Beating the Street (24 page)

This is a socially conscious enterprise like Celestial Seasonings or Ben & Jerry's ice cream. It relies on natural ingredients (including some that are extracted from the rain forest by Kayapó Indians who if they didn't have this job might be cutting down the trees to make a living), shuns advertising, gives all employees one day of paid leave per week for community service activities, promotes health instead of beauty (after all, how many of us will ever be beautiful?), recycles its shopping bags, and pays a 25 cent reward for each little lotion bottle that's returned for a refill.

The Body Shop's commitment to something other than money has not inhibited the franchises from making plenty of it. Cathy Stephenson told me that a franchise owner could expect to turn a profit in the first year. She'd done so well with the Burlington store that she was preparing to open a second store in Harvard Square, and this in the midst of a recession.

In spite of the recession, Body Shops worldwide reported an increase in same-store sales in 1991. (Same-store sales is one of the two or three key factors in analyzing a retail operation.) Body Shop products are priced above the shampoos and lotions sold in discount stores, but below those sold in specialty and department stores. This gives the company a “price niche.”

The best part of the story was that the expansion was in its early stages and the idea seemed to have worldwide appeal. The country with the most Body Shops per capita was Canada, with 92 outlets open for business. Already, the Body Shop had become the most profitable of all Canadian retailers, in sales per square foot.

There was only 1 Body Shop in Japan, 1 in Germany, and 70 in the U.S. It seemed to me that if Canada, with one tenth the U.S. population, could support 92 Body Shops, the U.S. could support at least 920.

With years of growth ahead of it, the company was proceeding carefully and expanding with caution. You want to avoid the retailers that expand too fast, especially if they're doing it on borrowed money. Since the Body Shop was a franchise operation, it was able to expand on the franchisees' money.

It was from Cathy Stephenson that I learned of the company's cautious, deliberate approach. She already had proven her ability to run a successful Body Shop in Burlington, but before she was
permitted to buy a second franchise in Harvard Square, the chairman of the board flew over from England to inspect the site and to review her performance. This wouldn't have been so remarkable if the Body Shop had been investing its own money, but this was Ms. Stephenson's money at stake and still her second store wasn't automatically approved.

It was a lucky coincidence that I knew the owner of a Body Shop, but millions of shoppers worldwide could get the same feel for the business from visiting one of the outlets, and the same facts and figures from reading the annual and quarterly reports. I mentioned to a poker buddy that I'd gone to a Body Shop, and he told me that his wife and daughter both loved the place. When a 45-year-old and a 13-year-old are enthusiastic about the same store, it's time to launch the investigation.

Same-store sales were OK, the expansion plans seemed realistic, the balance sheet was strong, and the company was growing at 20-30 percent a year. What was wrong with this story? The p/e ratio of 42, based on the S&P estimate of 1992 earnings.

Any growth stock that sells for 40 times its earnings for the upcoming year is dangerously high-priced, and in most cases extravagant. As a rule of thumb, a stock should sell at or below its growth rate—that is, the rate at which it increases its earnings every year. Even the fastest-growing companies can rarely achieve more than a 25 percent growth rate, and a 40 percent growth rate is a rarity. Such frenetic progress cannot long be sustained, and companies that grow too fast tend to self-destruct.

Two analysts who follow the Body Shop were predicting that the company would continue to grow at a 30 percent rate in the next couple of years. So here was a possible 30 percent grower selling at 40 times earnings. In the abstract these were not attractive numbers, but from the perspective of the current stock market they didn't look quite as bad.

At the time I was researching this company, the p/e ratio of the entire S&P 500 was 23, and Coca-Cola had a p/e of 30. If it came down to a choice between owning Coca-Cola, a 15 percent grower selling at 30 times earnings, and the Body Shop, a 30 percent grower selling at 40 times earnings, I preferred the latter. A company with a high p/e that's growing at a fast rate will eventually outperform one with a lower p/e that's growing at a slower rate.

The key question was whether the Body Shop could actually keep
up a 25–30 percent growth rate long enough for the stock to “catch up” to its lofty current price. This is easier said than done, but I was impressed with the company's proven ability to move into new markets, and its worldwide popularity. This was an international enterprise almost from the start. The company had installed itself on six continents and had hardly scratched the surface of any of them. If all goes according to plan, we could eventually see thousands of Body Shops, and the stock might increase another 7,000 percent.

It was the unique global aspect of this company that inspired me to support it publicly in
Barron's.
I wouldn't have touted it as the only stock a person should own, and I was aware that the high price relative to earnings left little room for error. The best way to handle a situation in which you love the company but not the current price is to make a small commitment and then increase it in the next sell-off.

The most fascinating part of any of these fast-growth retailing stories, whether it's the Body Shop, Wal-Mart, or Toys “R” Us, is how much time you have to catch on to them. You can afford to wait for things to clarify themselves before you invest. You don't have to rush in and buy shares while the inventor of the Body Shop lotions is still testing the original potions in her garage. You don't have to buy shares when 100 Body Shops have been opened in England, or even when 300 or 400 have been opened worldwide. Eight years after the public offering, when my daughters led me into the Burlington store, it was still not too late to capitalize on an idea that clearly had not yet run its course.

