In this podcast, Motley Fool host Ricky Mulvey caught up with Motley Fool Canada's Jim Gillies for a conversation about how retail investors can value stocks and why they have an advantage over institutional traders.
They discuss:
- The difference between price and value.
- What financial metrics can and can't tell investors.
- The valuation case for a sporting goods retailer.
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Jim Gillies: As an outside individual and I still consider myself, in spite of what I do for a living, I still consider myself retail investor. I could hold things forever. I don't need to worry about companies meeting guidance. I'm like, you know what? I'm good.
Ricky Mulvey: The market's pretty wild right now. I thought it was a good time to take a step back and look at the fundamentals evaluation. I caught up with Motley Fool Canada's Jim Gillies to talk about how regular investors can value companies before buying a stock, why a price-to-sales multiple can steer you wrong, and one advantage that retail investors have over the institutional ones. Jim, I think now is an interesting time to talk about valuation in the market. If you look at the way the equal-weighted Standard and Poor's 500 indexes have been doing compared to market-cap weighted, you can see that the big dogs are really pulling things forward. I think it's good to take a step back and give a little primer on valuation in investing and you are big valuation guy. To set the table, what's the difference between price and valuation for investors looking at any stock?
Jim Gillies: Sure. I have been accused of being a valuation guy from time to time. There is a cliche that price is what you pay, and value is what you get. That's actually not bad. All a stock price tells you is what other investors or prospective investors or soon to be former investors are willing to transact at the moment. It doesn't tell you much, doesn't tell you about the underlying business, doesn't really tell you anything about what's going on. One of the things I like to do when I used to teach this stuff and with some of the other analysts that I deal with, the young analysts that I mentor, is, I always say, the two most important questions in the valuation process, because you found a stock, you're really excited about it. You might be fine buying it today after you're really excited about reading about their opportunities or whatever.
But the two most important questions that come to investing are, what is it worth and why?
There's multiple ways to answer certainly that first question. But the stock price is just, again, it's the stock market is what the stock market is charging for the opportunity here. It may be right. It may be wrong. It's always up for debate. Everyone, every investor is playing a different game because everybody is at a different course in their life, has a different amount of money. Maybe you're a short-term holder, maybe you're hoping to be a long-term investor, and things are always in flux. A very obvious example would be, go look at stocks in the growth, so called growth and tech stocks, software stocks, SaaS software as a service, and SPACs in 2021. Go look and see what those prices were doing. Then you can go and look at what the valuation implications of all of those prices were, and then flip them a year later and look at those same stocks and the same implications that were tied in in 2022. They're radically different, even though they're the same stocks, the same companies.
Ricky Mulvey: If I'm thinking about valuation, do I have to build models of future cash flows? I know there's not just top-line growth, do I have to guess the effective tax rate for the companies I'm looking at five years from now? Are there ways to do this without getting the Excel spreadsheet out?
Jim Gillies: Don't fear the Excel spreadsheet, Ricky. I like to say that every model is precisely wrong, but you do have the opportunity to be roughly right. Frankly, roughly right is going to be good enough. Warren Buffett popularize the topic, but it comes from Ben Graham, the father of value investing, the concept of margin of safety. You do the best you can, and you can make it as complicated or as uncomplicated as you want. You may observe say that a company is a particular company translates about 5% or 6% of their top-line revenue into free cash flow. That is the cash that is left over after the company has paid all of its bill, made all of its capital investments, made all of its investments and working capital. Let's say, for thousand dollars in revenue they do, they end up with 50 bucks at the end. They end up with 5%. You can look back and you do a time series, a historical analysis. You might see, they've averaged between 4.5 and 5% for the past decade. You can build a really complicated model where you can use the capital asset pricing model to fine tune your weighted average cost of capital down to 14 decimal points, and you can make an estimate for tax rates, and you can read the tea leaves to see what well, if the next president is this person, the tax rates for corporations are going to go to here, or you can just say, you know what? I'm going to be wrong on those things, but they've largely been between 4.5-5% free cash flow margin for the past decade. I'm going to forecast my growth and then I'm going to hit at 5%. I'm going to call it a day at that point. Because it's far simpler to do that, and you're going to be roughly right. Then the concept of margin of safety is, if I figure out that a stock, at any particular company is worth say $100 a share. Well, if the stock is trading at $100 a share, that's not a great deal. Maybe I buy a few shares just to get my head in the game. But if that stock is trading at 80, that's a 20% margin of safety. That's going to allow you to have made a significant number of errors during your valuation process. Maybe the next couple of years, they only do 4.5% free cash flow. They underperform what you're expecting. It's not going to matter if you bought a discount to free cash flow. Similarly, if the company and this is always wonderful when it happens, when a company outperforms your expectations, and you've bought it at a margin of safety, it becomes magical because you get both, the company outperforms what you were expecting and you bought at a discount.
