.
Additional Buys
Except for Alphabet (GOOG), which I am moving from buy to hold, all other previous buy recommendations stay intact.
Additional buy recommendations include Magna International (MGA), Hanesbrands (HBI), Williams-Sonoma (WSM), Apple (AAPL) and Target (TGT).
HanesBrands (HBI)
Hanes reported its second quarter of organic growth and full year operating cash flow of $656 million. The company announced the acquisition of Australian specialty retailer Bras N Things. The firm reported a GAAP loss due to a one-time charge of $457 million related to the tax bill, but that has nothing to do with the underlying business, and the future lower tax rate should help. From a fundamental standpoint the company has been moving in line with expectations. Buy on dips. BUY.
Apple (AAPL)
Apple announced that it would be adding medical records to the health app in the next iPhone updates. Information on allergies, conditions, lab results, immunizations, medications, procedures and vitals from various sources will be available at users’ fingertips. Apple secured participation from Epic Systems, Cerner Corp. and AetnaHealth, so there’s plenty of interest. Having access to medical records will give Apple an edge over other players in big data analysis, which is essential for the insurance and tech industries.
Apple is still conservatively priced, given that it generates around $50 Billion in free cash flow. With an active installed base of 1.3 billion people, Apple has a significant opportunity to earn from digital content and services. BUY.
Sell Recommendations
LCI Industries (LCII)
I recommended selling LCII last week based on the recent report by Northcoast Research, which indicated that the RV inventory is reaching an unsustainable level. If the research findings are right, it would be risky to have significant exposure to RV stocks. To avoid such a risk, I had to sell either Thor Industries (THO) or LCI Industries (LCII)—I chose the latter based on the valuation.
In the December 14 issue, I wrote this about LCI Industries: “And if you hold THO, I would not recommend additional exposure to the RV industry as it’s hard to predict if the RV sales have reached a peak—though there’s room for further growth if millennials show interest in RVs.”
LCII released its fourth quarter report today and didn’t show any decline in backlog. Revenue grew 36% YoY albeit the EPS was slightly off the estimates and there is no sign of unsustainable inventory level, at least not yet. However, we can make a conclusive judgement only after analyzing the inventory level of Thor Industries, which is the largest consumer of LCII. Thus, reducing an exposure to RV industry seems prudent at this stage. SELL.
Starbucks (SBUX)
Starbucks (SBUX) reported earnings with comparable store sales growth of 2% globally and 6% in China. I do not expect Starbucks to improve much in the long run. At this growth level and with an estimated free cash flow yield of about 4%, Starbucks is clearly overpriced. I recommend selling SBUX. SELL.
Prudent Portfolio
Stocks in the Prudent Portfolio are ranked based on various factors, including the prospect of appreciation, maximum downside risk and expected annualized yield. I suggest that you allocate more capital to the stocks with the better rankings.
Updates on Current Recommendations
Lowe’s (LOW) rose sharply after D.E. Shaw started building an activist stake in the stock.
In “Lowe’s (LOW) vs. Home Depot (HD): Which is the Better Value Stock?”, which I wrote on December 9, I pointed out that Lowe’s needed to focus on operational improvements, including sales per square foot and same-store growth, to catch up with Home Depot, so I see the involvement of D.E. Shaw as a positive—the activist investor will serve as an additional catalyst for Lowe’s to focus on same-store growth rather than continuous store expansion strategy. After LOW’s surge, the stock is more or less reasonably valued, but I am recommending a hold thinking there could be upside if Shaw squeezes better-than-expected results out of the company. HOLD.
Alphabet (GOOG) launched Chronicle Security, a new cybersecurity unit. Chronicle uses machine learning to analyze large internal data and to identify threats faster than traditional means. Chronicle has the potential to gain significant market share in the $100 billion cybersecurity market, which is currently dominated by players like Symantec. Google’s entry into cybersecurity is a major milestone in its long-term strategy to enter enterprise markets. IBM, Amazon and Microsoft are the key players in the enterprise cloud market.
In light of its recent quarterly earnings report, it appears that the traffic acquisition cost of Google is continuously increasing because of Alphabet’s ongoing negotiations with Apple. My long-term growth projection thus is getting a bit more conservative, so I’m changing my recommendation from buy to hold. HOLD.
Gentex (GNTX) released its quarterly earnings, surpassing estimates. There was a 9% year-over-year growth in unit shipments and a 7% increase in sales, indicating some pricing pressure. Even so, the company grew its operating margin from 39% in Q3 to 39.2% in Q4. Under its new CEO, Gentex continues its innovative strategy in connected cars. The company has reached my fair value estimate, and you may take a profit now and hold the rest for long-term. SELL A PORTION.
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