So… what’s going in in the Real Money Portfolio this week, as we close up shop and get ready for a bit of time with family and friends? I do have one buy to share with you today, I decided to pick up some shares of the stock that I wrote to you about a week ago, Five Below (FIVE).
Why? Well, what helped to tip the balance is that Five Below (FIVE) will be a very big beneficiary of the lower tax rate, all else being equal… they pay about 36% in income taxes at the corporate level, so if we assume that they will pay roughly 21% in the future that’s a substantial boost. Right now, if the tax cut were retroactive to 2017 (it isn’t, of course, this is just an exercise), their net income would be about 23% higher.
If we use a slightly smaller number, say 20%, and apply that to future estimates (the average estimate almost certainly does not account for the new tax rate yet, since it was just passed and analysts are not typically aggressive with such things), then the 2019 earnings (they’re in FY 2018 right now) could go from $2.06 to $2.47. That means the forward PE goes from 32 to 27.
So yes, it still trades at a premium prices… but I’ll bite at that level, particularly because the stock was fairly appealing even before, and this tax cut isn’t likely to otherwise pressure the growth numbers… in fact, it could also be that the tax cut is positive for top-line sales, not just the bottom line profitability. If withholding is slightly lower for most middle class taxpayers starting in January, there could be more disposable income, which tends to leak down to the teenagers who frequent Five Below.
And really, other than Amazon my portfolio is quite lacking in retail or real consumer-driven companies, so it will probably be good to have some further exposure to that sector — even if I’m not willing to risk a lot on most of the struggling retailers right now… FIVE seems, with its fun stores and low prices, to be effectively immune from the Amazon flu that ails so many retailers, though that, of course, is no guarantee that they’re immunized forever.
It still could fall apart on an operational level too, of course, the next quarter (ending in January) is by far the most important one for FIVE, as it is for pretty much all retailers (close to 40% of revenue comes in the Nov-Jan quarter, and their profit margin tends to be about 12-13% at this time of year — versus 2-4% the rest of the year), so the late February earnings report will be watched very closely, as will any commentary from the company about holiday sales.
It could also be that some of that run from $55 to $65 was because investors were “baking in” the likely tax cuts — they had a strong “beat and raise” quarter right after Thanksgiving, at about the same time that most stocks and sectors started surging, so I think that operational performance was the primary reason for the jump… but I could be wrong. I think it will take a while for the tax cut to be fully priced-in to the expectations for a lot of stocks… and that could really add to the growth story for stocks that have fundamental growth that looks really strong and can lever that up with a really substantial increase in earnings per share from the corporate tax cut.
I don’t know what will happen with stocks that are just getting a one-time shot of earnings growth from tax cuts, or from repatriating overseas cash, sometimes one-time improvements that make a stock look like it’s growing earnings are adored by the market, sometimes they’re ignored as non-repeating windfalls… but since growth is projected to be very high for FIVE anyway, with a huge buildout in new stores that are apparently doing very well, I think it’s likely that the tax cuts will just be a bit more leverage for growth that was already coming… and I expect investors will reward that pretty handsomely as long as the economy overall is doing OK — as it should, at least in the first flush of tax cuts.
I expect we’ll see a substantial rise in inflation next year as a result of this additional spending and the projection of additional borrowing by the government, and that could bring faster interest rate rises that serve to put the brakes on a little bit, but you never really know for sure what will happen — particularly in this environment, where interest rates remain so much lower in most of the larger economies than there are here in the US.
So I’ve put on a small equity position and another levered bet that FIVE will also see some significant analyst estimate increases by next month that drive the shares higher — I did that through some January in-the-money call options, which are fairly inexpensive because the stock has run so much and there isn’t a formal “catalyst” before the expiration (the next earnings report won’t come out until late March), but I think estimate increases will come before then, largely because of taxes, and that will push the shares higher.
I’m comfortable with the equity investment, even at these high prices, and I think FIVE will likely do very well next year… but the options bet is far riskier, given that we’ve only a few weeks to expiration, and I could easily lose 100% on that position (that’s more of an “indulge my inner bettor” move than it is an actual investment).