Ricky Mulvey: Does a regular investor though have any hope of playing this game better than Wall Street analysts who do this for 12 hours a day and have fancier software, access to better data on Bloomberg terminals, that thing. It seems like if you're playing this game, you might be at significant disadvantages to a lot of professionals?
Jim Gillies: The professionals are at the disadvantage. Because the professionals being graded quarterly. They're running a fund, and they tossed up a couple of garbage picks during the quarter. They're probably having an uncomfortable conversation with their portfolio manager at the end of the quarter. Do it several quarters in a row, and you're probably having an uncomfortable conversation with your HR department, as you negotiate your exit. It is constant, what have you done for me lately? It's almost except for the rare shops, which can do their own thing and go their own way, it's inherently short-term minded. As an outside individual, and I still consider myself, in spite of what I do for a living, I still consider myself retail investor. I could hold things forever. I don't need to worry about companies meeting guidance. I'm like, you know what? I'm good. You can take the time. I've sat on a couple of stocks that have done nothing for years which would probably get me a talking to working for that large fund company on Wall Street. They do nothing for three, four, five years, and then they quadruple in three months. Those are fun.
Ricky Mulvey: That sounds like fun. Is this exercise, if you're doing this? Are you better off spending your time? It seems like you'd be better off spending your time with smaller companies, not the companies with all eyes with the eye of Sauron upon them?
Jim Gillies: Well, yes and no. It's an interesting exercise. Usually, if you are one of the few who is, if you are playing in the small cap world, which is where I usually play, you can have an advantage. Big funds can't come in and own it in any size to matter. If you're dealing with $1 billion company and a fund can only buy up to 5% of a company $50 million. That fund is a $10 billion fund. They're not going to look. Where I think you have again, this ties into the short termism. My favorite example of the species is Q4 of 2018. Now, people don't remember because we have short term memory most of the time. 2018 was a dismal year for the market. I wrote a column back then called The Year No One Made Money. I went through all the major asset classes and just, like bonds were down, stocks were down. The marijuana stock sector, which was big in Canada in 2018, it was down. Bitcoin was down. Housing prices were down. I know that never happens. But like every major asset class, nothing made money in 2018. You got to the end of 2018 and going into early 2019. There's this small fruit company at a Cupertino, California, Apple or something.
Ricky Mulvey: We're doing that if you haven't heard of Apple game.
Jim Gillies: Exactly. Apple at the time was the largest company by market cap in the world. Apple was trading at 10 times free cash flow, 10 times operating profit as well. Ballpark. I don't have my spreadsheet open, so ballpark. All of the stories at the time. All of all of the words of the wise, everything coming out was that Apple's growth was gone. Apple was going to struggle to respark growth. They hadn't had any really new innovative products for a few years. Steve Jobs had been gone for seven years at that point, and really, 78 years by that point. That Tim Cook guy well he's a good operator, but he's know Steve Jobs and on and on. You didn't need a detailed spreadsheet analyzing every product line and the rise of services. You didn't need that to go, here is Apple, the largest company in the world by market cap, the biggest cash generation story that I've seen in my career, and I've been doing this for a while, that had a really interesting habit of returning all of the cash and then sum to shareholders in the form of a small dividend and very large stock buybacks. When you tell people that Apples bought back over the last decade, about 40% of their stock, generally comes as a shock to them, but they have. Now, say, well they give lots of equity cook to the insiders. About 12-15% of the stock they buy back has gone back into the pool for employees, and that's just a cause of doing business. But they're still very much focused on returning that cash check to investors and reducing their share count, which ratchets up the stock price. But the sentiment about Apple at that time was very negative just in the popular press. Like I said, it got down about 10 times free cash flow. All the eyes are on Apple Ricky at that point. This is not an unknown stock at this point. If I told you Apple's been a five plus bagger since then in barely over five years, would you believe me?
Ricky Mulvey: I'd open another tab, but I don't want to do that.
