Beating the Street (43 page)

FIGURE 21-3

I read the latest quarterly reports from all 21 companies, and I called most of them. Some stories had gone flat, while others were more exciting than before, and in a few cases my research led me to other companies that I liked better than the ones I'd recommended. That's how it is with stocks. It's a fluid situation in which nothing is absolutely certain. I proceeded as follows:

Back in January, I determined that the Body Shop was a wonderful company, but overpriced relative to current earnings. I was looking for a drop in price as a chance to buy more. It didn't take long to get one—by July the stock had fallen 12.3 percent, from 325 pence to 263 pence. The Body Shop was now selling for 20 times the estimated 1993 earnings. I don't mind paying 20 times for earnings in a company that's growing at a 25 percent annual rate. As of this writing, the entire New York Stock Exchange was selling at 20 times earnings, for companies that on average were growing at a 8–10 percent rate.

The Body Shop is a British stock. British stocks had taken a terrible beating in recent months, and the Body Shop had gotten some bad publicity. A chieftain from the Kayapó Indian tribe, which the Body Shop had hired to produce Brazil nut hair conditioner, was arrested in London and charged with raping the Portuguese nanny for some of his numerous children. No matter how hard you try to imagine the next event that will make trouble for a company, it's usually something you haven't thought of.

Checking the price history of this stock, I noticed it had suffered two major setbacks, one in 1987 and the other in 1990, both in spite of the fact that the company was perking along with no sign of a letup. I attribute these exaggerated sell-offs to the fact that British shareholders are not as familiar with small growth companies as we are, and therefore abandon them more readily in a market crisis. Also, since the Body Shop is a global venture, British investors may equate it with several notable failures at expanding abroad, e.g., Marks & Spencer.

Table 21-1. STOCKS SELECTED FOR 1992
BARRON'S
ROUNDTABLE: SIX-MONTH CHECKUP

Table 21-2.

Even if you bought shares in the Body Shop after the 1990 setback, you had to be prepared for further declines, when you might consider buying more. But the fundamentals still had to be favorable, which was the point of the checkup. I called the company. Jeremy Kett, chief financial officer, told me that same-store sales and earnings had both increased in 1991, a considerable achievement given the fact that the Body Shop's four major markets are England, Australia, Canada, and the U.S.—all countries struggling with recession.

Another promising card had turned over. The company was using some of its cash to buy up suppliers of various potions and lotions. This would cut the cost of the merchandise down the line, and
improve the profit margin. This was the technique that helped Shaw Industries become the low-cost carpet maker.

I talked to Cathy Stephenson, my old friend from the Fidelity library who owns the Body Shop at the Burlington Mall plus the one in Harvard Square. She reported a 6 percent gain in sales over the previous year's results at Burlington and said it was too early to tell about Harvard Square. Her customers were flocking to several new products, including Complete Color for eyes, cheeks, and lips; tinted face moisturizer with sunscreen; pumice foot scrub; and mango body butter, which she couldn't seem to keep on the shelf—“Who knows what they're doing with it?”

The market for lotions, potions, and bath oil is still vast, with plenty of room to grow. The Body Shop was sticking to its expansion plan—40 new outlets in the U.S. in 1993, 50 more in 1994, 50 per year in Europe, an equal number in the Far East. I placed the company in the attractive mid-life phase—the second decade of 30 years of growth.

Pier 1 Imports had made a nice run, from $8 to $9.50, then promptly reverted. This is an example of Wall Street's being deaf to good news. The analysts had pegged Pier 1's first-quarter earnings at 18-20 cents, Pier 1 actually earned 17 cents, and the stock got clobbered. The company was expected to earn 70 cents for the year, and this in a wallet-hugging environment.

Pier 1 had strengthened its balance sheet by selling $75 million worth of convertible debentures and using the proceeds to retire debt. Long-term debt, which already had been reduced, was pared down even further.

Pier 1 had cut debt, reduced inventory, and continued to expand. Its major competitors, the department stores, were getting out of the home furnishings business. The longer this recession lasted, the more competitors would drop by the wayside. When the recovery comes, Pier 1 may have a virtual monopoly on wicker side tables, Scandinavian place settings, and Oriental room dividers.

It didn't take much wishful thinking to foresee Pier 1 earning 80 cents a share from its own stores, plus an additional 10–15 cents from a revived and dried-off Sunbelt Nursery, a company in which
Pier 1 continues to hold a substantial stake. That's a buck a share, which, given a reasonable p/e ratio of 14, makes Pier 1 a $14 stock.

General Host is another stock that rose up and then drifted back to just above where I'd recommended it. Nimble sellers had gotten a 30 percent gain, while long-term investors saw paper profits dwindle from $2 a share to 50 cents.

A disappointing card had turned over. In April, the company issued $65 million worth of a new convertible preferred stock with an 8 percent yield. This was exactly what Pier 1 had done, except that General Host had to pay a higher interest rate due to its shakier financial condition.

Shareholders in convertible stock or debentures have the right to trade these in for shares in the common stock at a fixed price sometime in the future. This creates more shares of common, which dilutes the earnings for the existing shareholders of the common. Earlier, General Host had bought back some of its common shares, which was a positive move, and now it had reversed itself by issuing the convertible, which was a negative move.

