Stock market declines have me singing a cheerier tune and adding four new stocks to the portfolio while one gets squeezed out.
The Crazy Has Left The Market
Or it’s got one foot out the door at any rate. Stock prices are coming down across the board. Many of the big, high-flying tech companies have taken a spectacular tumble. Corporate earnings are starting to normalise. P:E ratios are dropping, which means that earnings yields are going up, which means that you can perhaps start to earn a decent return again on the money you’re investing into this market. After a long, harrowing year of watching the covid mania unfold around me, I’m starting to breath a little easier as the mania unwinds. Some sanity is returning to the proceedings. The patient’s fever has broken.
Just to rehash: remarkably, with the world in lockdown mode, corporate earnings went on a tear. With government stimulus money pouring into the economy at the same time as corporations were reducing their expenses and tightening their belts the setup was there for a burst in corporate profitability. A dramatic shift from spending on services to spending on goods coupled with a severe shortage of many of those same goods meant companies had massive pricing power and profit margins sky-rocketed. Dramatic shifts in spending habits (work from home, play from home, shop from home) dramatically favoured some previously unremarkable players.
This all created a very distorted environment which was difficult to invest in, especially if you’re a fundamentals-based investor who is trying to gauge where earnings are likely to go next.
Looking at many companies’ long-term sales and earnings graphs, you were seeing big spikes over the last 2 years. In a more rational market, investors would discount that spike and assume an eventual return to the long-term trend. But for the most part, that didn’t seem to be happening. Investors were treating these windfall profits as if they were going to last forever. Even companies themselves seemed to be drinking the Kool-Aid and were treating these covid distorted earnings as if they were the new normal.
With the latest batch of Q1 results, though, we are seeing these covid distortions start to fade. Sales and earnings are beginning to return to their pre covid norms. Government stimulus has dried up, supply chains are beginning to sort themselves out, consumer spending patterns are normalising. And as those corporate earnings move back to their long-term trend, stock prices are following suit.
While no one likes to see their portfolio balance drop, overall, this is a very good thing for us value-oriented stock pickers. With some sanity returning to the markets, there are actually things to buy again at prices that offer the promise of a decent return.
The trick now, as we head down the backside of the covid bubble, is to figure out where companies stand after 2 years of dramatic upheaval. Everyone is not simply headed back to where they were in early 2020. There will be some winners and some losers. Society has likely changed in subtle but meaningful ways. Some companies will indeed have transformed during the covid years and will emerge on the other side stronger and more profitable. Others will have done the opposite. It will take a few more quarters before the picture comes into sharper focus but with Q1 results, we’re starting to get a sense of the outlines.
New Recruits
I started my review of first quarter results last week and I’m happy to report that it’s going fantastically well so far. I’ve already added four new stocks to the portfolio and am optimistic that I may eventually come up with one or two more fresh ideas by the time all is said and done.
I feel good about the four new recruits. They’re all solid, value plays, not just on a relative basis but on an absolute basis as well. I used up all of my excess cash to buy them, which also has me breathing a whole lot easier; I hate having cash piling up on the sidelines. Before I wrote the cheque, I debated about whether or not I should try to time this market. After all, it seems quite possible that the market will continue to slide into the fall as the economic slowdown we appear to be in picks up steam, but I’ve learned from bitter experience over the past 20 years that the market never seems to get as cheap as I think it should. Nor does the economy follow a straight line. The Fed always seems to ride in to the rescue at the first sign that rich people are actually getting a little less rich. Right now, there are stocks out there that I like, that I want to buy, that I feel good about buying. So I’m not going to try to finesse this. I’m back in, baby!
Signet Jewellers – SIG.NYSE
First up in the new starting lineup is Signet Jewellers. This is the largest jewellery retailer in both North America and the UK. Half their business is focused on diamond jewellery for the bridal market and the other half deals in everyday fashion jewellery.
60% of their stores are mall based which could present challenges as the retail landscape evolves, but they are actively managing their transition away from the mall and from underperforming locations and have shut down 20% of their fleet of stores in the past 3 years even as they have continued to increase overall sales. The average remaining lease term on their stores is only 2 years so there seems to be plenty of opportunity to continue to dynamically manage this transition.
They operate under a number of well-known retail banners including Zales, Kay Jewelers, Jared’s, People’s Jewelers in Canada and H.Samuel and Ernest Jones in the UK. They pride themselves on their technological sophistication with 20% of their retail sales coming from eCommerce and the majority of their customers beginning their journey on their online sites. They own and operate James Allen, one of the leading diamond engagement ring websites.