Jim Gillies: Well, I promise you I'm correct on that. Because I was a very heavy buyer in late 2018 or early 2019. But that's where you didn't need to come up with a giant spreadsheet to forecast all these things. You can do it. But, again, there's the concept of declining utility. All you really needed to know was premier cash generating story of our generation and religious about returning that cash of shareholders. Fantastic relative valuation relative being. I didn't build a DCF discounted cash flow model. I'm using a relative valuation metric. In this case, price to free cash flow, EV to free cash flow.
Ricky Mulvey: There any, price tag metrics that you used to help find those stories? We got our price to sales, we got our price to earnings. You mentioned price to free cash flow, which is especially useful for a mature business. You're smirking and shaking your head just a little bit for the listeners who can't see, Jim?
Jim Gillies: This is where I go off on. Number 1, I hate the price to sales multiple. I hate anything multiple to sales. Hate it all. You didn't really see that a lot, frankly, until about five, six years ago. The previous time where I'd seen it even used at all was largely in the tech bubble in 99, 2000 era. There's no faster way for me to throw out an investing thesis and to have an analyst tell me, well, this is cheap. It's trading at only 20 times sales. I'm old enough to remember when 20 times earnings was considered starting to get into richly valued. But that's because sales is at the top of the income statement, and earnings is at the bottom of the income statement. Earnings is after, in theory, at least on an accrual basis, after we've paid for all of the operating costs and the cost of sales of the business. I loathe the price of sales multiple, and the only times I can actually remember using it, I used it to illustrate a problem with the formerly largest company in Canadian history. I would be Nortel Networks because I showed how for those who don't know, Nortel Networks is the giant cautionary tale for most Canadian investors. It was the largest company in Canada, It was the largest company in Canadian history, frankly, by market cap. I think it hit about $350 billion in mid 2000. It's zero today. Largest company in in history to zero in less than two decades. That's some good work. But at the time, this is going back a long time ago. But basically, when Nortel started rolling over, and Nortel was a company that on a split adjusted, or I should say, reverse split adjusted basis, all time high about $1,250 Canadian dollars per share. It bottomed at $6.60 about two years later, less than two years later. That's about a 99.5% drop for those playing along at home. All the way down, I would have family members, I would have friends, acquaintances, as soon as they we talk investing, I'm going to buy me some Nortel. It's come down so far. It's got to go back up. No, it doesn't. It's under no obligation to go back up, just because it's come down so far and you think it's got to go back up. The exercise I was running was like, at the time Nortel, they had turned cash flow negative. They had turned accounting negative, like, accounting profit negative. Really, you had to move up, and the only thing they had that was a positive number at that time was really their sales. I would use the price to sales multiple and say, here's a company from 92-98 traded 1.5- 2 times sales. But because sales went up six times over that period, the stock went up about six bagger. It followed the valuation. In 1999, it went from two time sales to 10 times sales. The multiple expanded by a factor of five, and through a combination of a little bit of enthusiasm in the market and the markets they were serving, as well as making a couple of really turned out boneheaded acquisitions, they doubled their sales in a year. They doubled their sales and the multiple on sales went up five x. Nortel in 1999 was a 10 bagger. But I showed, those six years went up six times in value, that's fine because on a relative basis, it actually never got more expensive. That one year 99, where, the CEO at the time, John Roth he was feted in every magazine and every newspaper as the CEO of the year. No, Dude just got on the right side of a momentum wave and caught it and was smart enough to bail out and take a $100 million home the next year. Good for him. But the price of sales ratio I'm going to differ with some other people, some other Fools who are not going to agree with me, and that's fine. If all you got to hang your hat on is the price of sales ratio, you're probably going to get hurt.
Ricky Mulvey: We've not talked about price to earnings.
Jim Gillies: The price, it's the most quoted. It's fine.
Ricky Mulvey: You seem very tepid. It's to give you a price tag. You say price to sales doesn't give you any of the costs and expenses, a price to earnings. That'll give you some costs and expenses to which you can compare that company against other companies in that category.
Jim Gillies: Sure or against its own history. My main problem with priced earnings is again, there's no leverage consideration. There is non-operating expenses or income can skew the earnings line sometimes. If you're going to use an earnings multiple, Number 1, you want to be consistent, you want to look at the company over time. You want to be consistent and use your measures all the way along. Also living in the grand age of adjusted numbers. Now every number is adjusted 17 ways to Sunday. We've apparently forgotten that EBITDA is a made up number anyway.
