WOW! Prices Roll Back
Woolworth’s stock price rolls back. It’s time to take a fresh look at the fresh food people. Woolworths Ltd. (ASX:WOW) is cash machine all Australians know, some sad individuals may even love it. Woolies is an incredibly strong business with fantastic return on equity, a strong management team and a good moat based around location location location. We all know Woolies, but did you know now appears to be the best opportunity in years to pick up a piece of this great franchise? I recently took a two week free trial of StockVal and Wollies has consistently been in their top five undervalued low risk stocks. So today I decided to take a closer look. Before diving into Woolies please excuse the following plug for StockVal. I liked the service and fortunately they liked my site. So we exchanged advertising for a subscription. Here’s what StockVal say about their service.
“StockVal is a professional stock market investment service used by smart investors and fund managers to produce superior returns. This first rate service empowers its members to take full control of their capital investments through it’s sophisticated stock evaluation tool and expert market commentary.”
I hope you know that I wouldn’t recommend the service if I didn’t find it of use. I will not receive any payments from StockVal for clicks from this site, but clicking through to the two week trial from here means I may be able to get subscriptions to other good services. [Fingers crossed, as a cost neutral site has always been my aim.] At the very least a StockVal subscription should reduce the number of times individual investors over pay for companies. How much is that worth to you?
Woolies Chart
This chart is another great example of investors over paying for growth. While earnings per share increased 66% over the last three years, the shares can be bought for less today. Talk about a price roll back! Investors who bought at the peak in late 2007 are down 26%. The Big Chart tells the story. Despite consistent earnings growth the price has roller coasted down due to ratio compression, i.e. the P/E has compressed as people are prepared to pay less for each dollar of earnings. 
Woolies Valuation
The question now is has Woolies fallen enough? Will buying at the current price of $25.82 have acceptable or, better yet, good returns. StockVal values Woolies at $32 and change. That valuation isn’t far off my technical target of $31.50, so let’s use $32 as a target from a price of $26, for a 23% return. Now let’s throw in the dividend. The yield on Woolies has traditionally been low, per the norm with growth stocks. However, due to the increasing dividend and stagnant price the ttm yield is now an enticing 4% and I estimate a forward yield of 4.4% fully franked. As you can see by the following chart Woolies has a fantastic track record of increasing their dividend every year since 1994.
Due to the law of large numbers and the already outstanding net margins it is unlikely that Woolies income will increase as fast as it has over the last decade. Consequently the dividend is unlikely to continue growing at the last decades average of 19% per year, but half that amount certainly appears achievable for the next few years. 
Getting paid 4.4% per annum increasing by 10% per year while waiting for a 23% capital return on a recession proof low risk stock appears mighty attractive to me (and a mouth full to boot). This chart shows the possible annual returns based on those inputs, e.g. if Woolies hits my target in one year it’ll return 27%, while if it takes five returns the return drops to 8% per annum.
Keep in mind that valuation targets are fluid and if Woolies continues to perform the target valuation will increase. I like to look at possible returns this way. It give me a sense of how the returns may pan out based on how long my thesis takes to play out. It also conveys to me the importance of selling fully valued stocks. All to often investors hold on to stocks for too long. Or at least I know I do. The returns I seek from Woolies are from capital growth based on the price increasing to my valuation target. Once it gets there, possible future returns diminish and it’s time to sell. If you haven’t looked at Woolies lately then now is a good time to do so. Disclosure: No current position in ASX:WOW. I’m hoping the upcoming earnings release will bring another wave of selling to make Woolies a screaming bargain. 
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Hi Dean, I got some WOW at 28 and 25.5. I hope it goes to 24 where I would get some more. One concern is that they have lost focus with their stores. The move into petrol was smart, but they are redesigning some stores to increase the traffic flow for petrol at the expense of supermarket store customers. This is crazy. I went to the Ryde standalone store in Sydney for the first time in a while last week and the new layout of the parking was incredibly, unbelievably bad as was the new internal store layout. I hope that is not reflective of their general store strategy. I was also not impressed with the trolleys.
Coles have replaced their trolleys and it makes the experience a lot better. In my opinion, Wesfarmers also have latent potential to open new stores on some of the Bunnings locations. It wouldn’t be hard to add a supermarket to some of the Bunnings locations and some of them are located well. Wesfarmers also have Officeworks which also has a lot of potential and low hanging fruit.
All in all, WOW is good value but the market is seeing that Wes may have more growth potential going forward and WOW are losing some of their store focus from my limited observations.
