A value investor is always looking for bargain stocks to buy. With the US stock market trading at a P/E of around 22, it's hard to find cheap good quality stocks.
However, if you have been paying attention to the retail business environment, you may have noticed that retail industry is not doing so well as more and more stores are closing their doors and have been reporting dwindling sales for the past several quarters.
Lot has to do with the changes in customer's shopping habits and preferences when it comes to shopping online versus B&M store. Amazon is also not making things easier for these legacy retailers, even though many of them have online segment.
I personally still like to go to a physical store when I want to buy clothes, shoes, or something that I want to touch or try before buying. It's also fun to just window shop.
I believe that B&M stores will always be around as people do like to shop for its getting-out/entertainment experience which Amazon or online shopping lacks.
Looking into apparel stores, I see a few opportunities in terms of stocks that are trading at their historical low valuations while paying hefty dividends.
There are three such stocks that I've my eyes on. These are Kohl, Macy's, and Nordstrom department stores.
I always start my analysis by looking at the company's fundamentals. I also like to compare them against their competitor's to see which one is a better risk/reward for my investment.
On purely, valuation multiple basis, Macy's comes as the cheapest and Nordstrom being the most expensive. However, note that even at the P/E of 20.4, Nordstrom is still cheaper than the overall S&P stock market. Kohl is close to the bottom but not quite as cheap as Macy's but still a close contender.
Dividend Quality & Growth
Dividends are one of my primary reasons for investing in stocks. Therefore, I like to pay special attention to dividend health in terms of quality and growth.
A dividend is considered a quality dividend if it has an above inflation yield, a good coverage through earnings and/or free-cash-flow, and has a long-term growth history.
Looking at these dividend quality metrics, we can see that all three of the companies pay a very nice dividend. Both Macy's and Kohl even pay a dividend close to or in excess of 6%.
Normally, I would not buy a stock in a company that pays this high of a dividend unless they are REIT or facing a major industry or economic downturn.
I guess we can say that retail industry is facing an industry specific challenge/downturn due to increase in online competition. This is likely to be a temporary or short-term downturn and good solid retailers should survive in the long-term; however, not without some near-term pain.
This near-term pain provides investors a good opportunity to pick up some of these bargain stocks paying exceptionally high dividends.
Looking at the payout metrics, all three retailers have their dividends covered through earnings and free cash flow. The dividends are also growing at a double digit growth rate.
Kohl has the most coverage for its dividends through FCF payout ratio of only 22.5% while Macy's and Nordstrom not too bad either. A FCF payout ratio of less than 50% is usually considered pretty good.
Overall, dividends look safe or amply covered and growing at a healthy rate.
As for the balance sheet, all three retailers have good interest coverage multiples ranging from 4.4 to 6.7 with Nordstrom having the most coverage. Kohl and Macy's have about the same interest coverage. Interest coverage indicates the ability of a company to cover its debt servicing (i.e. interest payments). It's calculated by Interest Expense divided by EBIT (earnings before Interest and Taxes).
With the exception of Nordstorm, they all have reasonable debt/cap ratios. Nordstorm having a high 79% debt/cap ratio is somewhat troubling; however it can easily afford to pay the interest on this debt as indicated by the interest coverage ratio of 6.7.
S&P credit rating for Nordstorm is the highest BBB+ among the three retailers. Note that a credit rating below BBB- is considered a non-investment grade rating (high risk) and should be avoided.
All three of these retailers have investment grade credit rating.
Return-on-Assests (ROA) should be greater than 5%, ROE I like it over 10%, and FCF/Sales should be greater than 5% as that is the definition of a cash cow when it comes to a business. You want the business you are investing in to be generating lots of free cash flow as a function of sales.
Kohl is clearly the biggest cash cow among the three retailers with Nordstorm coming in second and Macy's being the last.
Fair Value Estimate
I cannot buy a stock without knowing its fair value. In short, a fair value is the intrinsic or true value of the stock/business and not what the market thinks it's worth. It is the value that defines whether you are over paying for a stock or underpaying.
The higher price you pay for a stock the lower is the chance for making big profits. Whereas if you buy a stock at or below its fair value, you are increasing your chances of making a big profit as the stock price in the long-term tends to follow its fair value.
Just because a market is asking a multiple of 20 for a stock, it doesn't mean the stock is worth that much. This is where one has to take special care in determining the fair value and then look for the right opportunity to buy that stock at or below the fair value.
So how does one go about calculating a fair value?
Unfortunately, there is no blue book for stocks. Instead, there are several different ways or formulas to determine the intrinsic or fair value of a given stocks. There are well known standard formulas such Graham Dodd and Discounted Cash Flow and then there are proprietary methods used by Morning Star, CFRA, and analysts.
Good news is that you don't really need to learn these formulas or methods as the tools and analyst reports take care of math behind them, though it is still a good idea to at least know how Graham Dodd and DCF formulas work. When I was starting to learn investing, I used to calculate fair value by hand using these formulas for every stock I wanted to buy.
Later, I became a bit lazy and started using the tools and reports to get the fair value.
If you have a brokerage account then you should have access to analyst reports. There should be at least a handful of reports available per stock for free.
My method of determining fair value consists of five steps:
1. Use FastGraphs Estimator to determine fair value based on next year's earnings.
2. Use FastGraphs 5-Year Normal P/E estimator.
3. Use CFRA report fair value.
4. Use Morning Star fair value.
5. Calculate the average, that's my fair value.
Both FastGraphs and Morning Star are a subscription based services, but they are worth it and not terribly expensive. BTW, I got a really good deal from Morning Star for a year of premium subscription for only about $60. That's a super cheap deal given their normal subscription runs for a few hundred dollars a year. If you want to know how I got the cheap deal from M*, leave me a question in the comment section.
Anyway, below is the fair value as I calculated or looked up through my four valuation methods:
Macy's is trading at the most discount of 41% to its fair value while Nordstorm has the least discount but still at 11.5% lower than its fair value. Kohl is somewhere in between the other two.
Remember, just because a stock is trading at the most discount doesn't make it a good stock to buy. A high discount most likely indicates higher risk.
Given these three stocks and the metrics I looked at, I would be comfortable buying either Kohl or Nordstorm. I would pass on Macy's as too risky and likely a speculation candidate.
If I want to be absolutely safe, I would go with Nordstorm as it has the best fundamentals among the three while still paying a very nice dividend yield.
As always, please do your own due diligence before buying any stocks or investing in the stock market in general.
Disclosure: At the time of writing this article, I do not own any of the stocks mentioned above. However, I may start a position in Kohl and/or Nordstorm in the next 48 hours after doing some additional research. All data presented in this article is accurate to the best of my knowledge and at the time of writing this article. Sources of data include FastGraphs, Morning Star, SeekingAlpha, and CFRA.
Disclaimer: Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. Any mention of stock names/tickers in this article or website is not a recommendation to buy or sell. This article is for informational purpose only. Full disclaimer can be read here: Full Disclaimer