Portfolio Review: Barrick Gold

“Inflation is always and everywhere a monetary phenomenon” — Milton Friedman

I don’t like being dogmatic about my investments. Many investors (including many value managers) have taken to buying gold in large quantities in the sure belief that currency debasement by countries around the world will erode the value of paper money. The standard paradigms of monetary theory which are the basis for this belief have been pretty fluid lately (see: St. Louis Fed thoughts on Money Velocity), but the threat of money losing its value certainly remains given the unprecedented rises in money supply. I can’t help but hear Milton Friedman’s “inflation is always and everywhere a monetary phenomenon” in the back of my mind.

Commodities are a bad investment for the long term. Commodities don;t produce anything, so you are just betting that a the supply and demand relationship will change over time and the price will rise. In fact you have to bet that the price will go up fast enough to offset the cost of holding a commodity in storage. Gold is no exception, despite its stellar performance over the last 10+ years (Performance looks difference if you look back to the early 80s).

It was with all this in mind that I made an investment in Barrick Gold (NYSE: ABX) on September of last year for $18.28 per share. The stock is down about 10% since then, having traded in a relatively narrow band all year. It is still well below its previous highs of $50+ (when the gold price was topping new highs).

On the one hand, it is hard to escape the fact that investing in a gold miner is inherently a bet on the price of Gold. What I like about it however, is that by investing in a mining business (vs. investing in the commodity directly), you get the optionality that comes along with backing a dynamic business that will adapt to the circumstances. In the short term, there is not denying the impact of the spot price on the Company, but in the long term, Barrick Gold (like most good business interests) will adapt to the environment in which it operates and adjust its operations accordingly. After all, almost no business has complete insulation from the pricing environment of the good they produce.

If the spot price rises dramatically, the Company might race to develop new assets and increase production (like it did in 2012-13), even if that means a rising cost per ounce mined. Conversely in a less favorable pricing environment (like today), the Company will be more cautious, dial back production and focus on its most cost effective assets. The halted development of the Pascua-Lima mine is a case in point.

I was looking for a good way to illustrate and visualize this, and I came up with the concept of “All-in Sustaining Profits” (or “AISP”) for a given level of gold price realized. I don’t pretend that this little model is predictive of near term results, but I think it is indicative of the long term profit potential of the current stock of mining assets.  The idea is based on the Company’s published All-In Sustaining Costs (“AISC”) for its gold core mining assets, and it simply assumes that in the long run mines that can be operated as AISC below the realized gold price (i.e. “profitable mines”) will operate at production capacity, while those which would not be run profitably will not be run at all.  AISC takes into account sustaining capex, and therefore my estimate of total AISP is roughly corresponding to EBIT.

The table below outlines the key statistics provided by the Company for its key assets for the last 3 years (2014 = midpoint of the Company’s “2014 outlook”) and shows the calculation of AISP based on realized gold prices for the respective years:

Source: Company Filings.
Source: Company Filings.

I think it is worth emphasizing again, that this is a rough and indicative measure. There are lots of issues with it, including: AISC may rise and fall over time, the Company may be able to realize lower AISC at lower production levels (i.e. my “binary” assumption of whether a mine is run or not is poor) and mines that have received heavy investment might have cash costs that are low enough to keep operating them, even if the total AISC might categorize them as unprofitable—just to name a few. Notice that despite my comment above comparing my AISP to EBIT, looking at 2013 and 2012 at the Company’s average realized gold price for those periods it represents 85% of EBIT (2013 EBIT: 4,703m) and 75% of EBIT (2012 EBIT: 6,606m) respectively.

The chart below shows AISP and production levels based on the Company’s 2014 outlook at various levels of the Gold price. If anything, I think it is helpful to note that even at very low price levels, the Company would likely still be able to run profitably in the long run, even if that means being a smaller concern, exploiting a smaller set of assets

"All-In Sustaining Profit" and assumed production at various level of gold price.
“All-In Sustaining Profit” and assumed production at various level of gold price.