There’s certainly risk in the stock, as well, and not just because it’s priced at a premium to the market or just because Amazon is, per investor consensus, destroying mall retailers. Five Below is largely a seasonal and fad-driven retailer, and that has brought plenty of ups and downs… those holding since the IPO five years ago would have done well thanks to this year’s surge, but there were also plenty of opportunities to lose money along the way, and it could easily be that one of the upcoming quarters looks relatively weaker year over year because of something fad-related (if, for example, nothing takes the place of this year’s “fidget spinner” craze that really ballooned earnings for a few months in 2017). Part of what has really worked for FIVE as a business model is pulling in people for fads, and keeping them for more “regular” stuff… so they think that those fidget spinner buyers from last Summer will come back and buy Star Wars gear this winter, or candy, or cell phone cases for their new phones, or whatever. The concept is very similar to a dollar store, in that everything is super cheap ($5 or less), but unlike Dollar Tree (DLTR) or Dollar General (DG) they don’t feature so much of the “boring” stuff like food and shampoo, it’s much more of a toy store for teens.
Despite the low prices, they earn pretty high gross margins — in the 35% range, a bit better than the 30% the big dollar store chains generally earn (gross margin is just the revenue minus the cost of goods). Add in the cost of operations, and the margin edge remains — their operating margin is about 11.4%, versus 8-9% for the dollar stores, and 7.5% for the demographically similar (sort of, at least) Urban Outfitters (URBN). And unlike those competitors, FIVE’s margins have been generally rising over the past five years as they grow and achieve better economies of scale.
The first time I remember hearing about FIVE was when Whitney Tilson mentioned it as an overvalued fad stock to short in 2014, and I hadn’t looked at it in any detail until Cabot was pitching it last week… and it’s still a fad stock, and it could certainly still have some huge downward moves if things go badly, but recent operational performance has been strong, with margins improving and the new stores really juicing returns (they added about 70 stores in 2015, 85 in 2016, it will be roughly 100 for 2017… that brings the total up to about 625 stores, and I would be surprised if they open fewer than 120 stores next year). The growth possibilities, if they are able to remain on-trend and keep appealing to college students, teens and preteens and their parents (and other folks, but those are the core focus), are pretty remarkable if you consider that they remain fairly regional. FIVE started in Philadelphia and really began to expand in earnest only about five years ago, including opening their first few stores in California just this year. Fads can fizzle, but those who can ride fad after fad and keep opening shiny new stores and selling mermaid blankets and fidget spinners and poop emojis may be able to keep rolling along.
If that particular stock doesn’t appeal, but you’re curious about stocks that might be undervalued because of the tax cuts, by the way, I experimented with some screens to see if I could ID some stocks that hadn’t yet moved dramatically but that pay high taxes and are growing and are likely to be valued primarily on their near-term earnings.
Here’s what I did:
- Exclude real estate
- Exclude energy
- Include only stocks headquartered and domiciled in the United States
- PE ratio for the trailing 12 months (TTM) of between 15-35 (meaning there’s a good chance the company is at a fairly mainstream valuation, and is valued based on current earnings)
- PEG ratio of less than 2 (meaning the PE ratio is less than twice the expected growth rate, a simple “might not be overvalued” screen)
- Market cap of at least $500 million
- 20 day returns in the bottom 75 percentile (stocks that have not been surging over the past month)
- but… 20 day returns that are positive, so stocks that haven’t recently taken a big hit.
- Current ratio not in the lowest quartile (meaning, it’s not one of the 25% of stocks that have the most stressed balance sheets)
And that leaves us with 45 stocks… I’m not recommending these, of course, and some of them I haven’t even really looked at (a few I’ve never even heard of, some probably have terrible, scary skeletons in their closets)… but perhaps it will be a fruitful area for sniffing out ideas, or it will inspire your screening and searching. I use YCharts for screening, but it’s fairly expensive for the full version — FinViz.com offers some good free screening tools if you want to poke around, and I’m sure there are others.
Five Below is not on this list, of course, because they’ve been a top gainer over the past month thanks to that excellent late November earnings report, and their PE ratio is too high… so if relative strength is more important to you, maybe you’d want to give more room on those kinds of metrics, for example. This is the data from the screen I did, for what it’s worth… I included dividend yield just to provide another data point, it wasn’t part of the screen: