Yesterday I mentioned the threat of Amazon and its effect on the Aussie retail industry. JB Hi Fi’s [ASX:JBH] share price promptly fell 3% to a five month low.
Another dominant and well-run retailer, Super Retail Group [ASX:SUL] saw its share price fall 1.6%. It’s not far off multi-month lows either.
These are quality companies that are heavily out of favour with the market. Will they continue to be out of favour? Probably. Trends tend to run further than you think possible. Just look at Bitcoin…
The reason I’m bringing this up is that the way to make money in the long run is to focus on what’s not hot in the market. When something is unpopular, there’s usually good value there.
Think of it this way…
You’re at a dinner party or a bar with some friends. Someone mentions they own bitcoin and a bunch of tech stocks that are set to ‘disrupt’ (it’s a buzzword now) whatever industry they’re involved in.
They appear to know what they’re talking about. People are impressed and everyone asks lots of questions.
You, on the other hand, own JBH and SUL, which you sheepishly admit. You’re immediately told by the group that Amazon is going to eat their lunch, and that you should cut your losses.
No one asks for your opinion on anything else. You feel like an idiot.
It’s a fictional conversation, obviously. But it’s probably not too far from the truth.
The thing to consider here is what everyone knows. People know that cryptocurrency and tech is cool to invest in. Past price performance tells you that.
But people tend to extrapolate and forget the old adage that past performance is not a reliable guide to the future.
And people know that Amazon is cool…and that just about every other retailer is toast because of it.
This is when things get interesting from an investment perspective. You need to stop yourself from thinking with the herd and look a bit more deeply into what is going on. You need to think about what everyone else is thinking about. And then ask yourself if that is in the price.
As it stands now, you can tell what everyone else is thinking by looking at the valuation metrics of the two retailers I’ve mentioned. Both trade on a price-to-earnings (P/E) ratio of around 10.5 times expected earnings in 2018.
That compares to a market average P/E of 16.3 times. In other words, these retailers are trading at a 35.5% discount to the market.
That doesn’t mean they’re cheap. But it does mean you should do a bit of work and try and understand the businesses, instead of ignoring them and chasing what’s hot.
I must stress that I wouldn’t buy them right now. Both stock prices are in a downtrend, and one of my rules is not to buy in a downtrend. No matter how cheap or attractive a company is.
But you can certainly get ready to buy with confidence once the trend turns. That means you won’t buy at the bottom. But no one can do that consistently anyway. The aim is to get in at the start of a trend change.
There are a few characteristics that I like about these businesses: They are profitable and generate plenty of cash.
By profitable, I mean they generate high returns on shareholders’ equity…around 18% for SUL and 25% for JBH.
The golden rule of wealth creation is to generate a higher return on equity and assets than it costs to fund those assets.
If a company’s cost of capital is 10% but its return on invested capital is 20%, then it’s doing very well. It’s creating wealth.
The thing is, the market doesn’t always care for this. Sometimes it rewards companies who destroy wealth, while ignoring the wealth creators. That’s why Benjamin Graham said that in the short run, the market is a popularity contest. Or as Buffett put it, a voting machine.
But in the long run, the market is a weighing machine.
Because these two companies generate high returns on equity and capital, they generate significant cash. It allows them to pay a dividend, invest in growth, and pay down debt quickly if they need to, or buy back shares.
All of these things enhance shareholder wealth. The market may not care in the short run, but in the long run, it cannot help but reward the economics of these businesses.
While these companies (and others in the sector) look interesting from a value/quality perspective, it’s still too early to buy in. That’s because the sector is still trending lower.
Have a look at SUL’s share price chart:
Since peaking in March, SUL is down around 30%. As you can see by the moving average lines, the trend is still down. There’s no point fighting the trend. So the best course of action is to step aside for now.
In the meantime, keep your eyes on the sector. Read any announcements about trading conditions or the Amazon effect. And get ready to buy when the cycle turns.
This is something I’m keeping in mind for subscribers of Crisis & Opportunity as we head into 2018.
Editor, Crisis & Opportunity