They are also one of the leaders in the new field of lab grown diamonds, an innovation which currently commands about 10% of the market but is growing fast. Lab grown diamonds are 60% cheaper than natural diamonds and could present both risks and opportunities for the company.
They have a long track record of solid, steady growth behind them with consistent profitability and only moderate slumps during previous recessions. Their balance sheet is strong.
However, they have not been spared the pain and disruption that has been inflicted on the retail sector over the past 5 years. They have just completed a substantial 3 year restructuring program which saw a substantial wave of restructuring expenses and write-offs. As with most retailers, they experienced the covid whipsaw effect of losses in the early stages of the pandemic followed by a blockbuster year last year. As we emerge from the pandemic, the challenge is to try to ascertain what their new level of sustainable earnings will be going forward. This is made even harder by the substantial restructuring they’ve recently completed.
The company made over $12 per share in profit in the year just ended, a record number for them. Their guidance for next year is for sales and earnings to improve modestly on that high water mark. They are enjoying the fruits of their restructuring efforts as well as pent-up demand for weddings coming out of covid, which has taken the number of weddings to 40 year highs.
The profit margins they are enjoying in this environment are not out of line with their previous performance over the last two decades. However, they are a jump up from the lower margins the company exhibited during the retail recession that immediately preceded covid.
Will their current healthy margins persist as we transition back to a new normal state of affairs or are these margins temporarily inflated by the pandemic and is the company fated to return to its pre-pandemic slump? Management says they can maintain margins at these levels. They certainly come across as being very pro-active, with clear plans to leverage their strength in technology, embrace new industry trends like lab-grown diamonds, and continue aggressively rationalising their fleet of stores for maximal profitability as leases come due. But the proof will be in the pudding.
Clearly, the market is skeptical. The p:e ratio is only 5 at the current $63 share price. That seems unusually low, even considering the difficulties they’ve had over the past 5 years. Clearly the market believes that these strong earnings are not sustainable. But at the current share price, earnings and profit margins could come down quite a bit and the company would still look like good value. In my analysis I pulled a number for future earnings per share of $10 out of my hat, assuming a moderate retracement of current elevated results. At that level, the stock would still sport a very enticing p:e ratio of 6. In fact, EPS could fall quite a bit more than that and the valuation would still look attractive.
It seems to me that the downside has been more than fully priced in. I think the market is being too skeptical. There are challenges the company will no doubt face in the future, but this has been a well-run retailer in the past and it is just finishing up a significant restructuring which by all appearances has been quite successful. They made a sizable new acquisition recently that they can play with going forward. I am half convinced that management is correct and that they can sustain earnings at these higher levels and even build on those. If so, this looks like a fantastic deal and I’ve bought into it whole heartedly.
Of note: The company is due to release Q1 results on Thursday morning. If they’re good, the stock could pop. If they’re a disappointment, the stock price could drop. I debated waiting until results are in to make my decision, but the story looks compelling enough to me that I decided to jump in early on the chance that Q1 results will beat what appear to be very low expectations.
Just Do It
Signet Jewellers was the last of the four new stocks that I bought in the past week and by the time I got around to it, I had already used up all my excess cash. Meaning I had to sell something else from the portfolio to make room for it. After looking at the sale candidates, the symmetry of selling one retailer to buy another appealed to me and so I sold off my position in Foot Locker to make way for Signet.
This is a somewhat jarring about face from my decision only a few months ago to double down on Foot Locker after its fall from grace. But after my recent review of the retail sector following Q1 results, I came across a few other companies that were trading at similarly low valuations, but without the baggage that comes with NIKE’s impending departure from the Foot Locker stable. Signet was the cheapest of these and I’ve got one or two others under consideration, so I felt that switching horses was justified.
While Foot Locker is cheap, it may take some patience to see this one out. NIKE is reducing their footprint in Foot Locker stores starting in Q4 of this year. As a result, the company has guided significantly lower in its earnings expectations for the year, hence the decline in the stock price. While the p:e looks low relative to this year’s reduced earnings (p:e 7.5), my worry is that next year could be even worse. My understanding is that it won’t be until Q4 that the full impact of NIKE’s pullback will be felt and so next year, Foot Locker may be facing additional headwinds as they contend with a full year of reduced NIKE exposure. Longer term, NIKE may well continue to reduce its presence in Foot Locker stores. That could create a drag on profits and keep a lid on the stock price. Given that I think I can find retailers with similarly low valuations but without this overhang to contend with, I decided to sell Foot Locker and buy Signet instead.
