Take Advantage of Short-Term Volatility and Buy This Long-Term Value

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

While traders abhor volatility, long-term investors profit from it. Value investors like Warren Buffett take advantage of unwarranted downside volatility that unfairly punishes great businesses. Value investing is often described as value arbitrage -- as in, value investors arbitrage the difference between price and value -- but it is sometimes better thought of as time arbitrage -- that is, buying the long-term view and ignoring the short-term outlook.

In no industry is time arbitrage a more profitable strategy than in consumer retail. Short-term traders tend to give heavy weight to quarterly same-store sales figures and similar measures that rarely provide any insight into the long-run prospects of the retailer. This provides many excellent opportunities for long-term investors to scoop up bargains after a quarterly miss.

A decent prospect

Although it is a few quarters removed from its most recent disappointment, Kohl's (NYSE: KSS) remains in the bargain bin due to short-term fears despite a healthy long-term outlook.

The company reported slower-than-expected same-store-sales growth last November, which spooked the market into a large sell-off. Although the stock price has retraced its losses, the company remains undervalued.

For one, Kohl's increased offering of private label products has enabled the firm to increase its margins significantly. In fact, its gross margins and pre-tax margins are higher than those of Target (NYSE: TGT) and J.C. Penney (NYSE: JCP).

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That Kohl's consistently earns a higher operating margin than both Target and J.C. Penney is no small feat. Target is a significantly larger company with superior economies of scale. Meanwhile, J.C. Penney has traditionally sold higher-margin products than Kohl's. Despite the lack of a clear advantage in any one area, Kohl's responsible growth strategy enables it to out-earn its toughest rivals.

Thankfully, J.C. Penney is much less of a competitive threat today than it was before Ron Johnson attempted to transform the company. As a result of the failed transformation, J.C. Penney is scrambling to return to its old strategy -- the one that led to the precipitous drop-off in its margins in the first place.

Even as J.C. Penney backtracks from Johnson's audacious plan, it has decided to focus on a younger -- and more fashionable -- crowd than it has traditionally served. This is unlikely to play well with the company's core customer base, and will probably lead to continued shortfalls in same-store sales.

Although J.C. Penney is floundering, Target is still a formidable competitor for Kohl's. Target and Kohl's both fared much better during the recent recession than J.C. Penney. In addition, Target's REDcard initiative has boosted same-store sales and its Canadian store openings are driving top-line growth.

However, Target's foray into the food business will inevitably lead to declining margins over time. The company's grocery section attracts more foot traffic into its stores, but the square footage and capital investment required to maintain the food aisle will hamper the chain's profitability in the long run.

Investment case

As a slow and steady grower, Kohl's is in a better position than its peers in terms of current profitability and future growth prospects. The company has yet to fully penetrate the Northeastern United States, and its continued adoption of private label products serves as potential margin expansion.

Over the last four quarters, the company earned $4.22 per share -- an 8.3% earnings yield on its recent share price. Over the last decade, however, the company grew earnings per share at a compound annual rate in excess of 10%.

If Kohl's can grow earnings per share over the next decade at just half the rate that it grew over the last decade, then investors will get a return in excess of 13%. For a consistently profitable retailer with a runway for growth, that is a pretty good bargain.

The retail space is in the midst of the biggest paradigm shift since mail order took off at the turn of last century. Only those most forward-looking and capable companies will survive, and they'll handsomely reward those investors who understand the landscape. You can read about the 3 Companies Ready to Rule Retail in The Motley Fool's special report. Uncovering these top picks is free today; just click here to read more.

Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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