Intuitively, people know good value and want to buy items when they’re on sale.
This also applies to the stock market. We can examine multiples, but determining true value requires understanding business fundamentals. Buying a fridge on sale is a done deal — the price paid relative to its value and utility is known. But buying a stock on sale is more complex: context matters and utility is uncertain.
Consider Tim Hortons, an iconic and dominant consumer franchise. It doubled over a two-year period, but the price dropped by more than 20% over the ensuing seven months, even hitting a 52-week low.
This should whet value investors’ appetites, especially when there aren’t many opportunities outside the TSX’s largest sectors, Financials, Energy and Materials.
But consider the outside view, as described by Michael Mauboussin in his book Think Twice: “The inside view considers a problem by using information that is close at hand. The outside view […] asks if there are similar situations that can provide a statistical basis for making a decision [and] wants to know if others have faced comparable problems.”
To develop the outside view, consider the path followed by other Canadian retailers (see “How four Canadian companies have fared” and “P/E ratios have dropped,” this page).
Shoppers and Loblaws have the longest records. At their peaks, both traded at multiples in excess of 20 times earnings for extended periods, thanks to strong growth and limited alternatives.
However, multiples contracted as competition intensified and the market became saturated. Shoppers Drug Mart’s growth was also impaired by increased drug price regulation, while Loblaws faced supply chain issues, poor information systems and duplication of management. This led to underperformance.
The outside-view conclusion: a dominant retail store can command an elevated multiple for an extended period, as Canadian investors, starved for ideas, crowd into businesses demonstrating strong growth. However, contraction is assured when growth slows.
Knowing this will inform decisions on the prospects of Tim Hortons, which is nearing saturation in Canada. The company estimates its 4,000 stores provide four years of unit growth at 5% per year. Through the end of 2011, Tim Hortons’ store count has grown at roughly 4%, so, somewhat counter-intuitively, planned growth is accelerating as the business comes closer to saturation.
Tim Hortons’ earnings growth has materially benefited from expanding its menu beyond donuts and coffee, and replicating this tailwind could be difficult. From a fundamental perspective, future growth looks challenging. There’s reason to regret not participating in the doubling of Tim’s stock through the beginning of 2012.
However, this same analysis can be applied to another opportunity: Dollarama. The fast-growing Canadian store also has a high multiple. Its fundamentals are strong: square-footage growth is between 6% and 10% and same-store sales growth has been accelerating at 3%-to-5%, versus Tim Hortons’ 2%, though Tim’s weakness has been partially cyclical.
The industry also provides a secular tailwind as Canada has fewer stores relative to the U.S., requiring a minimum of five-to-six years of growth to reach the same level of penetration — and likely longer as the U.S. market continues to increase store count at 6% annually.
The barriers to entry are low while the barriers to success are high, reflected by independents disappearing from the landscape. The case for Dollarama is further enhanced by its rapidly rising free cash flow — all of which is being used to benefit equity holders by deleveraging the balance sheet, repurchasing stock and increasing the recently instituted dividend.
The chart “P/E ratios” shows Dollarama trading at a premium to Tim Hortons on trailing earnings. But on a forward-earnings basis, both businesses command similar multiples. The lesson: value investing isn’t just multiples and perceived discounts. Even examining the underlying fundamentals of the business is not enough. Take the outside view to understand a company’s entire context.
In this case, precedent supports an extended period of elevated multiples, though the fundamentals reveal two businesses heading in different directions.
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Ken O’Kennedy, CFA, is a partner and portfolio manager at Dixon Mitchell Investment Counsel and manager of the Pender Canadian Equity Fund.
Originally published in Advisor's Edge Report
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