Rule #1 Finance Blog

With Investor Phil Town

CONTINGENT ORDERS: HOW TO CATCH THE GAPS UP

Phil Town posted the following as a Comment under this post on Monday, but I’m reprinting it here so you’ll all be sure to see it.

Question:

Using analysts’ future EPS and PE estimates, the Sticker Price of World [sic]
Foods
is about the same as its latest market price. But, you still like
it. Does that mean you’d keep it if you own it, but not buy more until
its market price drops to 50% of its Sticker?

Answer:

Whole Foods is a bit of a unique case for me.  But it may apply to businesses you will own in the future, so I’m going to write about my thinking a bit here.

Whole Foods is one of the best run businesses I’ve ever seen on all the levels I’m interested in.

The business products and way of doing business match my values
(natural food combined with excellent business sense), and the CEO is a
poster-boy for an honest, owner-oriented manager with a Giant Big
Audacious Goal.  (Owner-oriented to me means what it means to him:  that the three major stake holders in the business — the owners, the
employees and the customers — are considered with fairness and justice
for all, in all decisions).

It’s always rated one of the top
businesses to work for in the US.

And it has been building its Brand
Moat big time.

It can expand twenty times its current size, so its
growth rate is not hobbled by size.  And the bigger it gets, the bigger
the moat gets.

All those things make Whole Foods one of those businesses that, if I didn’t have arrows, I’d be happy holding until it
got massively overvalued.

So with that in mind let’s look at the Big Five numbers and determine value from those:

  1. ROIC:  Is it high enough and holding / growing?  10.5% long term.  11.% last
    year.  That means management is using the surplus capital well and
    getting nice returns on it.  Which means they are not wasting my money
    building an empire to gratify their egos.  Good.  I like the ROIC.
  2. Equity
    Growth Rate
    :
      Ten years it’s 20%.  Awesome.  But the last three years it
    is averaging 25% and last year it was 27%.  WOW!  The surplus cash is
    making it to the owner’s bottom line — our equity ownership.  That is
    enviable growth.  Couldn’t look better.  (And while I’m looking there I
    check the debt and it’s down to nearly nada.  They could pay off their
    total long term debt with their current cash and not even miss it.
    Fantastic)
  3. Sales Growth Rate:  Also high and growing nicely
  4. Free Cash Flow Growth Rate:  Also high and growing nicely.
  5. EPS
    Growth Rate
    :  Ooops.  $0.99 is lower than 2004’s $1.05.  And if we use
    the TTM EPS of $1.03, with a growth rate of 21% (my personal choice for
    WFMI based on Equity growth rate and the CEO’s confidence for the
    future), and a PE of 42 (lower than the Historical), we get a Sticker
    of $73 and an MOS of $36.

Except when I look deeper into what’s
going on with EPS I find two important things
:

  1. The quarterly
    earnings are all quite good — in a range of $0.30 to $0.40 per quarter
    — except for the third quarter last year when the biz only made $0.03.
  2. That a year ago the CEO told everyone on an analyst conference
    call that was posted to the website that the third quarter was going to
    suck because of all the construction they were doing for new stores was
    going to cause a temporary earnings hit.

Lots of expenses going into
one quarter. So I knew way ahead of time that the big guys were going
to sell off WFMI in spite of the fact that they were told it was a one
time blip. 

Why?  Because they are sheep and must follow the momentum
herd.  Which is why Warren Buffett says you get nothing when you put
your money with a fund manager.

So how to put a Sticker Price
on WFMI?

Do what I do.  Ignore the bad quarter in my calculation. 

I
just substitute some reasonable number for the bad one.  In this case I
substitute $0.30.  Seems reasonable to me.  That raises the TTM EPS
from $1.03 to $1.30.  A much more reasonable number for WFMI.  Let’s
see what that does to the Sticker:

  • TTM EPS $1.30
  • PE 42
  • Growth Rate 21%
  • Sticker $92
  • MOS $46
  • Current Price $72  (a few days ago it was at $62!)

Still head room for a Rule #1 investor who got in before and understands the biz.

Wish
I wasn’t so disciplined about the arrows sometimes.  I didn’t buy at
$62 simply because I know that if there is bad news it’s going to show
up on the arrows before it shows up in the news…
and I’m a big chicken
with my retirement money.  So I missed the bottom for WFMI and it
gapped up to $66 before an entry.

By the way, want a cool trick
to get in on the gaps up?

You can put in a contingent buy order for
any stock and the brokerage will buy when the contingency happens. 

In
this case I just put in a buy order for WFMI at a price that I know
would have triggered the Tools to say get in.

Why would I?  Because
the Stochastic has turned green and the MACD is going greenall signs
point to getting in soon.  The price is at $62 but moving slightly up.
If the price breaks 5% above $62 — say to $65 — that will almost
certainly mean that the MACD turned green and the MA is green, too.

Time to buy.

So put in an order that says Buy at $65 and you don’t
have to be there during the trading day if the thing gaps up like WFMI
did.  That way you catch the big day run up. And you don’t have any
extra risk because the broker isn’t going to put in your order if the
price never breaks out.  A few days later if the price doesn’t move and
the signals are going red again, you take the contingent order off.
Simple.

Now go play!

Phil Town

(And use my Excel guide on RuleOneInvesting while we make adjustments to the Margin of Safety calculator. You’ll need to Log In to view it.)