Archives For February 2012

In valuing Aeropostale in the previous post, we built an ugly scenario that assumed ARO’s operating performance deteriorated significantly. I suggested that, were this to occur, the market would punish the shares through a broad sell-off that could easily push its price down by 50 to 60 percent from the current $18 level.

This is pretty much what happened in October 2011. After years of growing same store sales quarter after quarter in an unblemished winning streak, ARO went into a slide for several consecutive periods. Same store sales were declining, inventory wasn’t moving, gross margins were taking a hit, and it was clear that another winning streak was at risk…growth in earnings per share.

 Investors stuck with ARO through the first couple misses. Management deserved some leash, they had demonstrated a lot of success with this business model over the years. But from the spring of 2011 through the autumn, the one-time darling was quickly becoming a toad. The stock price plummeted from $26 per share to a multi-year low of $9.16. Even the most stalwart supporters were losing their resolve – irrespective of their views of the long-term business prospects – as they saw their holding value collapse by two-thirds. While they may have reached the same conclusions about the business as I did in my original post (here), few could stomach being part of a quick fall and then trudge through a recovery that would likely take many quarters if not years.

For a construct to understand the dynamics of that sell-off, and the resulting opportunity to buy into a good business at a cheap price, I turn to the field of behavioral finance and Harvard economist  Andre Shleifer.

In his book Inefficient Markets: An Introduction to Behavioral Finance, Shleifer builds on the work of Robert Shiller and Richard Thaler, pioneers in this burgeoning field that blends theory from economics and psychology.

As we discussed previously, Professor Andrei Shleifer’s Inefficient Markets provides an instructive lens for viewing the past year or so of Aeropostale’s business operations and ensuing price volatility.

In short, investors watch a business, evaluate its performance, and form an opinion that tends to extrapolate its recent performance into the future. This tendency is called representativeness.

Once they form an opinion, they stick with it even in the face of disconfirming evidence. This is called conservativeness, and it remains the case until multiple pieces of evidence finally overwhelm them and force a change of mind. Investors then fall prey to overreaction – classic Mr. Market – getting overly excited about a company or depressed about it and pushing its price up or down (whichever the news may warrant.)

The concept passes my reasonable man test for how people (I’ll include investors in this category) behave, and so I’ll graft it on top of what we’ve observed with ARO to see what we can learn.

First, let me step back a little for an aside (albeit a long one) that I think drives home the point. A few months ago I watched a re-broadcast of the Fourth Annual Pershing Square Challenge at Columbia Business School. It took place in April 2011 and features teams of business student presenting their best investment ideas to Bill Ackman and a panel of judges. (Thanks to Value Walk for posting the video. You can access it here.)

In the last post we looked at several assumptions that, when accepted as more-likely-than-not correct, paint a picture of Aeropostale as a business with a market that’s not going away and seems to benefit from barriers that would prevent competitors from encroaching. On those fronts, it shows real promise as an investment opportunity.

Now I want to look at a few scenarios for thinking through its value. When we initiated our ownership position in late-October, ARO was trading just below $14 per share. Today it’s nearer to $18, and we’ll use the more current price in considering a range for its intrinsic value.

For the following, we’ll use these given assumptions:

1. ARO has 4.2 million square feet of retail space across its store base,

2. It will be taxed at 40 percent of operating income,

3. It has about 82 million shares outstanding, and

4. Its current share price is $18.

Now, let’s plug in some variables to see how the business looks on a price-to-value basis.

Scenario I: Ugly Forecast   

Here we assume that ARO continues taking a licking. Sales drop 20 percent from its 2010 high of $626 per square foot. Gross margins match the lowest of the previous ten years. And SG&A expense are the highest in ten years.

We started building a position in Aeropostale in late-October but I’m just getting around to writing about it now as I’m revisiting the thesis and thinking through potential risks. Let’s just jump in…

Assumption 1: The Mall Continues to Deliver Captive Market of Teenage Consumers

The mall is now and will remain fertile sales territory for retailers peddling wares to teenagers. While the traffic counts might ebb and flow a bit, these temples for commerce seem to have staying power with the teen demographic. In short, we assume they will continue going to malls and doing so with varying amounts of cash in their pockets.

Assumption 2: Mall-Based “Value” for Teen Clothing is a Distinct Market Niche

There is (and will continue to be) an important role for the value option for clothes in the mall. Indeed, it is a distinct market niche – as compared to full-price teen clothing retailing or value options outside of the mall – with its own set of unique properties and dynamics to consider.

Continue Reading…

The Fanatic, as profiled in this previous post, is a construct to apply to all investing opportunities. Two vantage points to consider:

Vantage Point One – Is the business you’re evaluating run by a fanatic?

This presents its own set of opportunities and challenges that I won’t go into here. Suffice it to say, investing with fanatics requires that you possess a deep conviction in the upside of the opportunity for market growth, the fanatic’s ability to win that growth, and his ability to win it in a way that provides suitable returns on capital over the long-term.

As the profile suggests, fanatics will not show many traits of shareholder friendliness while engaged in the thrall of winning market share from the competition.

Vantage Point Two– Can the business you’re evaluating survive attacks by the fanatic?

This the more common construct you’ll use in evaluating investment opportunities. It forces you to understand the deepest competitive advantage of any business by forcing your thinking process outside the simplistic world of rationally-motivated agents.

A rational agent competitor will work through MBA uber-logic in determining whether and how to compete with your business.

