Since the end of 2014 consumer staples stocks have been one of the better performing sectors in the stock market. Many investors attribute this recent outperformance to concerns about an economic slowdown and the record low level of interest rates. Most companies in this sector offer dividend yields above the 10 year Treasury Bond yield, which stood at 1.78 at the end of the quarter. As a result, some investors view these stocks as bond substitutes and money has been flowing into this sector, pushing prices higher. We think this is potentially dangerous thinking.
Much of the risk of a stock is related to the ratio of its price versus its intrinsic value—not the attractiveness of its dividend yield compared to a U.S. Treasury Bond. When the price of an investment compared to its intrinsic value is low, the risk of the investment is generally low. When the price of an investment compared to its intrinsic value is high, the risk of the investment is generally high.
During the first quarter we saw Mr. Market get enthusiastic about two of our consumer staples holdings – Philip Morris and Sanderson Farms. As a result, their stock prices drifted upward and approached our estimated intrinsic values. When a company’s stock price equals its intrinsic value, there is no margin of safety and the risk of owning the stock is high. Hence, we sold our shares. (We owned both of these companies in our Intrinsic Value and Dividend Growth & Income Strategies.)
We purchased Philip Morris in our Dividend Growth & Income strategy in January 2011 and in our Intrinsic Value Equity strategy in December 2012. At the time of our purchases, Philip Morris’ stock price was about 20 percent below our estimated intrinsic value. During the first quarter Philip Morris approached our estimated intrinsic value and we sold our shares on March 11th at $96.62. Over the time that we owned Philip Morris, their business did not perform well as revenues and profits were flat to down. (The company does a fair amount of business in emerging markets and their sales have been adversely affected by the depreciating emerging market currencies.) However, the fact that we purchased the shares at a discount to our estimated intrinsic value, and the gap between our purchase price and intrinsic value closed, we were able to generate an attractive return.
Sanderson Farms is the third largest poultry processor in the U.S. We like the business since it is not sensitive to the gyrations of the economy, has strong secular tailwinds of people eating more chicken and generates high and consistent returns on capital. During August and September of last year the stock market sold off on concerns about a slowdown in China’s economy. Many times when the market sells off on broad-based fears of a slowing economy or over the Fed raising interest rates, investors will indiscriminately sell companies with solid long-term business fundamentals. As a result of the sell-off, we purchased Sanderson Farms between August 25th and September 1st, at an average price of $66.77, or at about 70 percent of our estimated intrinsic value
The gap between Sanderson Farm’s stock price and it estimated intrinsic value closed quickly. On March 9th, during the strong stock market rebound of the second half of the first quarter, we sold our shares at $93.10 — within one percent of our estimated intrinsic value. This was a very atypical holding for us. It usually takes years for the gap between a company’s stock price and intrinsic value to converge. However, as part of our disciplined process, we sell whenever a company’s stock price reaches our estimated intrinsic value. This is because once a company’s stock price sells above its estimated intrinsic value the holding ceases becoming an investment and borders on the line of becoming a speculation.
The above post has been excerpted from a recent letter of Granite Value Capital.
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