Value

In many ways the “value play” in this investment has a lot more to do with the original point regarding currency debasement. If this will prove to be a great investments, then some part of that thesis will be correct. The other face of the argument is ultimately more about downside protection and safeguarding against loss (a very important factor!).

Assuming 10x long term sustainable EBIT multiple (i.e. AISP in my example), The Company would retain its full current value even if Gold prices settled around $1,000 per ounce. Again, this is not to say that if the gold price dropped to $1,000 tomorrow and stayed there the Company’s stock would not go lower, but rather to imply that if that were a long term scenario, the chances of at least breaking even on the investment would be good. If I further assume that AISP should be “grossed up” to EBIT based on it representing 85% of it (again, a very rough assumption), then the gold price level at which the long term value of ABX remains attractive is even lower.

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Portfolio Review: Apple

Being the largest company in the world by market capitalization, there is a lot written about Apple. Obviously the Company is widely followed, and you would expect the market for its shares to be as close to efficient as a market can be, so what chance of outperformance is there? I am consistently surprised by how volatile the shares of such a large company can be: Over the last 18 months or so, the shares have traded for as high as $100 and as low as $64, while arguably nothing major has changed with respect to the long term value of the business.

Company: Apple Inc.

Investment Thesis: Apple is (1) a solid company with great stable of products. (2) it trades at a reasonable valuation and (3) there is great optionality in the future of the business.

(1) Solid Company with Great Stable of Products: I won’t dwell too much on this point. By some metrics, Apple is the largest company in the world. It’s main products are iPhone (53% of 2013 sales), iPad (19% of sales), Mac Computers (12% of sales) and iPod (5% of sales). It is a market leader and category definer across the board, sporting very high gross margins (37.6% in 2013) to prove it. It distributes through a variety of channels, including its own retail stores (13% of sales in 2013).

(2) Valuation: Apple trades at 15.7x trailing earnings. That is right around the long term average for the stock market and a fair value for business of the scale and clout Apple offers. The business is highly cash generative and has been actively returning capital to shareholders. Apple started paying a dividend  in 2012 and has grown it significantly since (current yield of almost 2%).  The Company has also been deploying significant capital towards share repurchases ($33.9bn over the last 12 months), especially while its share price has been somewhat depressed.

(3) Optionality in the future: Apple is not a bargain, it is fairly priced.  What makes the investment attractive is that we can earn a fair market return and get an option on the Company’s future developments. I feel confident Apple can continue to innovate enough to maintain its current level of earnings over a long time, and that alone would represent a good return on my investment. I really like the idea of buying a business at a fair price that will earn a decent return under regular circumstances, but have some upside in the event that a new product introduction is successful.

I think the chart below is instructive to see the effects of a successful product introduction:

Apple Revenue Growth since the introduction of the iPod (Source: CapitalIQ and Company data)
Apple Revenue Growth since the introduction of the iPod (Source: CapitalIQ and Company data)

The “next one” may or may not come. If it doesn’t then I expect my investment in Apple to have a mediocre but acceptable return.

Conclusion: Apple offers a good return for the level of risk in the long term. The Company has great products and generates a lot of cash. One new successful product launch in the next 10 years would be enough to make this a great investment. Even if that does not happen, I expect the company would generate an acceptable return.

 

Portfolio Review: General Mills

I made my investment in General Mills (GIS) in late November 2013 and paid $50 per share. The shares have not moved significantly since then and I believe the original thesis for the investment holds, but given that I have not written about it yet, I want to take this opportunity to describe it in more detail.

Company: General Mills (GIS)

Investment Thesis: General Mills is (1) a market leading in several strong food categories. (2) It is well positioned to grow internationally. (3) It’s current valuation is attractive given its growth potential.

(1) Market leader in good categories: General Mills is the owner of several markee brands including: Cheerio’s, Nature Valley, Yoplait, Progresso, Pillsbury and Old El Paso.