International Money Express – IMXI.NASDAQ
In the sluggish growth environment of the last decade, I’ve often had trouble finding higher growth stories to add to the portfolio. They still exist, but they’re not as common as they were in the 90’s and 2000’s, at least not outside the tech field. And the high growth opportunities that do exist typically come at a significant premium.
So I was pleased to come across this rapidly growing money transfer service. It is very decidedly low tech and old school which is probably why I can buy it for something approaching a reasonable price. I was still forced to pay up to buy in, mind you. I put the current trailing p:e at around 16, relatively steep compared to my other more pedestrian holdings. However, this company has been growing quickly, more than doubling profits in the past 2 years. The company is guiding for EPS to grow another 25% or so this year and is aiming for a doubling in the next 3.
IMXI operates a money transfer service, principally aimed at Hispanic immigrants who want to send money home to their families in Latin America. They’ve got a market leading position in this space and come highly regarded in the community. They operate through locations spread across the US but concentrated in the south where the largest Hispanic population is. They currently are setting their sights on greater expansion in the west and even the northeast with a recent acquisition of a money transfer service to Europe.
While they do have some online presence and a passable money transfer app, their bread and butter is the transfer of physical money often for the unbanked (on either end of the transaction). If you want to get $300 in cold, hard cash to your Grandma in Mexico or Guatemala this is often the fastest and most reliable way to do it.
They compete against much bigger players like Western Union and Moneygram and against a slew of online start-ups. Not to mention, of course, cryptocurrency.
No doubt, this is why the stock price is depressed. I do admit, this caused me significant pause as well. I did a review of this company last fall when the share price was 20% lower and decided to pass. But the company has continued to grow since then, it’s put up another couple of great quarters and the guidance for the upcoming year is quite positive. The CEO sounds exasperated on the conference calls when he says that everyone is focused on the latest high tech money transfer start ups and ignoring the fact that physical retail transfers still make up the lions share of the market and are growing quickly.
I often buy in to disrupted industries, not by buying the disruptors which are typically priced for perfection but instead by buying into the legacy, disrupted companies at a cheap price, hoping that they can adapt, survive and even prosper. The low price often, though not always, offsets the challenges caused by the disruption.
That is the case with Linamar, where I think the opportunities available in electrified vehicles can offset the declines they face in the legacy internal combustion market. It’s the case with Omnicom Group where I believe they can find opportunity and success in the rapidly evolving online advertising industry and I am hoping it is the case with International Money Express. I bought into this stock last week at a price of around $20.85.
In a very similar vein, I also bought shares in Sylvamo, a global paper manufacturer.
Sylvamo – SLVM.NYSE
Like IMXI, Sylvamo’s industry is under attack by technology. The use of physical paper is in secular decline. People are getting used to working and transacting online and relying less and less on hard copies. I don’t see this trend changing, nor does the management at Sylvamo. But they do see an opportunity to service a flat or slowly declining market with a global fleet of low cost, vertically integrated paper mills. They think they can earn good money for years to come by being one of the cost leaders in this industry and can pass that cash flow back to shareholders.
At the average $51 share price I paid for my stake last week, I bought into this potential cash cow for 7 times earnings. I’m not looking to shoot the lights out on this one, but I’m hoping for a solid return as they execute on their strategy, pay down debt and start passing their cash flow on to shareholders.
The company was spun out of the much larger paper company, International Paper last year. Sylvamo specialises in printer and copier paper and produces the well-known brand “Hammermill” along with several others. They have operations in North America, Europe and Latin America. Their business is highly vertically integrated which they think gives them a competitive advantage, especially in this environment of spiraling commodity prices. They own their own timberlands, do their own harvesting, and process their own logs to produce the pulp they need to make their paper. 78% of their energy requirements are met with biofuels that they generate from the cast-offs of their own pulp operations. (They use the bark and off-cuts to power their plants.) They say that their plants rank in the highest quartile worldwide for cost efficiency.
So the basic building blocks seem to be there. The company is going to use its cash flow over the next year or so to pay down debt which should bring it down to a comfortable 3 times earnings. After that, it has identified a few high return (25-50% IRR) projects that it can invest in and shortly after that, it should start to return money to shareholders in the form of dividends and share buybacks. When and if that happens, I am hoping the stock price could re-rate higher to reflect a strong and sustainable dividend.
This is a new entrant to the public markets and the company still has to prove itself. The scenario might not unfold as seamlessly as I would hope. I wonder if perhaps their depreciation expense is under-estimating the amount they will have to invest back into their paper mills to keep them in good working order. For their US operations, which make up 35-40% of their total, they are reliant on a supply contract with their parent company which could be terminated at some point and leave them scrambling for a replacement. To date, the decline in demand for paper has been offset by companies leaving the sector, shutting down older, underperforming plants or converting existing plants from paper to packaging. This may not be the case in the future.
