Would Buffett Own These 3 Retailers?

Marc is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I’m certainly not the first person to come up with a stock-selection approach that pays homage to Warren Buffett, but I may be distinct in that I openly acknowledge that I really have no clue what the Oracle of Omaha might actually buy. Yes, I regularly read his shareholder letters and have read books about Buffett, and even spoke to him quarterly in the late 1990s when I initiated coverage of Berkshire Hathaway in Value Line. Remember, though, that despite the folksy rhetoric, the guy has speculated in silver and as well derivatives, so we can’t confuse the image with reality. Hence I state up front that the Buffett-inspired model I created on Portfolio123 is my own and does not stem from any attempt to guess at what screening or ranking criteria Buffett himself might sanction. It is, however, based on three lessons I draw from what Buffett has often said he cherishes: solid company fundamentals, reasonable valuation, and consistent growth.

Note the adjectives I used: solid, reasonable and consistent. Spectacular is not among them. But I’ll take spectacular if I can get it and interestingly, we do see some spectacular fundamentals with some retailer names that appear presently in my model.

Bed Bath & Beyond

Interestingly, Barron’s cited home-products mega-merchant Bed, Bath & Beyond (NASDAQ: BBBY) as possibly attracting interest from Warren Buffett but that has nothing to do with its having appeared in my model. More relevant is the company’s debt-free status, returns on equity typically in the mid-20% range and even during the 2009-10 “bad” years, it was in the mid-to high-teens, huge free cash flow generation that has provided more than enough to support the company’s stepped-up e-commerce efforts, has so far supported share buybacks and could conceivably spark a special dividend and/or implementation of a regular payout, and a rate of annual sales growth that stayed positive and seems to hover near 10% despite the company’s having grown large enough to be considered “mature.” Even during the worst of the late 2000s, sales growth remained positive having bottomed at 2.3% in 2009.

Might competition from on-line merchants, including Amazon.com, cause Bed, Bath & Beyond to sweat? Yes, of course. Everybody competes (I think “economic moats” are as valuable as the real ones were. How many medieval fortress-castles ultimately survived? Answer: Zero!) and Bed, Bath & Beyond has had lots of rivals form day one. Might the company post disappointing comparable-store trends and earnings results from time to time? Of course it will? Reality isn’t like a spreadsheet. Those who can’t live with that should stick with CDs. Focus on the big picture. For many today, when they need something for the house, Bed, Bath & Beyond is the first thing that comes to mind and the company makes handsome profits from supplying those needs. Think, too, of a PEG ratio of about 1.00 (the forward P/E and the projected long-term EPS growth rate both being about 14).

Dollar Tree

When you contemplate retail chic, where the emphasis is on a shopping experience featuring little if anything you need but much that you desire, you might consider something like the Apple Store. Now, imagine yourself moving 180 degrees in the opposite direction, an exercise that might lead you to local discounter Dollar Tree (NASDAQ: DLTR), which offers little if anything you desire but much that you need and where the quality of the shopping experience is measured by how fast you can get in and get out and how little you can wind up paying. But while the stores have nothing that could actually be considered interesting, there’s much cause for fascination when one looks at the company’s financials: minimal debt (about 15% of capital); a gross margin that usually holds steady near 38%, a trend of an improving operating margin (indicating improving corporate-level efficiency), a trend of rising inventory turnover (higher turnover often means lower margins, but not here), and a ridiculous – in a good sense – trend in return on equity which rose from the mid-teens in the mid-2000s to 34.8% in fiscal 2011, which ended January, and 38.6% by my estimate (I excluded a large gain from an asset sale) in fiscal 2012. Usually as companies get bigger, we’d expect returns on equity to trend from higher to lower.

As with Bed, Bath & Beyond, there’s the ever-present risk of below-expectations numbers every now and then. Also, competition for Dollar Tree has always been brutal, not just from Superman a/k/a Wal-Mart but also from countless others that operate just like Dollar Tree (smaller more local stores) not to mention on-line. Dollar Tree is one more illustration of how being good at what one does, rather than having a monopoly or a moat, can be a money-maker.

The forward P/E, a tad shy of 17, is a bit above the industry median (about 14) but not unreasonably so and in line with the consensus forecast of an 18% long-term rate of EPS growth. And as with Bed, Bath & Beyond, cash flow at Dollar Tree is ample and leads one to wonder if a dividend will be introduced to replace or accompany a trend of share buybacks.

Hibbett Sports

Here we go again with the great numbers but this time for Hibbett Sports (NASDAQ: HIBB), an outfit with which you may be unfamiliar: strong and up-trending returns on equity which are now around 30%, negligible debt, plenty of excess cash generation (Me to company: How about a dividend?), a rising gross margin with a steady operating margin, gently rising trends in inventory turnover, and consistently positive rates of sales growth with the pace now back to the mid-teens after having spent some time at single-digit levels while the economy was under the most pressure. Valuation metrics are in line with what we’ve seen above: a forward P/E of 18 for Hibbett versus a 16% consensus long-term EPS growth-rate forecast.

This chain sells sporting goods primarily in Southern and Midwestern areas having county populations ranging from 25,000 to 75,000 with many stores in strip centers “influenced” (company’s phrase) by a Wal-Mart. On paper, Hibbett should have to worry about such better-known outfits as Dick’s Sporting Goods, Foot Locker. Actually, though, Hibbett has carved out a nice niche underneath, so to speak, the majors through its low-population regional focus and its strong attention to products that are of particular interest to those local populations. That doesn’t sound so exotic, but Hibbett’s numbers suggest it’s more than ample to produce eye-catching results.

Marc Gerstein has no position in any stocks mentioned. The Motley Fool recommends Bed Bath & Beyond. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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