Cereal: Ready to eat cereal is the Company’s biggest segment, representing $3.9bn of worldwide net sales, and it is a good one. Cereal is the #1 food eaten for breakfast at home (28%; the next is fruit at 14%) and most people eat breakfast at home (80%) (Source: 2014 Investor day presentation, The NPD Group’s national eating trends). Moreover, it is a sector where brands really matter, and General Mills owns many leading brands.

Yogurt: Greek yogurt changed the landscape in this category and this hurt Yoplait’s overall leading positioned. General Mills may have been ‘late to the party’, but they have added a full range of Greek yogurt offerings and are getting good traction. They have now captured 10% market share of the Greek yogurt market. There are also good signs that the decline in original style yogurt has now stopped and that business should be stable to growing going forward. Yogurt in general is a great product–people who consume it tend to do so regularly.

Better-for-you snacks: This has been an area where most food companies have been struggling to meet consumer’s rapidly changing tastes. Seems like there is a new health craze every day, and it is hard to keep up. General Mills has a good set of products and a fairly methodical approach. They have been successful with a few key brands including Larabar and Nature Valley. These products represent a significant portion of the Company’s snacks business, which is encouraging.

(2) International  growth potential: The Company generated $6.6bn of net sales outside the US in 2014 (35% of sales). $5.4 billion in their direct international segment (excluding JVs) broken out below:

 

International Sales Breakdown (Source: 2014 AR)
International Sales Breakdown (Source: 2014 AR)

This has grown significantly over the last few years, although 2014 represented a year of slow growth:

International Sales and Operating Profits over time (Source: 2014 Investor Day Presentation)
International Sales and Operating Profits over time (Source: 2014 Investor Day Presentation)

 

(3) Valuation: A 3.1% dividend yield is a great place to start. I like investing in companies for the long term, but I am also susceptible to feeling like I am “wasting my time” with capital tied up in a company whose valuation is not going anywhere. A decent dividend yield pays you to wait, which I see as a plus for many reasons: It rewards shareholders who are patient, it encourages shareholders to be patient (not the same thing!) and it signals a real commitment from the company to deliver value to shareholders over time.

Given the Company trades at a premium to the market, and therefore needs to grow into its valuation, it is helpful to be rewarded for this patience. I think it is helpful to think about the eventual likely prospect that a company like General Mills will trade for 15x (the long term market average) and be crisp about what we need to believe will be the development of the business that would earn a satisfactory return under this scenario.

GIS BoE Math

 

The numbers above certainly do not make my sock go up and down. I am left thinking that this kind of return is all you can expect in this kind of market (after all, this represents 2 times what a government bond would yield!). Nevertheless, there is not much point in putting capital at risk if the prospects for a decent return are limited. Will the Company grow faster? perhaps the market believes this kind of ‘safe bet’ will trade at a premium forever, but that kind of thinking relies too much on ‘greater fool theory’ for my taste.

Conclusion: Having reviewed the investment thesis for the Company has been helpful, but I am still on the fence about what to do. General Mills is a very nice company, with a great product portfolio and good prospects going forward, but the valuation is high. There is some reason to be optimistic, but not overly so. In many ways, I see this investment as a bit of a hedge–a company that is well positioned in the even of a bear market–but given a relatively high valuation, I question whether that is the case.  For the time being, I will hold on to the shares until I find a more compelling investment in the food space.

 

Portfolio Review: Dr. Pepper Snapple Group

I made an investment in Dr. Pepper Snapple Group (DPS) in June 2013 at $46.37 per share. The shares are up 30% since then, which is a much higher return than I would have expected in a year. Valuation was key to the original thesis, so I thought now would be a good time to revisit the company.

Company: Dr. Pepper Snapple Group (DPS)

Investment Thesis: Dr. Pepper Snapple Group is (1) a great business with a stable, repeating revenue base (2) at an attractive valuation. (3) The Company strategy to return capital to shareholders is also very attractive.