Ricky Mulvey: There's too many problems with GAP. They have too many rules, doesn't work for my company. I'm sorry, but keep going.
Jim Gillies: Well, actually, that's valid in a lot of cases. But my take on price earnings is it can be fine. Like anything, like any tool, hammer works great as a hammer. It might work OK as a lever. It's a terrible wheel. You want to have multiple tools that you can bring to bear. When all those different tools, maybe you are telling you similar stories, that's something to pay attention to and say, I think this is pretty decent. Accounting earnings is fine, but it's not cash flow. If you're going to force me to use a relative metric and a quick metric, I am going to be a fan of a free cash flow multiple. But then, so whether that's price or whether it's enterprise value, we can, there's applications for each. But that's still only part of the story because then what does a company do with its free cash flow? There's a company in Winnipeg Manitoba, Canada called Win-Pack of all things, and has been a tremendous cash generator over the past I'm going to say decade or, so for most of its history. It's really well. It makes plastic cups. If you like the little cup that your single serving pringles come in or your single serving cups or little jams you get at the diner. Congratulations you're using a Win-Pack product. They made a tremendous amount of cash. They're really well managed. They respect their equity by that, I mean, they're not, constantly deluding themselves. But the cash has just piled up on the balance sheet. I tell very recently, they haven't done anything with it for almost a decade. It's like, that's great. You're piling it up on the balance sheet, and I guess maybe its value is it makes some interest income, except until the last year and a half, the last two years, we've been in historically low interest rate environment. Who cares. As opposed to companies where company, I think we've talked about before in the past, Ricky, company called Medpace Holdings. I know we've talked about them.
Ricky Mulvey: But diagnostic testing.
Jim Gillies: It's a great company, contract research organization run by a really great, foolish founding CEO who continues to be the CEO and largest shareholder. He founded the company 32, 33 years ago. They were piling up the cash, tremendously cash generative debt free. They were piling up cash on their balance sheet until late 2020, early 2021. Then the stock got continually whacked. Every earnings report was down 15%, even though every earnings report looked pretty good, actually. The market just wasn't believing that things could be that good there. You saw Medpace Holdings, which, I believe, had about 425 million cash at its peak. They blew all of it buying their stock back, and they took on some debt and threw that against it because no one else is going to respect the equity, and they were buying it, between 130-150 cent. The stock is 400 and change today. It was a tremendous capital allocation move, but they were piling up that cash from their free cash flow generating ability. Then when opportunity presented itself, you might say when the valuation was attractive, and they knew they were worth more than the market was given. They said, fine, we will take advantage of this, and they did.
Ricky Mulvey: Let's wrap up with this part of the conversation, Jim, I think we have more to talk about. I think there's another show in here. With using some of the multiples we've talked about that you have very tepid feelings about to at least talk about one story. That's one you've mentioned on the show, that's Academy Sports and Outdoors, especially in comparison to Dick's Sporting Goods. These are companies that are pretty easy to compare because they're sporting goods retailers. But the investment community is not just on a market cap basis, but also on a multiple basis, much more optimistic about the future of Dick's Sporting Goods. We'll use the price to free cash flow multiple. Dick's Sporting Goods is about a 17 times free cash flow multiple. But Academy Sports and Outdoors is it an eight times free cash flow multiple, less than half. Even though maybe it has more room to expand, its store count while Dick is a more mature business. Why is the market so much more feeling the way you feel toward multiples about Academy Sports and Outdoors you think?
Jim Gillies: I am asking myself that same question because Academy Sports and Outdoor. It's probably one of my favorite stocks right now for buying new shares of today. I don't know why the market is valuing Dick's more. I think it was 2019. I'm going to be precisely wrong here, but I'm going to try to make up for it. 2019, I believe this is before Academy even IPOed, at one point they were voted retailer most likely to go bankrupt by someone. I don't know. I remember who appeared, but I thought that was funny. They largely switched out, and they were greatly underperforming in terms of sales per square foot and same store sales and all the things that we look at for retail change. They did a wholesale management change. Again, this is pre IPO. They basically sent the present incumbents out, and they brought in new folks, and they came forward with a five year financial plan. Here's what our sales are going to be in five years. Here's our net income margin, here's our how many times we're going to turn our inventory. Here's our target return on invested capital. Here's our target sales per square foot. Here's our percentage of e-commerce sales. Spoiler, they hit all their metrics that they laid out well before the five years had gone out. This new management team is excellent. About a year ago, Academy Sports and Outdoor actually brought out a second five year plan that they're working on.