Interesting movements in Telstra lately, where it may go back to 3.00 or sub 3 ex dividend next monday. I’d be interested to know if you have you modified your valuation of TLS based on their recent performance/announcements ?
Hi Sean
Thanks for your interesting thoughts and insights. I’ll take a closer look at Wesfarmers. It’s often true that businesses are cyclical, the weak become strong and the strong weak. It’s very difficult to maintain growth and focus and after years of success even the best management team can run out of ideas and enthusiasm. I’m a Coles shopper and always enjoy the experience.
When I lived in the UK 99-04 the supermarkets there were leagues ahead of Australian ones. I couldn’t understanding why Australian chains weren’t emulating them. Tesco sold more CDs than the top three music stores combined, more pharmacy products than the top pharmacy chain. Each supermarket was clearly positioned for a market segment. Waitrose up market, Sainsbury and Tesco were similar, but different.
Once again thanks for sharing you thoughts, I do appreciate it.
Hi Dean, stockval is interesting but after a brief trial, I’m not sure it adds much to Morningstar/huntley. Thanks for the link though!Valuecruncher, although less user friendly is free.
For $300, Morningstar/ Huntley is great value for money. Try out the trial if you haven’t.
http://www.morningstar.com.au/
Eureka report is ok for a read but I’ve made very little money on any of the ideas or information from it. I like Alan Kohler though, he’s entertaining.
About the only thing I find worth reading in AFR is Bassanese. I pretty much buy the weekend AFR, read his column and throw the rest out. I found out he has a site on investing/trading ETF’s :
http://www.pennywiseinvestment.com.au/webpages/1_home.php
Which is basically my philosophy except that I trade a bit more. I’ve signed on for the trial subscription but I’m not sure it’s worth the $300 per year.
Out of the sites I’d rate (out of 10):
Morningstar/Huntly 9/10
Your site 8/10 (love your site, keep it up!)
Bassanese 7/10
Eureka/business speculator report 6/10
AFR 5/10
Since being taken over by Morningstar, huntley doesn’t do small companies as much. So there’s a niche if you want to explore that. He used to produce a small companies book annually and had more weekly coverage of small industrials in the late 90’s if I remember correctly. He correctly identified WOW as a bargain in the late 90’s in the $3 range just at the end of their store rollout and before the benefits of that had started to come through.
Once again thanks for starting a fab site.
Currently I’ve sold out of RIO, CSl for 10% swing trade. With the proceeds. I’m thinking I might top up on telstra at 3.00 and wonder whether it might explore 2.90 or even 2.80.
WOW I am looking at for a swing trade, I should have exited break even at 28, but didn’t so I picked up some at more at 25.5 and I’ll pick up another batch if it gets to 24.5. My plan is to sell 50% of the holding at a 10% profit and hold the rest to the target of 30ish.
I think I might start trading 50% of my TLS holding too because I am starting to get the impression it could take a while to break out of 3.60. My Average cost basis on TLS is 3.2 at the moment.
I’ve studied the books by Brian McNiven (the developer of StockVal) and I vaguely remember disagreeing with some of his assumptions in the model. Consequently, I think that Woolworths is a reasonable buy at the moment, but not a screaming bargain. My model forecasts that if you buy it and keep it for 5 years, then you’ll probably earn 14% pa in dividends and capital gains (lots of assumptions, of course). The most likely range of returns is between 5% and 21%. This ranks WOW at 23 out of 50 on my list of desirable investments.
Which reminds me, I bought WOW in about 1993. I still have them, but they will probably go once I have done a little more research after the recent half year results.
Which reminds me, I created my own indexed fund in 1993 when I was too busy at work to devote the time to investing. I just bought the top 10 stocks and made their weighting in my portfolio proportional to their market capitalisation. I hardly ever sold anything, just rebalanced by buying when I added more money. It worked a treat, followed the All Ords closely enough and I could control the capital tax effect of sales. After taxes and fees, it beat most of the fund managers year in year out. I think it has to be the best return per hour of your time spent of all the investing techniques.
Has anyone else tried this?
Hi BuffettFan, Thanks for your comment. I’d love to discuss your valuation model someday.
On StockVal. I just checked and funnily WOW is ranked 23rd out of the stocks they cover! Fancy that. It was fifth and now third on their “very low required return” list.
Congrats on buying WOW and having the temerity to hold for so long. More investors could profit from your time horizons.
I hope you share more about your investing success as this site is all about helping individual investors.