 (1) Great business model with stable revenues: The Company is focused on the flavored non-alcoholic beverages category and owns several well-known brands such as 7up, Canada Dry, Dr. Pepper, Mott’s apple juice, Orangina and Snapple. One of the things I love about this Company is that it is not chasing after fads in the market. Case in point is that they do not have an energy drink offer (which some analysts ‘fault’ them for). That means less growth and ‘excitement’ about them, but I see their revenues as much higher quality. People who drink Canada Dry, have it as part of their routine–nobody walks by a display of drinks, sees a Canada Dry and thinks “oh, some ginger ale sounds lovely!”. You get the Canada Dry because you were looking for some Canada Dry. Chances are you have even bought it there before.

Revenues are have been remarkably steady around $6bn and expectations are of sub 2% growth (Source: Company filings and analyst reports). I think it is encouraging that volumes have been quite steady as well, so this is not a case of price increases making up for lost volumes. I am not expecting this to change going forward, but I will say this: I like the idea that if revenues grow any faster for whatever reason (a core brand that was out of fashion comes back in vogue, a new market getting traction), they have a good chance of remaining at the higher level. Generally speaking, I expect revenues to grow with inflation, which is one of the great things about investing in a business, rather than a fixed income instrument.

Perhaps the one area where there is most room to grow is in Latin America Beverages. This segment has been growing at a nice rate and represents a real opportunity to ride the rise of a consumer class in those economies. ultimately, however, it represents only about 8% sales today, so it will be a while before it is a meaningful contributor to earnings.

(2) Valuation: Shares have traded up significantly since my original investment, so I want to be especially crisp about my view on the current valuation. Some key data points:

TEV / LTM EBITDA: 10x

TEV / LTM EBIT: 12x

P / LTM EPS: 17x

I think these are acceptable multiples for high quality business like DPS. I am not expecting to make enormous returns out of this investment, but rather a reasonably consistent, inflation protected return of 5-10%. At current valuations (earnings yield of 6%) it may be reasonable to assume that it may be closer to the bottom of this range.

One other things I find encouraging is that Depreciation & Amortization has been running ahead of Capital Expenditures (which are modest) for some time. This should provide some EPS tailwind over time as D&A normalizes:

D&A and CapEx (Source: Company Filings and CapitalIQ)
D&A and CapEx (Source: Company Filings and CapitalIQ)

While overall fundamentals about the Company have not moved dramatically over the last year, it’s share count has decreased by almost 5% as a result of share buybacks (source: Company filings). While multiples have expanded slightly, that has been combined with healthy a combination of share buybacks and some fundamental improvements/business growth to deliver capital returns over the last year. This combined with a healthy and increasing dividend (yield: 2.7%) makes for good shareholder returns, which brings me to:

(3) Returning capital to shareholders: It is quite rare to see a company with such a clearly stated strategy to return capital to shareholders. It takes a particular kind of manager to be both good at running a large business efficiently and humble enough to think that the business is big enough, and its returns belong to the shareholders. The Company’s management constantly reiterates its commitment to return excess cash to shareholders and has been doing so efficiently with mix of dividends and share repurchases for years. CEO Larry young once said: “We aren’t the biggest, but we tell people what we are going to do and we do it. We generate a lot of cash and give it back to shareholders.” I like that attitude. Looking at the numbers, this commitment comes through.

Cash flow from Operations and major uses of cash over 5 years (Source: Company Filings and CapitalIQ)
Cash flow from Operations and major uses of cash over 5 years (Source: Company Filings and CapitalIQ)

The spike in cash flow in 2010 is related to a large licensing deal signed with CocaCola and Pepsi that year. The additional cash was used to fund additional share repurchases in 2010 and subsequent years. Looking at 5 years cumulative sources and uses of cash provides a clear portrait of the Company’s strategy to return capital to shareholders:

5 years cumulative sources and uses of cash (Source: 2013 Annual report)
5 years cumulative sources and uses of cash (Source: 2013 Annual report)

The chart above is my favorite part of their annual report and illustrates one of the key reasons I think the Company is a solid investment for the long term.