Ponder this…

Continue Reading…

Becton Dickinson (BDX)

February 10, 2012 — Leave a comment

A hat tip to Matt Mandel of the Mandel Capital Blog for sharing his thoughts on Becton, Dickinson & Co. (BDX). It’s an excellent piece of high-level analysis steeped in a fundamental premise with which I could hardly agree more: when you find good companies priced fairly by the market, buy them!

My own analysis has BDX trading around 14.5x its previous year owner earnings and that it has compounded those earnings at an annual rate of 14.1 percent since 2004. It did this while maintaining a healthy balance sheet (i.e., debt it can easily manage based on its cash flows) and returns on equity hovering around 20 percent. Not bad at all.

We can make conservative estimates of its future by cutting that earnings growth rate in half (seven percent), projecting an earning multiple on par with the general market (15x), dividends growing slightly below its historical rate, and using excess cash to buy back shares on the market to the tune of 24 million over the next five years. These assumptions would give us a business worth about $142 per share in 2016. That’s about 13 percent compounded growth. Again, not too bad.

The financial analysis looks pretty good. Add to that some basic facts about BDX’s products: they tend to be non-discretionary purchases primarily from hospitals, with some elements of the razor-and-blades revenue model,  changing suppliers seems to be hard to do, and the price points of various needles and syringes (the primary business) don’t make it worth the headache of customers trying out new vendors anyway.  The thesis seems to be getting stronger by the moment.

Alas, the paranoia kicks in. Two things bother me. 1. Healthcare payers are under duress, and they are a major force behind buying decisions in the service of healthcare…something upon which BDX is highly dependent; and 2. What does something like the BD Insyte Autoguard with Blood Control do? I have no idea.

On the first point about healthcare payers, my thinking goes something like this…while I understand the demographic drivers of healthcare consumption – that human population growth is inexorable, that aging populations have a nearly insatiable need for health services, and that developing countries are a growing source of demand for western-style healthcare – I have no idea how people (or THE SYSTEM) will pay for it. I help old ladies across the street not because I’m a good Boy Scout, but because as an informed contributor to the Medicare and Social Security tax base. In other words, I know what ceramic hip replacement surgery costs if she falls down!

The point is this: healthcare demand is not driven by typical models of supply and demand. There is a powerful X-factor in the form of government and other payers. These payers are under stress. (Indeed, it’s not too difficult to argue that the government sources of payment in the U.S. and Europe are effectively insolvent already based on future obligations versus any reasonable assumption of having that funding available without bankrupting taxpayers.) When the payers become more strict with their approval of procedures and diagnostic services, it has a direct affect on the manufacturers of the products that are used in surgery or blood tests or whatever else.

It certainly puts Stryker at risk of selling fewer ceramic hip replacements when the aged population has to jump through more hoops to get approved for a $15,000 procedure. There are fewer of these surgeries. BDX faces a similar risk, albeit less pronounced. Fewer surgeries mean less demand for their catheters and needle systems and all of those other items they sell.

Non-discretionary products becomes a misnomer when the service that requires their use becomes discretionary.

All that being said, no matter how gloomy we might be about the future of healthcare reimbursement, there is no question that will continue to be tremendous demand for needles, diagnostic cell testing, and the like. The question is more about how much demand there will be and what impact that might have on BDX earnings growth.

So here’s my paranoia on point one…with the uncertainty surrounding payment methods for healthcare services, can we be very certain BDX (and its peers, for that matter) aren’t priced at a peak of market demand for their products? Part of my checklist for any investment is to ask whether the business itself is showing peak earnings for one reason or another. If so, you try to normalize those earnings to get a more realistic expectation for the future. And you certainly don’t want to pay a high multiple on top of peak earnings! Well, apply the similar logic to the question of whether the healthcare market has shown peak demand for its services based on physicians ordering excessive cover-their-rear diagnostic testing (fear the tort) and surgeons being eager to cut with the knife because they know they’ll get paid (a lot!).

What if we’ve peaked there? Despite the demographic trends suggesting increased demand for more healthcare in the future, the challenge of the payers makes me highly uncertain about how it plays out. I don’t like that level of uncertainty when investing.

Second, despite having some background in the healthcare supply chain, I have no idea what the vast majority of BDX products actually do – like the titillating BD Insyte Autoguard with Blood Control mentioned above. Nor can I make a reasonable estimate of what the market for these products might be. Moreover, if I assume I have the brain wattage to learn enough about it at all, adding it to my circle of competence would easily take months or years buried in a deep research dive.

All that being said, the company could very well go on to compound its earnings in the coming years as the issues I cite become moot. In which case, I have the regret of omission. It would not be the first, and it won’t be the last.

To sum it up, BDX has many hallmarks of a great company and a respectable investment opportunity…BUT…the flux surrounding the payment models for the industry makes me anxious about its ability to achieve even an historically conservative rate of earnings growth (seven percent versus 14 percent)…AND I tend to need to understand the products or services of the businesses I invest in (at least at a minimal threshold anyway)…AND I’m living proof that altruism (e.g., helping old ladies cross the street) is bound-up in self-interest. Call me homo economicus.

How does a business compete against a true fanatic?


A fanatic with a winning model?


A fanatic with access to resources?


The fanatic is, by definition, either oblivious to criticism – so convinced his path is correct – or he is constitutionally impervious to its effects.

He is NOT a rational player who sticks to conventional rules or employs conventional tactics. He has a higher threshold for pain, does not keep banker’s hours, and revels in keeping foes off balance.

The fanatic chooses a path, making appropriate corrections as he proceeds, and sticks to it with stubborn resolve.