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Jubak's Journal
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4 stocks that Peter Lynch would like
In troubled times, consumers substitute cheaper goods and services for the more expensive. For the savvy investor following the legendary Lynch's formulas creatively, that spells opportunity. Here are 4 stocks to consider.
By Jim Jubak
Peter Lynch called it the amateurs edge, the ability of non-professional investors to outperform Wall Street professionals because 1) they invested in what they knew, and (2) they werent blinded by Wall Street conventions.
This is how Lynch (and co-author John Rothchild) begin the chapter in the classic One Up on Wall Street on how to find a 10-bagger, a stock that will go up 10 times while you own it:
The best place to begin looking for the 10-bagger is close to home -- if not in the back yard, then down at the shopping mall, and especially wherever you happen to work.
I think thats still great advice for the individual investor. But I think it needs a bit of a tweak to fit current conditions.
Lynch was writing in the midst of a fast-growth economy that produced a massive explosion in creativity in the consumer sector of the economy. Companies like Wal-Mart Stores (WMT, news, msgs) and Dell Computer (DELL, news, msgs) were inventing new ways of doing business. Startups like Starbucks (SBUX, news, msgs) and Whole Foods Market (WFMI, news, msgs) created new market niches and then took them into the consumer mainstream. The amateur investor with an ear to the ground could identify these new businesses early enough to get in at the first stages of opportunity.
A different world
The current environment is quite different. Growth is tepid at 1.6% in the first quarter and at a projected 2.5% or less for the entire year. The creativity that characterized the earlier period has given way to consolidation and extension, as the Dells and Starbucks and the like build on their earlier momentum.
That doesnt mean that the current consumer sector isnt going through big changes now -- and wont go through even bigger changes in the years ahead. But if the current period of below-average growth turns out to be an extended one, and I think theres a good chance that it will, then the consumer sector wont be characterized by companies exploiting new demand, but rather, by companies trying to take advantage of what I call substitution.
Substitution in the current economy takes place whenever any consumer decides to buy one product in place of another because:- He wants to save money
- He wants to maintain as much of the psychological pleasure of buying the higher priced product as possible.
Substitution is about finding a way to get the same kinds of ego gratification, personal fulfillment and emotional pleasure out of consuming as we get now, but at a lower cost. (Substitution is actually a fairly hopeful state since it indicates that consumers are not so worried about the future that they are looking to reduce spending at any cost.)
The substitution solution
Substitution can take place at any price point. At the upper end, a wine lover decides not to spend an extra $20 or $30 on a bottle of red wine with a rave rating from one of the wine magazines because an $18 no-name red is just as satisfying. Thats substitution.
Further down the price scale, deciding to buy a new pair of earrings to freshen up a familiar outfit rather than buying an entirely new ensemble is substitution. So, too, is planning ahead to buy that favorite Nora Roberts bestseller at the next trip to Wal-Mart rather than impulsively buying it when you see a display in a bookstore window. And so is deciding to bring home a take-out meal from Boston Chicken rather than taking the family out to some casual-dining restaurant.
Substitution doesnt mean denial. Far from it. After all, the consumer is still buying something.
But the change in whats being bought is enough to throw a consumer sector into turmoil. When consumers substitute one product for another (store-brand crackers for, say, Wheat Thins), new winners emerge, and some companies inevitably lose. Remember that substitution is close to a zero-sum game. Companies positioned by luck or skill to catch the direction of a substitution can ride the trend a long way -- sometimes all the way to permanent gains in market share. Companies with competitive advantages such as flexible pricing, lean inventories and just-in-time marketing gain an even bigger edge during a substitution economy.
The amateur's edge
Going back to Peter Lynchs original point, amateur investors do have an edge in separating the substitution winners from the losers.
Substitution is a very complex behavior since it involves a balancing of price and personal satisfaction. So you cant predict what will happen merely by looking at which companies are the low-cost producers or which companies serve the discount segment of the consumer market. As consumers themselves with lots of friends who are also consumers, amateur investors have in-the-trenches knowledge of what is being substituted for what. But your own reaction to the complexities of psychological value in this economy may well be the best place to start. And thats a significant edge as investors try to figure out where the current economy and stock market might be headed. (I concede its dangerous to generalize from your own individual behavior to that of consumers as a whole.)
Here are my own four very personal substitution stocks. Use them to jumpstart your own thinking about how substitution is changing the consumer sector -- and the lineup of winners and losers.
Claires Stores
The largest retailer of teen-oriented fashion accessories in the world (items are typically priced at $2 to $20), Claires Stores (CLE, news, msgs) is a classic substitution play. When the economy gets tight and consumers look to pull in a little, previous economic slowdowns tell us that theyre likely to substitute small, feel-good buys for more expensive, big-ticket purchases. Wall Street projects that Claires earnings per share will climb 17% in the fiscal year that ends in January 2004 and 12% in fiscal 2005. If history follows form, the substitution effect should give those projections plenty of protection, even if the economy continues on its current slow-growth path. The stock now trades at just 14 times projected fiscal 2004 earnings and at just 1.2 times trailing-12-month sales, a 10% discount to the price-to-sales ratio for the Standard & Poors 500 Index as a whole.