Conclusion: The Company may not be particularly exciting, but it has a solid business and a great track record of shareholder returns. The current valuation is modest and should deliver a good return over a long time horizon. This is a great Company to own for 10 or 20 years. I would strongly considering adding to this holding if the price drops significantly, but for now I will hold on to the shares I own.

1994

Read “Risk in Today’s Markets” by Howard Marks. It reads like it could have been published this week, but it was published on February 7, 1994. The market took a hit a few weeks later (prompting Marks to publish”Risk in Today’s Markets: Revisited“) and it was generally mixed for most of 1994. But who remembers 1994? It certainly doesn’t evoke the images of overpriced markets and subsequent busts that we associate with ‘2007‘ or ‘1999‘.

Part of the reason is the end of 1994 was the beginning of the 5-year long bull market that led to the 1999 tech bubble, with PEs expanding for around 15-20x (well within historical norms) to more than 30x (a level never before seen). Stock market valuation multiples expanded at a rate of over 10% per year for the subsequent 5 years–earnings and the macro-economy can do whatever they want and you will still be in the black with that kind of tail wind.

Does having 5 years of incredible, irrational multiple expansion justify paying elevated prices today? Seems like a classic case of ‘greater fool’ theory, or what little kids call a game of hot potato. It seems easy to answer ‘No’, but that begs the questions of what is one to do at a time like 1994. There are great benefits to staying invested over the long term; continuing to own stakes in good businesses will generate a return, even if it is a moderate one, while holding cash will not. Staying out of the market between 1994 and the bottom of the tech bubble (i.e. “waiting for valuations to come back to a reasonable level”) would have been a big mistake. If you bought a broad index in 1994 and sold it at the worst possible time at the bottom of the market in mid-2002, you would have made an 89% return. It would have been a wild rollercoaster ride, but that is actually a pretty decent return! Sustained periods of both overvaluation and earnings growth like the 1990s really accentuate this issue.

Another easy answer is to say we should only invest in undervalued assets, even if the broad market is overvalued. There is certainly some truth to that, but as it turns out, that is easier said than done. It is especially hard, given that a generally overvalued market has a tendency to push up all prices in unison and reduce the dispersion of valuations. See chart below:

 

Multiple Dispersion (Source: Business Insider)
Multiple Dispersion (Source: Business Insider)

While the tech bubble was an exception (high overall market value was mainly driven by astronomical valuations in the tech sector), generally elevated pricing environments tend to exhibit lower dispersion in valuations. This is certainly the case today, with valuation dispersion at their lowest point in over 20 years. A difficult task becomes harder.

So what is a prudent investor to do in a time like this? I try to maintain some discipline with the following goals in mind:

  • Buy securities that are fairly priced: You may not find absolute bargains out there, but if you buy the securities of companies with a solid business at a price where you feel comfortable you can earn a decent return over a long horizon,  then you protect yourself on the downside.
  • Stay invested: I struggle with this, but a little struggle can be a healthy thing. If you can avoid taking excessive risks, then making sure you earn some return on your capital will pay off in the long term. As Albert Einstein said “Compound interest is the eighth wonder of the world”.
  • Know where you stand: Just because we can’t predict where the market will go next, doesn’t mean we should pretend like all times are the same. There are times to be cautious and there are times to be courageous–It is usually best to do the opposite of what everyone else is doing (yet another difficult task!).

Let me book-end this post with one more Howard Marks memo, as he has some great comments on the very last point I made:You can’t predict, you can prepare, published on November, 2001.

Whole Foods: Undervalued Retailer

Retail is a tough sector and it is getting tougher. More of the market will move online over time. Food may just be the one place where a retailer with a good USP has a chance at continuing to be a good business for a long time.