I've used that plan to inform my valuation model, and I'm not just using multiples here, Ricky. I do have an actual DCF built on this one. I'm not as optimistic as management is. I'll put it that way. This five-year plan, they want to be at over $10 billion in sales by the time this five year plan is done. I think in year five, I've got them just shy of nine billion sales as I look at my spreadsheet here. I've got slightly lower margins, free cash flow margin. Right now, we're running about 8% on a trailing basis. My model, I don't have them any higher than 6.5% over the course of the next decade or so I think I'm penalizing them appropriately for their cost of capital and for growth beyond the next decade or so. I've made sure I valued all of the outstanding stock options that are going to go to insiders and make sure that I detract that from the business, make sure I take off their debt. It's real hard for me to get a stock value that's under $80 right now and the stocks trading at 52, I think. Where that comes back to the multiple. Again, I'm aware of the Dick's thing because we have talked about Dick's before, but I've not done a similar amount of deep dive work into Dick's Sporting goods, because it's a little largerthan I want. I like the smaller and the upstart. I own several US-facing index tracking ETFs. I figure I've got enough exposure to Dick's Sporting goods through those ETFs. But where it comes back is when you see peer groups, when you see two companies in peer, and it's on and you see one at such a sharp discount to the other in terms of valuation metric that I do like, which, as you've used, is a free cash low multiple. That's a good place to start your research and go, OK, so what's going on here? Why do we have Maybe you find out that, one store is just so much better, well run than other, and you start finding reasons for the discrepancy. I will say this. The setup is going to get me in trouble, I'm sure in a year or two, but the setup for Academy Sports and Outdoor really reminds me of are you familiar with Sprouts Farmers Market?
Ricky Mulvey: Yes, I am.
Jim Gillies: The organic grocery, poor man's Whole Foods. This reminds me of the setup for Sprouts Farmers Market about 3.5, four years ago. That is the market just doesn't care about the prospects. Sprouts was hovering around 24-25. I recommended it a couple of times, 25-30. Again, run the DCF. This is undervalued, look on a multiple basis. It's actually cheaper than other grocery stores who have lower profit margins than they do. They have good management who had a very clear and stated plan going forward. I built a DCF that undercut the plan of the insiders, which is conservative measure. I'm like yeah, I still can't get the stock price below. It's minimum, 40% upside from here. Then stock basically tripled in a year and a half. As the market caught up with it. That's the setup I'm looking at with Academy here. Then the last piece of the puzzle is, again, remember what I said earlier, what does the company do with its free cash flow? It's lovely to be cheap visa vi it's cash generation. But what are you doing with it? If you are utilizing it in the service of shareholders, and in the case of Sprouts, what they were doing is they have very minimal leverage, they have more cash than debt. They were aggressively shrinking their share count by buying shares back. When I first started looking at Sprouts a few years ago, at 150 million shares, I think they might be around 100 million today. That, by the way, that's going on with academy sports as well. They are aggressively shrinking their share count, pay a tiny pittance of a dividend, whatever. But when you get all of those things working together, the multiple say it's cheap. The DCF discounted cash flow multiple says it's cheap. You can see with your own eyes the cashiering ability of the company, and they're using it in the service of shareholders at which, you may or may not be one, or you may or may not be a larger shareholder.
Ricky Mulvey: It's on my watch list.
Jim Gillies: Well, what I'm saying is, if you see that happening, I think that's a really good, solid place for you to enter hopefully what will be a long term relationship with a fantastic company, which is really all we're looking for here.
Ricky Mulvey: That's a good place to end it. Jim Gillies. Let's do this again. I think we have more to talk about. Appreciate your time and your insight. Thanks for being here.
Jim Gillies: Thank you, sir.
Ricky Mulvey: As always, people on the program may have interests in the stocks they talk about, and the Motley Fool may have formal recommendations for or against so don't buyer sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow
Jim Gillies has positions in Academy Sports And Outdoors, Apple, Medpace, and Sprouts Farmers Market. Ricky Mulvey has positions in Adidas Ag. The Motley Fool has positions in and recommends Apple, Bitcoin, and Medpace. The Motley Fool recommends Academy Sports And Outdoors and Sprouts Farmers Market. The Motley Fool has a disclosure policy.