So there are risks to be sure, but there is also decently good upside. If the company can demonstrate market average growth through a combination of stock buybacks, dividends, acquisitions and targeted plant improvements then it could merit a p:e closer to the market average of 16-17, offering the possibility of a 2 bagger or greater from current levels. And if instead, earnings stagnate, there is still room for that p:e to make some more modest gains to bring it into line with other companies that have a similar growth profile.
Preformed Line Products – PLPC.NASDAQ
Finally, I welcomed an old alumnus back into the fold. Preformed Line Products makes fasteners, connectors, cabling, housing and various other bits and bobs necessary for building and maintaining electrical and telecom networks. They provide many of the boring, but essential building blocks for the electrical grid which seems like it might be a good business to be in as we rush headlong into a greener, more electrified future.
I made a stab at this stock once before, about 3 years ago, but I got scared out by an unusually bad quarter only a few months after I bought in. In retrospect, that quarter stands out as an anomaly. Earnings recovered the very next quarter and have been consistently strong since then. In fact, earnings today are over 50% higher than they were 3 years ago while the stock price is only up 16%. That disconnect led me to take a second look at this company and I liked what I saw.
On a trailing 12 month basis, the p:e is 8.7 at the $63 range I bought into it at last week. The balance sheet looks healthy, the recent performance has been good and in their Q1 results, the company said its backlog was extremely strong, which hopefully will help to maintain current earnings and could provide the fuel for additional near-term growth. They are instituting price increases to counter rising input costs which will hopefully keep them ahead of inflation.
Given the valuation, a 2 bagger seems a real possibility, especially if the company can maintain its momentum and continue its streak of solid year over year growth. I think what has been holding the stock price back is the slump the company went through in the mid 2010’s. Longer term, looking way back to its genesis on the public markets in the early 2000’s, this company has grown at a market average rate of about 7% per year in addition to paying shareholders a regular dividend. All other things being equal, that should merit a market average p:e of 16 or 17 and indeed, the stock has at times traded at that level. However, there was a period from 2013 to 2019 when sales and earnings slumped, and I believe this is keeping a lid on the stock price now. I’ve gone back and looked at their reports from this era and I don’t see any obvious explanation for the slump. The company stayed profitable throughout this time period, but business was just not as brisk. I suppose there is the real possibility that another slump like this could occur in the future, but for the moment, the near-term outlook looks positive. I’ve bought into this with a long-term view and am hoping I don’t get thrown by another lumpy quarter.
Back To Business
As I mentioned, I’m only partway through my first quarter review. I wanted to pause and get my thoughts down on these initial four companies before all the facts and figures started muddling together in my head. I also wanted to post on Signet Jewelers in case anyone wanted to join me in a speculative stab at this stock before results get reported later this week.
I’ll be diving back into my review tomorrow and am hoping to find another one or two new prospects. I’d love to add more Canadian stocks to the portfolio, but I’m constrained by the size of the market. There just aren’t that many companies to choose from on my home turf. Nonetheless, I’ll be combing through the less likely parts of the market, the unprofitable companies, the more heavily indebted companies and the mining sector, to see if maybe I might uncover something juicy.
There is a lot of doom and gloom out there right now. The pendulum seems to be swinging back the other way again from breathless optimism to rampant pessimism as this market tries to find an even keel. A recession could be in the cards, but that doesn’t worry me overly much. Stock prices have retreated and valuations, while not cheap by any means, are no longer as scary as they were at their zenith last year. We could easily squeak by with a mere slowdown like the one we saw in 2012, 2015 and 2019. I’m already looking across the valley and trying to position myself for an eventual recovery on the other side.
After a tough slog during the height of the mania, I feel like the market is opening up. I feel like I’ve got choices once again. I don’t just have to take whatever meagre scraps of value the market will give me. I can pick and choose. Do I buy this retailer or that one? Do I buy this steeply discounted turnaround play or that moderately discounted growth stock? Do I add another auto parts company to the portfolio or leave all my money on the one I’ve got? Maybe I put a few companies on my watchlist and mull them over for awhile before committing. At these prices, maybe I can afford to take on a bit more risk.
In short, I’m having fun again!
Full disclosure: I own shares in Signet Jewelers, International Money Express, Sylvamo, Preformed Line Products, Linamar and Omnicom. I do not own shares in Foot Locker.