Whole Foods Market (WFM) is probably the strongest premium food retailer in the world. As such it has often commanded a valuation that is too rich to consider investing. The recent poor news have sent the shares tumbling on concerns that same-store-sales are not growing fast enough and that gross margins are eroding. This may present an opportunity.

In late March 2012, I bought some shares in the company for $42.33 (split adjusted) with the intention of holding them for a long time (10+ years horizon). About 18 months later, in October 2013 I sold them at a 40% profit–it was trading at a 40x LTM PE and I thought that was unsustainable. The shares have since come down to about $38.50, so I think it is time to reconsider investing. The long term thesis has not changed, but the valuation is once again somewhat attractive.

Company: Whole Foods Market (WFM)

Investment Thesis: Whole Foods is (1) a leading premium food retailer, (2) with significant additional global rollout potential. (3) It is trading at an attractive valuation considering its long term potential.

(1) Leading Premium Food Retailer: Without dwelling on this point for too long, there are only a few global companies in this space and Whole Foods is certainly among the top names. Perhaps the only comparable company of real scale is Sprouts Farmers Market (SFM), which is in fact considerably smaller today. Traditional retailers like Wal-Mart (WMT) might present a bigger threat in the long term, but I believe being focused and “niche” will prevail in retail.

(2) Global Rollout: This is really where the crux of the thesis is. At some point Whole Foods will run out of room to roll out additional stores, and we should not expect it to trade much higher than 15x PE then. So how many stores do we need to believe they can open to feel good about this investment? Doing some very rough math, you would feel pretty good if they can get to 800 – 850 stores in 10 years. That is about 2.2x the current store count which would be no small accomplishment. It also means opening about 45 stores per year, which is a much faster pace than their current c. 27 new stores per year. My ‘back of the envelope’ math is below:

'Back of the Envelope' Calculations
‘Back of the Envelope’ Calculations

If we assume the shares will trade at 20x in 10 years (still within the bands of ‘typical’ trading multiples, an 18% discount to today’s multiple, and a 50% discount to some of the lofty multiples at which the shares were recently trading), then we would only need about 25 new store per year to reach similar return goals. But what if 25 stores per year for 10 years is all we get before we are out of room and the shares trade at 15x? That is an interesting base case to consider, and the returns would actually be acceptable:

'Back of the Envelope' Calculations - Base Case
‘Back of the Envelope’ Calculations – Base Case

A 7% – 10% total return over 10 years certainly sounds acceptable to me, but all of this assumes the Company can open 250 – 500 stores over this period, while maintaining or slightly improving margins.  Regarding the–more interesting–topic of whether or not this is commercially achievable, I thought it would be helpful to look into more detail at the Company’s current stock and other comparable retailers to get a sense of what the rollout potential might be here.

International Opportunity: Perhaps the most interesting fact about this Company is that almost 97% of revenues are in the United States (source: WFM annual report). In other words, it is very early days in terms of the Company’s international expansion. The Company has 7 stores in the United Kingdom and 8 in Canada, with the remaining 359 being in the United States. If we can believe the overall concept will work well in a few other geographies, believing in the store count doubling does not seem very hard. It should be noted however that Canada and the UK combined represent roughly 100bn people, or about 1/3 the population of the US.

Comparable Retailers: Whole Foods stores are big, so only a few global retailers represent meaningful comparables. Wal-Mart has 4,779 stores (70% of revenue in the US), which may not be relevant, other than to set an absolute aspirational maximum. I thought the following retailers were interesting to get some perspective:

