This column was originally published on RealMoney on Dec. 8 at 7:18 a.m. EST. It's being republished as a bonus for TheStreet.com readers.
It doesn't make a lot of sense to be bullish right now. The yield curve is as flat as a pancake, and the
appears resolute in its plan to push short-term rates still higher. That means the yield curve will soon invert, a dynamic that has been followed by recession in every instance over the last 100 years, with two exceptions. And in both of those exceptions, a no-growth economy barely skirted a recessionary decline.
While backward-looking governmental statistics show that the economy continues to grow, forward-looking evidence continues to mount that we may be facing a slowdown in the near term. In conversations I've had recently with professionals in the mortgage business, home construction, real estate and new cars, the response is amazingly uniform: A slowdown has already started.
In the face of a potentially difficult economic backdrop, how can a value investor justify taking new equity positions? One reason is stark in its simplicity: because value materially exceeds price. Another reason is that historically, stocks always launch a major rally in the midst of economic turbulence. Over the last 100 years, the equity market has never failed to rally in advance of the end of a recession. In one case, the rally began at the beginning of a recession.
Investors who get in front, who take positions in advance of fundamental improvement, perform better than those who wait for the evidence of a turn. I believe that will be the case for the turnarounds recommended below, the second set of picks for my two-part series, Top 10 Turnarounds for 2006. (
Click here to read Part 1.)
On an earnings basis,
is struggling with the worst interest rate environment in many years. Operationally, the business is not struggling at all; the company is growing deposits at well over a 25% annual clip, while taking market share in every region in which it competes.
The flat yield curve is the root of Commerce's earnings woes. Commerce is particularly vulnerable to a flat yield curve because of its combination of conservative lending policies and rapid deposit growth. It isn't an aggressive lender, so its rapid deposit growth is plowed into fixed-income securities. A flat yield curve squeezes profitability by squeezing the spread between the fixed-income yield and the rate Commerce pays on deposits.
But a simple syllogistic inference makes the case for Commerce here: Earnings per share at Commerce are depressed because of a flat yield curve. Historically, flat yield curves never last more than three or four quarters. Therefore, it is faulty, or misguided, to value Commerce going forward on the basis of a flat yield curve.
Calculating the normalized earnings power at Commerce isn't difficult. If the yield curve were to be normal for all of 2006, the earnings power of the company would be $2.75 per share, not the $2.05 per share expected by most analysts. Normalized earnings power is about $3.20 per share for 2007, based on a normal yield curve. Of course, the yield curve will not revert to a normal slope in the next month or two. But we will have a normal yield curve again in the not-too-distant future.
When the market recognizes this certainty, look for Commerce's quote to move quickly into the $50s. Expect a quote north of $60 per share sometime in 2007. Even these estimates may prove to be conservative, based on a price-to-earnings multiple of 18 with a normal yield curve. That's because you can't find a 20% annual grower that sells for a P/E of less than 20. Organic growth, as opposed to the riskier growth via acquisitions, is valued very highly by the market. You can't find a 20%
grower like Commerce that sells for P/E lower than 25. Most sell for 30 to 45 times earnings.
are a couple of examples.
is an operating leverage story. The company is gradually ratcheting down certain variable expenses over the next couple of years to bring operating margins to 8% or higher. With solid top-line growth and a stellar balance sheet, this is a conservative stock to own that I expect to have lots of upside. If I'm right about the margin leverage in the operating model, this stock will at least double over the next couple of years.
I haven't seen so much misplaced negativity swirl around a stock since
was given up for dead a few years ago. The growling bears are dead certain that
will be a "goner" in short order. I think they're wrong.
The financials reveal the true story. Blockbuster took on too much in late 2004 and early 2005, allocating substantial capital to a nascent online business, a growing game business and a DVD trading business, while at the same time eliminating $550 million in high-profit late fees from its $6 billion annual revenue base.
The extraordinary outlay of capital coincident with a revenue pinch (the elimination of late fees) isn't going to be repeated. Aside from its DVD rental business, which grew over the last year if you back out late fees, Blockbuster has a substantial and growing game business, with more than $700 million in revenue. It is also a significant retailer, growing at a double-digit rate with more than $1.8 billion in annual revenue. Look for big upside out of Blockbuster over the next couple of years. Predictions of its early demise are way overdone.
is a low-risk turnaround with reasonably good upside. TJX is the leading off-price apparel retailer, with more than $15 billion in annual revenue. The founder is back at the helm, as of September, and is aggressively implementing a lot of operational changes. Look for earnings to improve markedly off of recent depressed results. With share buybacks supported by a healthy free cash flow stream, I think a quote of $28-$30 in 2006, a significant improvement over the current quote of around $22, is a conservative expectation.
The turnaround at
is just starting to gain traction. This $370 million natural foods grocer with $1.1 billion in annual revenue had 6% same-store sales growth last quarter. With growth of 10% in square footage planned for next year and growth of about 5% in same-store sales, this company could surprise many on Wall Street. Shares of Wild Oats should be worth more than $18 to $20 per share by next year, with a double from the current quote of $12 per share achievable in two to three years.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider 1-800-Flowers.com and Wild Oats to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At time of publication, Alsin and/or ACM was long Commerce Bancorp, 1-800-Flowers.com, Blockbuster, TJX Companies and Wild Oats, although holdings can change at any time.
Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback;
to send him an email.