Following from Part #1, here are two examples of unpopular stocks that we think will benefit from both an improvement in fundamentals and sentiment.
Empire Company Ltd.
Empire Company Ltd. is the 2nd largest supermarket chain in Canada, and operates the Sobeys, FreshCo, Safeway Canada, and Foodland supermarket brands. When Empire acquired Safeway Canada in 2013 for $5.8b, the market reacted positively, sending Empire shares up over 15% in the week after the deal was announced.
Since then, Empire has struggled tremendously to integrate Safeway with the Sobeys existing business. To compound Empire’s problems, low oil prices has caused Alberta consumers to be more careful in their spending. This impacted Empire proportionately more than other chains, due to Safeway’s prominent position in Western Canada as a full-service grocer. As of Q2 2016 Empire has had to write down all of Safeway’s goodwill, essentially saying that there was zero value from acquiring Safeway, apart from the assets received. The result of all this has caused Empire shares to fall by 30% and the CEO to step down. After subtracting Empire’s 41.5% stake in Crombie REIT and interests in Genstar, Empire’s core supermarket business is currently trading at 13x trailing 12 month adjusted earnings, which is a discount to both the TSX (16x) and its peers Loblaw and Metro (18x and 19x adjusted earnings, respectively).
We think that with a new CEO, Empire will ultimately be able to resolve these issues, and customers will return when the shelves are stocked, with added optionality from an improving Alberta economy. The improved financial results should also be rewarded with better sentiment in the form of a higher multiple, and Empire’s stock should appreciate nicely from these factors.
I probably don’t need to explain what Apple Inc.’s business is. Many people may take issue over my assertion that Apple is only a “fair” company, but I say this primarily because of the unpredictable nature of consumer technology. Concerns over Apple’s future product pipeline and slowdown in China has caused Apple’s share price to fall by 20% from its 2015 highs to $108 as of right now.
Apple has $29 per share of cash net of debt, of which $26 is held in foreign accounts. This values Apple’s core business at $79 per share, or about 9x trailing earnings. Even if you assume Apple will blow through its entire cash balance, Apple’s valuation of 12x earnings is a significant discount to the consumer electronics sector that is trading at 21x trailing earnings and U.S. stocks as a whole trading at 25x. This valuation would suggest that Apple is doomed to fail. We think this is likely to be an overreaction. The current concern is that the iPhone has reached its peak and is on a declining trajectory. Several threats appear to be contributing to this, including aggressive competition from Chinese competitors such as Xiaomi, Huawei, and Oppo, and fears that people are taking longer to switch phones. To further contribute to this, everyone can see the data and assumes that the iPhone is following the way of the iPod and the iPad, which both declined after reaching their respective peaks. The iWatch was also much less successful than hoped for, and there are no new products confirmed in Apple’s product pipeline.
To be sure, Apple’s recent financial results have been poor, with Apple’s revenue declining by 18% in the most recent quarter. However, apart from the low-priced iPhone SE (which targets a different demographic), there have been no recent product launches. With the new iPhone 7 being expected to launch in fall 2017, there is little incentive for users to buy a new device in the meanwhile.
Apple’s brand loyalty is among the highest of any consumer product, and both Apple and Google’s Android are working hard to maintain this loyalty by adding system-specific services such as Apple Pay, cloud services, and the iTunes app store. The result of all this is that the cost to switch platforms (i.e. iOS to Android or vice versa) has increased. With smartphones remaining a staple of daily life for the immediate to mid-term future, Apple should be able to hold on to it’s market position in the high-end phone segment, and this should manifest itself in, at a minimum, flat iPhone 7 unit sales from previous iPhone 6 levels. This improved financial performance along with a change in sentiment that Apple is not declining, should result in a higher share price than current levels.
I write this with the humble view that tech is fast-changing and unpredictable, however look at it from this perspective:
1) If the market expects something to fail, and it does fail, then you neither make nor lose money;
2) If the market expects something to fail, and it doesn’t fail, then you make money. In my opinion, Apple would fall into this category.
It is entirely possible that Empire and Apple will end up just as poorly as the market expects. However, these are two examples where we think the current market opinion is not predictive of future performance. In our view, to invest any other way, without taking regard of both fundamentals and sentiment, would be unintelligent.
August 23, 2016
Clients of Baskin Wealth Management are shareholders of Empire and Apple. The author personally owns shares of Empire and Apple.