Lowe's (LOW): Entering Shleifer Effect Watchlist

Some Background

Last November I spent a little time looking at Lowe's, an interest generated by a "follow-the-leader" mentality. Bill Ackman of Pershing Capital made a detailed presentation at the Ira Sohn Conference in which he made a compelling case for Lowe's as undervalued, as quickly improving shareholder value by buying back shares, and as protected from the threat of internet encroachment on its business (aka, Amazon.com) by virtue of the type of products its sells. (You can access the presentation here.)

At the time I made my own stab at trying to understand its owner earnings (see here for a description of what I mean by that) and applied a conservative approach to valuing the business. I assumed it had somewhat depressed earnings based on the housing market crunch from the last few years, and I projected that a slow recovery over the next few years would lend itself to owner earnings improving an average of ten percent per year over the next five years. I further assumed the share count would drop from 1.4 billion to 968 million over the five years, for a total of $10 billion used for buy backs (versus the $18 billion Lowe's has allocated). And the dividend would grow at a rate that basically mirrored the growth in owner earnings. 

The price then was about $20 per share. I thought it needed to be around $17 to satisfy my requirement for a clear and conservative path to realizing 15 percent compounded gains over a five year period. Lowe's proceeded to rocket over the next few months, going as high as $32. It didn't hurt having Ackman on board.

I did not invest.

Entering Shleifer Effect Watchlist


In the words of the chartists, Lowe's "gapped down" on news of its Q1 sales and earnings this Monday. (The press release is here.) It dropped more than ten percent, earning it a spot among the biggest price losers of the day...and earning it attention for the Shleifer Effect Watchlist.

Wall Street had been building higher expectations, pegging Lowe's as a bellwether for whether the housing market is improving. They get excited by Lowe's and Home Depot when sales are improving, and they get depressed at any signs of deterioration. That dynamic lends itself to volatility and (hopefully) opportunity.

I've added "Market Mood" as a new designation on the Shleifer Effect Watchlist. The concept is predicated on investors being either overly optimistic or overly pessimistic about a business' prospects, overreacting to a string of news events suggesting a trend pointing one direction or the other. If the mood is optimistic and multiple negative events happen, there is a good chance of overreaction on the downside. Conversely, a pessimistic mood followed by more bad news might not create a price shock, but - if the price doesn't move much more at bad news - it could signal the skittish investors have jumped ship, setting the stage for better things to come.

I think it's fair to say the overall mood is on Lowe's is fairly pessimistic, but there were greenshoots of optimism. (Do I sound like an economic forecaster?)

The earnings on Monday represent just one bad news event. The reaction was strong. But I'm willing to hold off an investment until/unless there's another piece of bad news. That could create a strong buying opportunity.

Ackman Thoughts

I should note that Bill Ackman was not long for his Lowe's investment. According to 13-F filings (reported here), the longest he might have held it was six months. But it could have been much less time. He told CNBC (here) that he sold to take advantage of the quick rise in price and then took the gains over to his better idea...Canadian Pacific, the railroad company.

For those tempted to follow the gurus in a blind manner, let this be a lesson...you'll never fully  know their thesis or timeline for holding something. Make your own decisions. Make sure you have conviction behind your bets. 

The Investments Blog

Finally, Adam at The Investments Blog provided an excellent investment thesis for Lowe's back in June 2011.  It belongs to his Six Stock Portfolio, a concept he started in 2009 with several high ROIC businesses that were trading at fair-to-depressed prices. His bet is that by purchasing these stocks (Diageo, American Express, Wells Fargo, Lowe's, Pepsi, and Philip Morris International) at a time when the market wasn't so enthusiastic about them, the reasonable purchase price plus competitive qualities of the franchises promised a very satisfactory return over extended periods of three years to...well, forever. His results (as you can see here) have been impressive.

You can read Adam's Lowe's thoughts at Lowe's Shareholder-Friendly Buyback Plan.