Company 2013 Retail Sales (000) Worldwide Retail Sales (000) USA % of Worldwide Sales 2013 Stores Growth
(’13 v ’12)
Sales per Store
Kroger $93,598,000 $93,598,000 100.00% 3,519 -1.80% $26,598
Safeway $37,534,000 $42,982,000 87.30% 1,335 -5.30% $32,196
Aldi $10,898,000 $50,081,000 21.80% 1,328 5.40% $37,712
Publix $28,917,000 $28,917,000 100.00% 1,273 2.80% $22,716
PetSmart $5,298,000 $6,117,000 96.90% 1,247 4.10% $4,905
Michaels Stores $4,132,000 $4,570,000 90.40% 1,147 2.00% $3,984
Trader Joe’s $8,350,000 $35,214,000 23.70% 410 3.80% $85,888
Whole Foods Market $12,491,000 $12,917,000 96.70% 347 7.80% $37,225
Apple Stores / iTunes $26,648,000 $30,736,000 86.70% 254 1.60% $121,008
Harris Teeter Supermkts. $4,710,000 $4,710,000 100.00% 216 3.80% $21,806
Roundy’s Supermarkets $3,946,000 $3,946,000 100.00% 163 1.20% $24,209
Price Chopper $3,784,000 $3,784,000 100.00% 132 1.50% $28,667
IKEA North America $4,370,000 $37,877,000 11.50% 38 0.00% $996,763

(Source: https://nrf.com)

I find the table above relatively encouraging in terms of  how much additional potential there may be in the US. It is interesting to note that only a few retailers have actually had the ability to go cross-border.

(3) Valuation: One of the main reasons I am looking at this Company again is that it’s valuation has come down significantly in the last few months. The shares have not traded at this kind of level since 2010, when the market overall was trading at a much lower valuation than today. The chart below shows EV as a multiple of LTM Revenue and LTM EBITDA (PE tells a similar story but is ultimately less representative of underlying trends):

WFM Valuation over the last 10 years (Source: CapitalIQ)
WFM Valuation over the last 10 years (Source: CapitalIQ)

Valuation has varied dramatically over the last 10 years, influenced heavily by the market conditions as well as by the Company’s same store sales growth (SSS) for the last quarter. The historical SSS track record of the Company is spectacular, but I find the valuation swings based on short term changes to SSS to be unwarranted. This is the trouble with a stock that becomes a Wall Street darling. My assumptions above assume 2% SSS going forward (in line with inflation). Needless to say, if the Company can continue to deliver anything like the what it did over the last 5 years, the picture could look dramatically different.

Whole Foods Quarterly SSS (Source: Company Filings)
Whole Foods Quarterly SSS (Source: Company Filings)

Conclusion: At current valuation levels and with reasonable growth assumptions, Whole Foods represents an attractive investment opportunity. It is still trading at a premium multiple, so the Company needs to continue to grow at a decent rate for a few years to justify its current valuation. The growth prospects are strong and at the current depressed valuation should be sufficient to deliver a good return over the long term, even assuming that the multiple will come down to a market average over time.

 

More on Absolute Valuations

I felt pretty good after writing the post on Absolute Valuations a few days ago. It felt like a nugget of useful insight that had come out of forcing myself to write down my thoughts–exactly why I was hoping would come out of this exercise. It has been on my mind a lot since and while I still believe the idea has value, I am coming to think it may be overly biased by the current state of the market.

I am relatively young, and I did not experience what it was like to invest in the 70s and 80s, when long term rates were 10% or higher. The idea of getting a 10% risk-free return is completely foreign to me. Granted, inflation was a much more significant factor then, but event account for that, real rates were significantly higher than than anything I have seen in my investing career. Here is a helpful chart from a Paul Krugman post:

Real Rates since 1959

So when I say to myself that any investment must meet a basic level of absolute return for me to consider it interesting, I am inadvertently comparing it to what might be the “prevailing market rate of return”. The more interesting thing however–and what I think led me to write the original post–is that the prevailing market rate of return is so close to zero today. And zero is a special number because cash earns a return of zero. I may say I am unwilling to make an investment unless I am comfortable I will get a minimum return of 5%–that 5% is my absolute floor. But if I could get 5% risk free by buying government bonds, wouldn’t that be a silly floor to have?

There is merit in having an absolute floor, especially when valuations are high and prospective returns at historical lows. I admit, however, that as overall returns become more attractive, engaging in a more selective comparative process has a lot of merit.