What makes us want to buy into a business?
Of the hundreds of businesses we have analysed over the last 12 months, only a dozen or so have ended up making it into our portfolios. Here we explain how we decided one stock had made the grade
Discussing individual stocks we own can be tricky, here on The Value Perspective. Regulatory considerations prevent us writing about those we have just bought or are weighing up, while focusing on those we bought or passed up a while back can leave us open to accusations of trying to look wise after the event.
Hopefully the example of Dillards, which offers insights into how we think about potential purchases, avoids both pitfalls.
And no, this time last year we had not heard of Dillards either.
Last summer, though, the US-based department store chain began to flash up on our screens, largely because its share price had dropped a third from $79 to $56 in the space of a fortnight – and indeed it had been as high as $140 in April 2015.
It had not risen very much higher by this January when we highlighted the stock at a number of public presentations – which is why, now it trades around the $90 mark, we feel OK mentioning it here.
Before buying in, we went through our standard analysis process, including building a 10-year model of the business to understand its history and running through our checklist of seven ‘Red’ questions.
As we wrote in Big tick, these are the questions we ask of every single company we consider as a potential investment, addressing the different aspects of any distressed business that need to checked and double-checked.
Our seven ‘Red’ questions
* Has anything been missed off from the company’s enterprise value?
* Have profits – that is, the company’s net operating profit after tax – been misrepresented?
* Is the company’s past a good guide to its future?
* Do the company’s profits turn into cash?
* Is the company’s balance sheet good enough?
* Is the business itself good enough?
* Are there other risks to consider?
Source: The Value Perspective
After we had finished all of that, the business still looked interesting so we went a stage further. We analysed Dillards’ competitors – 22 other retailers in the US and the UK – with a view to calibrating what they had all been doing.
What, for example, had the financial performances of these businesses been – the good ones and the bad ones, the ones that kept growing and the ones that had stopped?
As we explained in more detail in Value investing skills #3, for every single business we analyse, we grade the associated risk out of 10 and we look at the potential upside to what we have calculated as the stock’s fair value – its ‘normalised target price’.
What that means is we can look at a business at any point and consistently conclude, given its risk score and potential upside at the market’s current valuation, whether we want to invest.
By the time we finished this process with all 23 businesses, we reckoned Dillards had the long-term potential to more than double our money – obviously a hugely attractive prospect for any investor.
Three other reasons why we invested
Three other aspects that emerged from our analysis are also worth picking out – the first of which is governance-related – Dillards is a family-controlled company, which means external shareholders have no real influence on how the business is run.
Second – and much more worrying – was the long shadow cast across all other retailers by Amazon.
The way we accounted for that risk was, in our model of the company’s future finances, to reduce Dillards’ prospective sales by a fifth. Even after we had taken the ‘Amazon factor’ into account in this way, however, we still ended up with that very significant potential upside.
The final point of note was the company’s balance sheet. For one thing, Dillards has taken on only modest debt but, more interesting, is that while most retailers lease the majority of their premises – creating large off-balance sheet liabilities that have caused real problems for the likes of Carpetright – Dillards owns 90% of its stores.
A lot of work goes into stock selection
Yes, that is a lot of work to decide whether or not to buy a single stock but, at the end of it, we had identified a business we believed had the long-term potential to more than double in price – even after accounting for some of the risks posed by Amazon.
There were other risks to be aware of also – not least the governance question – but, on the plus side of the equation, also stood the company’s very strong balance sheet.
As we wrote in Value investing skills #4, only 3% or 4% of the 300 or so business we have analysed as a team, here on The Value Perspective, over the last 12 months have ended up in our portfolios.
Dillards is the sort of stock that makes the grade.
Note that we have used Dillards as an example only and it is not a recommendation to buy or sell the stock yourself. Please remember also that past performance is not a guide to future performance and Dillard's (or any other stock's) results may not be repeated in future.