If anybody ever tells you that a stock that's already gone up 10-fold or 50-fold cannot possibly go higher, show that person the Wal-Mart chart. Twenty-three years ago, in 1970, Wal-Mart went public with 38 stores, most of them in Arkansas. Five years after the initial offering, in 1975, Wal-Mart had 104 stores and the stock price had quadrupled. Ten years after the initial offering, in 1980, Wal-Mart had 276 stores, and the stock was up nearly 20-fold.

Many lucky residents of Bentonville, Arkansas, the hometown of Wal-Mart's founder, the recently deceased Sam Walton, invested at the earliest opportunity and made 20 times their money in the first decade. Was it time to sell and not be greedy and put the money into computers? Not if they believed in making a profit. A stock doesn't care who owns it, and questions of greed are best resolved in church or in the psychiatrist's office, not in the retirement account.

The important issue to analyze was not whether Wal-Mart stock would punish the greed of its shareholders, but whether the company had saturated its market. The answer was simple: even in the 1970s, after all the gains in the stock and in the earnings, there were Wal-Mart stores in only 15 percent of the country. That left 85 percent in which the company could still grow.

You could have bought Wal-Mart stock in 1980, a decade after it came public, after the 20-fold gain was already achieved, and after Sam Walton had become famous as the billionaire who drove a pickup truck. If you held the stock from 1980 through 1990, you would have made a 30-fold gain, and in 1991 you would have made another 60 percent on your money in Wal-Mart, giving you a 50-bagger in 11 years. The patient original shareholders have that to feel greedy about, on top of the original 20-fold gain. They also have no problem paying their psychiatrists.

In a retail company or a restaurant chain, the growth that propels earnings and the stock price comes mainly from expansion. As long as the same-store sales are on the increase (these numbers are shown in annual and quarterly reports), the company is not crippled by excessive debt, and it is following its expansion plans as described to shareholders in its reports, it usually pays to stick with the stock.

How the “Collapse” in Real Estate Led Me to Pier 1, Sunbelt Nursery, and General Host

Digging where the surroundings are tranquil and pleasurable may prove to be as unrewarding as doing detective work from a stuffed chair. You've got to go into places where other investors and especially fund managers fear to tread, or, more to the point, to invest. As 1991 came to a close, the most fearsome places were all connected to housing and real estate.

Real estate had been the principal national scare for more than two years. The famous collapse of commercial real estate was rumored to be spreading into residential real estate—house prices were said to be plummeting so fast that the sellers would soon be giving their deeds away.

I saw this despair in my own neighborhood in Marblehead, where so many for-sale signs had sprouted that you would have thought the for-sale sign was the new state flower of Massachusetts. The signs eventually disappeared as the frustrated sellers got tired of waiting for decent offers. People complained that the indecent offers they did get were 30–40 percent below what they could have gotten two or three years earlier. There was plenty of circumstantial evidence,
if you lived in a fat-cat environment, that the great boom in real estate had gone bust.

Since the owners of fat-cat houses included newspaper editors, TV commentators, and Wall Street money managers, it's not hard to figure out why the collapse in real estate got so much attention on the front pages and the nightly news. Many of these stories had to do with the collapse in commercial real estate, but the word “commercial” was left out of the headlines, giving the impression that all real estate would soon be worthless.

What caught my eye on the back pages one day was a tidbit from the National Association of Realtors: the price of the median house was going up. It had gone up in 1989, in 1990, and again in 1991, as it had every year since the organization started publishing this statistic in 1968.

The price of the median house is only one of the many quiet facts that can be a great source of strength and consolation for investors willing to explore the scariest areas of the market. Other useful quiet facts are the “affordability index” from the National Association of Home Builders and the percentage of mortgage loans in default.

I've found that on several occasions over the years, the quiet facts told a much different story than the ones being trumpeted. A technique that works repeatedly is to wait until the prevailing opinion about a certain industry is that things have gone from bad to worse, and then buy shares in the strongest companies in the group.

(This technique isn't foolproof. In the oil and gas drilling industries, people were saying things couldn't get any worse in 1984, and they've been getting worse ever since. It's senseless to invest in a downtrodden enterprise unless the quiet facts tell you that conditions will improve.)

The news about the price of the median house having gone up in 1990 and again in 1991 was so poorly disseminated that when I brought it up at the
Barron's
panel nobody seemed to believe me. Moreover, the decline in interest rates had made houses more affordable than they'd been in more than a decade. The affordability index was so favorable that unless the recession was going to last forever, a better housing market seemed inevitable.

Yet while the quiet facts pointed in a positive direction, many influential people were still worrying about the collapse in real estate, and the prices of stocks in any enterprise remotely related to
home building and home finance reflected their pessimistic view. In October 1991 I looked up Toll Brothers, a well-known building company that has appeared from time to time in my portfolio and in my diaries. Sure enough, Toll Brothers stock had dropped from $12⅝ to $2⅜—a five-bagger in reverse. A lot of the sellers must have owned fat-cat houses.

I chose Toll Brothers for further study because I remembered it as a strong company with the financial wherewithal to survive hard times. Ken Heebner, a fine fund manager who'd recommended Toll Brothers to me years earlier, had told me what a classy operation this was. Alan Leifer, a Fidelity colleague, also had mentioned it to me in an elevator.

Toll was strictly a home builder and not a developer, so it wasn't risking its own money by speculating in real estate. With many of its poorly capitalized competitors going out of business, I figured Toll Brothers would end up capturing more of the home-building market after the recession. In the long run, the latest slump would be good for Toll.