Ritchie Brothers Auctioneers
One strength of the idea of substitution is that it takes account of our desire to shop. In the early 21st century, shopping is one of the major leisure-time activities of the average U.S. consumer. If eBay (EBAY, news, msgs) werent so expensive, Id include that as a substitution stock in this column because eBay offers an incredible value proposition. Theres lots of shopping to satisfy the desire to shop and the ability to save money (or at least the perception of saving money) in the process.
Consumers, however, arent the only ones looking for value in this economy and willing to go outside traditional purchasing channels to do so. Ritchie Brothers Auctioneers (RBA, news, msgs), based in Richmond, British Columbia, hits that same value sweet spot -- but for the corporate purchaser of agricultural, construction, forestry, mining and transportation equipment. Wall Street projects the companys earnings per share will climb 20% this year and 9% in 2004. That latter number is likely to be low if the economy continues to grow slowly. In that environment, corporate buyers will look for ways to find equipment at a discount and a slow-growth economy will give Ritchie Brothers Auctioneers lots to sell. The stock trades at 19 times projected 2003 earnings per share.
GameStop
GameStop (GME, news, msgs) is the new brand name for a computer and video game retailer that combines the former Babbages, FuncoLand and Software Etc. chains. What makes GameStop an interesting substitution play for me is its rank as the No. 1 seller of used games. Of the companys 1,200-plus stores, the 45% in malls focus on impulse buyers looking for new games. The other 55%, located in strip shopping centers and other locations, target value-buyers and hardcore gamers looking for new game titles at value prices. And that often means used. But before you turn up your nose at the idea of buying a retailer of used games, consider this: Used games sell for a higher profit margin than new games. That has helped GameStop increase operating profit by 2.4 percentage points in the fiscal year that ended in January 2003. Thanks to its 1996 bankruptcy reorganization, the company carries almost no debt and showed $3 a share in cash at the end of 2002. Cash flow is positive, and the company is buying back shares. In the conference call after its May 21 earnings report, the company projected earnings per share of $1.03 to $1.06 for the fiscal year that ends in January 2004.
Longs Drug Stores
In a substitution economy, I expect consumers will try to curb impulse buying. But I dont expect them to succeed very well, despite their best intentions. The attempt, though, will shift where impulse buying takes place. In a slow-growth economy, the buying will likely occur in a store that consumers enter to buy necessities. The humble drug stores, the place most consumers have to go to get prescriptions filled, should reap a disproportionate share of that impulse buying, and no drug store chain is better set up to snare those impulse dollars than Longs Drug Stores (LDG, news, msgs). The companys stores are larger than those of CVS Corp. (CVS, news, msgs) and Walgreen (WAG, news, msgs), and managers already have the power to customize inventory to local tastes. That produces higher than average per store sales of high-margin items such as cosmetics and greeting cards. The stock trades at 17 times projected 2003 earnings per share.
The more substitution stocks to study like these come out of your own experience, the less likely this kind of analysis will feel fuzzy to you. For example, Ive personally spent a lot of time shopping for games, so I know the retail choices frustratingly well, and Ive spent more hours than I care to admit in our local GameStop with my son. I feel that Ive got a Lynchian personal understanding of this part of the consumer market that makes me confident enough to add GameStop to Jubaks Picks. (Full disclosure: I will be starting a personal position in the stock three days after this column is posted.)
But for those who like more numbers in their analysis and less psychology in their picks, in my next column, on May 30, Ill take a look at what I think is one of the best opportunities in the current market, balance-sheet restructurings.
New developments on past columns
Have you mortgaged your future?
It looks like the Senate and House have agreed on a tax-cut package of around $350 billion over 10 years -- if you believe the accounting. The package includes an immediate acceleration of cuts in individual income tax rates, a temporary increase in the child tax credit and a temporary reduction in the tax rates on both dividends and capital gains. To keep this measure in perspective, note that even if you count the whole $350 billion as stimulus for the slow-growth economy, on an annualized basis, its dwarfed by the $200 billion that consumers pumped into the economy in the last 12 months alone by drawing down on home-equity credit lines.
Updates to Jubak's Picks
Buy GameStop (GME, news, msgs)
Shares of GameStop came under pressure on May 22 after the company announced that it expected same-store sales to fall 6% to 12% in the quarter that ends in July. I think that has created a buying opportunity in the stock. To see why, youve got to understand where GameStop makes money. The projected drop in second-quarter revenue comes from an expected slowdown in sales of video-game hardware: Sony (SNE, news, msgs) and Microsoft (MSFT, news, msgs) only cut prices on their players by $20 instead of the anticipated $50 a machine. (Microsoft owns MSN Money.) But since hardware sales carry the lowest margins of all the stuff that GameStop sells, the per-share impact of that drop in hardware sales on earnings comes to just about 1 cent. Software sales, on the other hand, are projected to grow 25% to 30% for the quarter. I especially like the stock in this slow-growth economy because GameStop is the market leader in sales of used game software, and sales of used video games yield about twice the margin of new games. With about $3 in cash on hand at the end of the first quarter, climbing margins, and solid inventory controls, the companys operations and finances look solid. Earnings per share are projected to grow 15% to 18% this year. As of May 23, Im adding GameStop to Jubaks Picks with a December 2003 target price of $18. (Full disclosure: I will open a personal position in GameStop three days after this column is posted.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: : Microsoft, Pfizer and Whole Foods Market. He does not own short positions in any stock mentioned in this column.
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