Valuation model: a spreadsheet based on Buffettology, StockVal, and StockValue (by John Malloy) plus a lot of fine tuning by reading Buffett, Graham, Fisher et al. One objective is to avoid a lot of hassles and mathematical issues by estimating the (after tax)IRR of investing in each stock for 5 years. Then rank the stocks by IRR. Then start at the top and eliminate those with poor fundamentals, low liquidity etc. Then invest in about the top 20. Continually monitor and recalculate. Rebalance whenever major changes occur, probably half a dozen transactions a year.
Lots of assumptions – require a fair bit of industry, accounting knowledge etc.
The principal is to buy a stock only after comparing it to all the other candidates on the short list. After all, we don’t buy a stock in isolation: there is always a hidden opportunity cost, even if it is only a bank deposit rate.
When I retired, I spent almost an entire year (full time) researching all the Technical/trading techniques, bought some trading software and did countless simulations and paper trades. At the end, I came to the conclusion that short term trading was a lot of work and the after tax results couldn’t beat the All Ords over a reasonable time frame. That’s when I became a Buffett fan, hopefully for obvious reasons.
Hi Buffetfan and Dean, one problem I have with fundamental analysis of individual companies is that the valuation/NPV and IRR are affected greatly by the terminal growth rate, which is the hardest variable to know with any accuracy. In fact I would say it’s always a massive guess.
I would argue that it is easier to estimate the fair value of an index for a country than any company because you have a reasonable estimate of GDP growth and profit share% and can invest based on mean reversion.
For example with Telstra currently, almost every analyst report I read has a terminal growth rate of 2%+. The market from what I can see values it at about 1% at current prices. Half the time the market turns out to be right. There is too much firm specific risk to be able to rely on mean reversion for individual stocks for it to be more than a guess.
Here are some scenarios, all with moderate 9% discount rate :
1. Telstra revenues down 10% in next 3 years then zero terminal grwoth rate NPV: 2.2
2. Revenues down 10% next 3 years, 1% terminal growth rate NPV 2.5
3. Revenues down 10% next 3 years, 2% terminal growth rate NPV 3.0
4. Revenues down 10% next 3 years, 3% terminal grwoth rate NPV 3.6
5. Flat revenues for next 3 years, 0% terminal growth rate NPV 2.9
From 0-3% terminal growth rate, the valuation of the company changes by 60% (ie $1.4). Obviously the market and actual outcome depend on management, the sector, government, economic growth, but how can you accurately predict the terminal growth rate within a 0-3% range ? Of course the range could be larger than this say -1 to 5%
Sean
While I don’t use terminal growth rate in the sense that you do, I think I understand your position. Yes, I agree that the calculation results are very sensitive to some variables. I have attempted to address the problem these ways:
1. Develop a short list of investments. Over the years, I have reduced the list to the 300 largest Aust equities because I have been burnt by exchange rates, consider that other investments don’t have the long term returns, small stocks don’t have enough liquidity or competent management etc
2. Only invest in industries that I understand (usually because I have worked in them.) Hopefully that helps narrow the range of forecasts.
3. Only invest in companies with strong fundamentals eg good financials, quality management and all the other things Buffett et al talk about
4. Research as widely as possible, listen to analysts’ opinions, but be prepared to avoid going with the crowd.
5. Prepare a best guess, optimistic figure and a pessimistic figure to calculate a likely range of values
6. Then compare that range to the other stocks that look likely at the moment. Often, the entire range of one stock will be different to the range of another. I don’t try to do Monte Carlo or anything too “scientific” as all I am trying to do is decide if stock ABC is a better long term bet than stock XYZ.
7. Then compare all the other fundamentals to get an overall comparison between the stocks.
8. Then go with what I think is best
Yes it’s messy, but after studying stacks of books and doing lots of simulations, so far it’s the closest I can get to emulating Buffett.
Hope this helps…….
Hi Buffetfan, thanks for your thoughts!
I’m not sure if Buffet would look at Telstra. Unfortuantely I bought some and I’m increasingly getting worried it’s a value trap. Still, he does have a large stake in Burlington and Conoco Phillips which to me don’t particularly strike me as sticking to his principles. I suppose the devil is in the detail and application. I think I’ll apply a 15% stoploss to my Telstra purchase.
I found this site interesting.
http://www.empireinvesting.com.au/
They attempt to apply classic value investing principles. I also like that they share their info and that it is about the local market.
Thanks for the link Sean, interesting stuff. I also penned you a long reply to your question on valuation, but it seems to have disappeared. Bother that! In summary valuation is more art than science. The reason changing the terminal rate changes the value so much in your example, is that your terminal rate starts so soon. If it started at year 10 then it would have a much smaller effect.
I’d argue mean reversion works as well for an established company as it does for a country. I know there was more, but brain dead now after a late lecture.
cheers – Dean
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