True Value Wins in the End

“But I am convinced that Benjamin Graham was correct in suggesting that while the stock market in the short run may be a voting mechanism, in the long run it is a weighing mechanism.  True Value will win out in the end.” - Burton Malkiel                                                                                                       
Value investing, first defined by Benjamin Graham and David Dodd in their book Security Analysis, published in 1934, has a long and storied history.  Since this original introduction during the Great Depression, thousands of individual and institutional investors have accepted the ideas presented by Graham and Dodd as the “intelligent” way to invest your excess funds.

As we all know, the world is a bit different today than it was over eight decades ago, but the concept of value investing has stuck around.  We might question why this is so, given the great advancements in our abilities to dissect market and company data instantaneously.  I myself certainly have, but I know it is individuals who control the short and long term market price of any and all publically traded securities.  As long as individuals are making the decisions on prices, value investing will still be a valid approach to the selection of securities and portfolio management.

There are three primary beliefs all value investors must accept.  This is true whether one is a professional or an individual investor.  The first is that one can, through research, place a fair or intrinsic value on an asset, be it a stock, bond, or any other type of asset.  The second is that people will misprice these assets at times, and the third is that they will recognize the error of their ways and reprice the asset to fair value.

I am going to limit my discussion to publically traded common stocks.  The first belief that we can, through research, place a fair or intrinsic value on a business is easy to believe, yet difficult, if not impossible to execute.  Given public disclosure of just about every detail concerning the operations and financial results of companies, you would think that everyone would know how much a company’s business value is worth at any given point in time.   For the majority of companies, the public investor has been pretty accurate in determining a business’s current worth.  However, because all returns are earned in the future, not in the present, our research must try and place a future value on a business. 
 
 The second belief, that the public will misprice assets at times, is much easier for all of us to accept.  In just the past two decades we have seen massive mispricing.  The technology bubble, the real estate bubble, and the decline of the stock markets have reminded us that our ability to make decisions under stress has changed very little over the decades. 
The third belief, that we will recognize the error of our ways and reprice an asset to fair value, is also easy to believe.  Every market crash in our and our parents’ lifetimes have recovered in price.  There is no doubt that we will have another bout of euphoria in the markets, with prices appreciated well beyond any calculation of fair value, followed by a decline and another recovery.  However, I hope that it will not happen for a very long time.

It was easy for me to accept value investing due to the great teaching ability of Benjamin Graham.  As a professor he taught a few individuals who went on to make themselves and many families financially secure for generations.  Alas, I never had the opportunity to take lessons from him, but I have read his books.  He was the champion of teaching through examples.  It was through these examples that I came to understand the concept of buying low.  I believe you will find it easier to accept this concept if we do the same and share with you an example of an investment we made some time ago.

Target Corporation

We are using Target as our example company. Target’s recent experience demonstrates all three of the required value investor beliefs.  Even though the vast majority of us have visited and spent a dollar or two in a Target store, we may not have an understanding of the business history of the company.  The origin of Target began with the opening of the Dayton Dry Goods Company store in Minneapolis in 1902 by its founder, George Draper Dayton.  It was later renamed the Dayton Company in 1911, the Dayton-Hudson Corporation in 1969, and finally, Target Corporation in 2000.

Today the company operates 1,790 discount stores of which 1,536 are owned by the company.  The stores average 134,000 square feet and the company employs approximately 347,000 throughout their operations.  This is a large company, and for the majority of its existence it would be considered a growth company.  This brings up a problem for many pure value investors who concentrate their efforts on small companies, believing it is easier to find bargains with companies “under the radar.”  Large companies are known and followed by every analyst in the country, and because of this, they provide limited opportunities to buy at bargain prices. 

Of course I differ from that opinion.  I believe that large companies can be mispriced for many reasons, and, most importantly, believe that the public is quick to realize their mistakes and reprice to fair value in a shorter period of time.  In the case of Target, this mispricing took place because of a failed attempt to operate in Canada and because of a computer hack during the holiday season in 2013.  It is worthwhile to review some fundamental data on Target for the ten year period ending in 2013, the year of the hack.

In reviewing these results, a couple of items jump out at us.  You can see that the struggle of the Great Recession had limited impact on Target’s business.  Although the share price fell along with all other companies, the management ran Target exceptionally, with almost minor impact on the returns generated on common stock equity.  You can also easily see the results of the Canadian operations and the hack that took place over 2012 and 2013.

We purchased shares of Target in late spring of 2012 for an average price of $58.4.  We felt the market was punishing the share price of Target well beyond the impact the Canadian operations would have on the long term value of the business.  At our purchase price, we placed the fair value of the company at $68.41 per share which was 15.2 times trailing earnings per share, well within the average valuation of the company for the past ten years and close to 20% below the company ten year average.  At our purchase price we paid just 13.6 times trailing earnings, or close to a 30% discount from average.

In November of 2013, shortly after the hack was announced, we purchased additional shares at $65.4 per share.  That purchase was a bit easier, as the market punished the company severely.  The market value of Target dropped some $10 billion due to the hack.  After a review, we estimated that the cost of the hack to Target would be less than $100 million. 

There are a multitude of value investing practitioners.  Each will approach the process by their own somewhat unique method.  We believe that even conservative investors can find and purchase great companies at bargain prices.  The companies do not have to be small or obscure, nor do they have to be in the bottom decile of companies ranked by price-to-earnings or price-to-book.  They simply have to be consistent enough in earnings and operations to offer us a realistic approximation of fair value. They have to offer us a purchasing entry point due to marketplace mispricing. And finally they must be visible enough for the public to realize and correct that pricing error.

We saw all three of these characteristics when we first began to review Target. Given its size and history of operations, simple calculations produced a fair value.  The mispricing took place on two occasions based upon problems that could be corrected in a short period of time.  And once again, because of its size, the public quickly repriced the value of the company close to a fair value.

We still own the original shares of Target purchased in 2012 and 2013.  However, we have sold a few of these shares based on diversification and construction rules we apply in managing your portfolio.  At the current price of $80.9, there is a limited margin of safety in the price, so barring any major changes, we will not be purchasing additional shares.

Until next time,

Kendall J. Anderson, CFA