Whereas Pier 1 had used the proceeds from its convertible sale to pay off debt, thus reducing interest expense, General Host was using its proceeds to further renovate its Frank's Nursery stores. This was a chancier proposition, with no immediate benefit.

Meanwhile, sales at the Frank's nurseries were sluggish to moribund, as the revival in the housing market had begun to fizzle. Back in January, when the stock was selling for $7.75, the company was expected to earn 60 cents for the year, but now it was an $8 stock in a company that was expected to earn 45 cents.

Still, General Host had a strong cash flow, its dividend had been raised for the 14th year in a row, the stock was selling for less than book value, and the expansion was proceeding according to plan. From punching up GH on my Quotron, I learned that Mario Gabelli had bought a million shares for his value-oriented fund. I counted this stock as a hold.

Sunbelt, my other recommendation from the nursery, had lost money since January. More rain in the Southwest, where Sunbelt is located, had dampened people's enthusiasm for working in the garden.
What had been an $8.50 stock at its initial public offering in 1991 was now a $4.50 stock, and this for a capable company with $1.50 a share in cash. If you bought Sunbelt now, you were getting all the garden outlets for $3, and someday, when the rains abate and people rediscover flowers, they will have a sunnier disposition toward Sunbelt shares as well.

What keeps me from backing up the truck and buying more Sunbelt is Calloway's. You may recall that Calloway's was regarded as the class of the industry, which I hadn't recommended the first time around because Sunbelt was cheaper. But while checking up on Sunbelt, I discovered that Calloway's stock also had fallen in half in the rain.

To find out more, I called Calloway's to talk to Dan Reynolds, the investment relations person. He told me there were 20 employees in the administrative office, all of them sharing the same 3,000 feet of floor space. I could hear them the background. Obviously, there is no communications gap in this company—to get the management's attention, all you have to do is stand up and yell.

Calloway's has 13 nurseries, plus 50 cents per share in cash, and is expected to earn 50 cents in 1993. This gives the stock a p/e ratio of 10. Calloway's has no followers on Wall Street, and the company is buying back its own shares.

When the best company in an industry is selling at a bargain price, it often pays to buy that one, as opposed to investing in a lesser competitor that may be selling at a lower price. I'd rather have owned Toys “R” Us than Child World, Home Depot than Builder's Square, or Nucor than Bethlehem Steel. I still like Sunbelt, but at this point I think I like Calloway's slightly better.

After a strong run and a three-for-two stock split, Supercuts, too, has reverted to its January price. Two lousy cards have turned over. The first is the fact that Ed Faber, the expert from Computerland who knew how to roll out a franchise, has left the company. The word is that Faber wants to devote himself to managing his own Supercuts salon. This explanation is not entirely convincing.

The second lousy card is something I noticed in the proxy statement. I must have overlooked it earlier. A group called Carlton
Investments owns 2.2 million shares of Supercuts stock. It turns out that Carlton is part of Drexel Burnham Lambert, the bankrupt Wall Street firm. Drexel's creditors will surely demand Carlton's liquidation, which means that along with everything else, the 2.2 million shares of Supercuts will be sold. This will cause the price to fall. In fact, the price may already have fallen on fears of this “overhang,” which is what Wall Street calls a big block of shares that's about to be dumped on the market.

The company itself is having a good year. Supercuts was named “Official Hair Salon Services Supplier for the Olympics,” so maybe the same woman who snipped off my sideburns got to shave the swimmers' heads. The all-important same-store sales are up 6.9 percent in the first quarter of 1992. Several new Supercuts have opened in upstate New York, where the mayor of Rochester got a free ceremonial haircut.

As long as same-store sales improve and the company succeeds in new markets, I'll add to my position, although I'm beginning to worry that the company may expand too fast. Between 80 and 100 new franchises are planned for 1993.

I've already seen several promising franchises, from Color Tile to Fuddrucker's to Bildner's, ruined by overeager corporate conquistadores. “If you have a choice between reaching your goal in fifteen years or in five years, fifteen is better,” I advised the CEO of Supercuts in July.

So far, the best performers of my 21
Barron's
picks are the S&Ls. This is no accident. Take the industry that's surrounded with the most doom and gloom, and if the fundamentals are positive, you'll find some big winners. With interest rates falling, it's been a happy year for financial institutions in general. They're making huge earnings thanks to the spreads between the interest rates they charge for mortgage loans and the rates they pay on savings accounts and CDs.

Since I recommended it, Germantown Savings is up 59 percent, Sovereign has declared two 10 percent stock dividends and also is up 64.5 percent, Eagle Financial has advanced from $11 to $16, Glacier Bancorp has climbed over 40 percent, and People's Savings Financial is up 26 percent.

Of my two long-shot S&Ls, Lawrence is up 37 percent and First Essex is up 70 percent, proving that the riskiest stocks often carry the greatest rewards. I called CEO Leonard Wilson at First Essex to see how things are going. This is the man who earlier described his predicament as “bottom fishing with a six-hundred-foot line,” but by late spring he had reduced the length of the line to 60 feet.

Wilson reported improvements on several fronts: foreclosed properties are selling, nonperforming loans are down, and the mortgage market is picking up. Not only has First Essex managed to break even in the first quarter, it actually dared to make a new construction loan. Though I normally dislike construction loans, the fact that First Essex feels optimistic enough to make one after having been driven close to the poorhouse means that somebody thinks this region has a future.