By Chuck Carnevale
Updated from 11:04 am, to include closing prices on the last page.
NEW YORK (
) -- The stock market can often overreact to even the slightest amount of bad news. On Thursday,
was down big, over 7.5%, on heavy volume. There were two pieces of news that could be attributed to this drop, although neither was of great importance to my way of thinking.
First, Piper Jaffray announced that they substantially lowered their price target from $86 a share to $71 a share. That represents a significant premium to their stock price currently at $55.23. However, I believe that this is the least likely reason for the big drop in Ross.
The most likely reason for their price drop was that Ross issued a
press release announcing a modest increase in sales for the four weeks ending March 3, 2012. This seems to have greatly disappointed the myopic stock market. Although the announcement was below expectations, I for one do not believe that it justifies a 7% drop in their already reasonably-priced shares. In fact, I contend that it is completely irrational to believe that the intrinsic value of a publicly-traded company like Ross Stores could change by as much as 7% in one day.
Ross Stores The Business
I am more interested in the business behind the stock than I am the stock itself. I believe it is much easier to analyze the fundamentals behind a business in order to calculate its intrinsic value than it is to try and guess where the stock price might go next. The venerable Ben Graham taught us all that the market is bipolar with his famous Mr. Market allegory.
Ross Stores has one of the best operating histories of any company I've ever examined. It is the largest off-price apparel and home fashions chain in the United States. The company operates over 1,000 Ross Dress for Less stores in 33 states and over 100 dd's DISCOUNTS stores in eight states. The company earns high returns on capital and their stores operate with high gross and operating margins. Ross Stores is fiscally fit with only 8% debt to capital and generates consistently strong cash flows.
Perhaps most importantly, they bring these strong fundamentals to the bottom line while simultaneously offering customer savings of 20% to 60% off department and specialty store prices. Consequently, the company's business model has proven to be very recession resistance as their historical record of operating earnings clearly illustrates.
The following graph plots earnings per share (the orange line) and dividends (the blue shaded area) only on Ross since 1999. Ross has consistently grown earnings at over 17% per annum, and the dividend has grown along with profits. On this graph the slope of the orange line is 17% (Ross's growth rate) and simultaneously represents a PE ratio of 17. Based on this graph, I believe Ross Stores represents the quintessential example of what a growth stock should be. Notice how Ross Stores' earnings growth actually accelerated during and after the Great Recession of 2008.
After examining thousands of companies, I have confidently determined that earnings drive market price in the long run. The following earnings and price-correlated graph magnificently validates the earnings and price relationship. The orange earnings justified valuation line represents a PE ratio 17.1, and the dark blue line represents a blended average normal PE ratio of 15.9. Notice how closely monthly closing stock prices (the black line) track and correlate to earnings.
Moreover, take note of how the price continuously moves back into alignment with the orange fair valuation line. When Ross Stores' price rises above the orange earnings line, it shortly moves back down, and when the price falls below the orange earnings line, it again quickly moves back into alignment. By August 2012, Ross's stock price had become overvalued but has since moved into slight undervaluation territory. Earnings clearly determine market price in the long run.
When a stock can be purchased within a reasonable range of fair value, then long-term earnings growth will be the primary driver of capital appreciation. Additionally, since dividends are paid out of earnings they are also functionally related to the company's profits and the growth thereof.
When you examine the long-term performance of Ross Stores, you discover that capital appreciation of 18.6% per annum correlates closely with the company's 17.1% earnings growth rate, adjusted only by valuation discrepancies.
Moreover, by examining the dividend cash flow table within the performance report, we discover that dividends have grown in close concert with earnings over time. Consequently, shareholders have received a raise in pay each year because Ross raised their dividend each year.
Therefore, even though Ross offers a below-market current yield, its growth yield (a.k.a. yield on cost) generated significantly above-market cumulative dividend distributions. Since 1999, a $1,000 investment in Ross Stores generated $523.73 worth of dividends compared to only $227.46 from the
The consensus of 31 analysts reporting to
forecast Ross to continue growing earnings at 13.9% for the next five years. Personally, I feel the company can do better than that, evidenced by the fact that their earnings growth rate since the great recession of 2008 has averaged 25.9 % per annum. Since this is almost twice the consensus forecast, earnings growth somewhere between consensus and their historical average is at the very least plausible.
Summary and Conclusions
Clearly, Ross Stores is an extremely well-run retailer with a strong history and a bright long-term future. After being overvalued for much of 2012, Ross's share price has reverted to the mean and moved back into fair value territory. Moreover, I believe that the recent precipitous one-day drop in their share price has created a bargain for their shares that might be the equal to the bargains found by shopping in their stores.
Consequently, I think Ross Stores represents an excellent opportunity for the long-term investor seeking above-average growth and rising dividend income, coupled with a margin of safety based on current valuation.
Ross closed friday at at $56.20, up 97 cents or 1.76%.
At the time of publication, Carnevale was long ROST, although positions may change at any time.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.