A Value Investor’s Shopping List for an Expensive Market

The S&P 500 is poised to deliver sub-historical returns. That doesn’t mean your portfolio has to.

This coming spring will mark the 9th anniversary of the current equities bull market. An investment in the S&P 500 at the beginning of 2009 would have returned 244% as of today – good for an annualized return of 14.7%. History would suggest that the current bull market may have further to run.

Since 1882, there have been a total of 10 market cycles – both bull and bear. The average secular bull market has lasted 11 years and the average secular bear market has lasted 14 years. That compares favorably to the 9-year length of the current bull market.

This bull market has produced a real return of 206%. That compares to an average bull market real return of 552%. Again, a positive indication.

Other indicators do not produce such a sanguine view. For one, the previous bear market cycle from 2000-2008 was also short by historical standards. For another, valuations in equity markets continue to be stretched.

Adjusting earnings to an inflation-adjusted ten-year average indicates a severely overvalued market. It is less so when comparing to current and future earnings. That is an indication that profit margins are above the long-term trend. Whether margins stay this high is subject to debate. But, what is not subject to debate is that future equity returns will lag the historical real average of 7% annually.

While the market is expensive in absolute terms, it is not relative to the bond market. So, outside of a recession, equity investors should be most concerned about a sustained increase in long-term interest rates. If long-term rates stay low, the stock market may continue to be the best place to invest, albeit at a lower return than history would have given. Depending upon your preferred measure of earnings, the earnings yield on the S&P 500 is between 3% and 4% right now, compared to 6% historically.

While few good asset classes exist to place money, there are still some excellent bargains to be had that should outpace the overall stock market regardless of the future environment. Here are three names to consider.

Bed, Bath & Beyond (BBBY) has been punished recently like almost every other retailer. In 2013, the stock peaked at about $80 per share compared to its current price of $20. Investors are worried about Amazon’s potential entrance into the furniture market. The company’s recent earnings have not helped matters either. Third quarter comparable sales were down 2.6% and earnings per share this year are down 37% from last year.

Still, the market reaction may be overdone. Bed, Bath & Beyond has always been one of the most skilled operators and merchandisers in retail. They also have significant business outside the core Bed, Bath & Beyond franchise from prudent acquisitions. And they are repurchasing a large number of shares, with 7% of the company having been bought back in the last year. The stock now trades at an enterprise value to EBITDA multiple of 3.9x. Macy’s, which has seen a huge deterioration in its share price amidst challenges of their own and which arguably has a less sustainable business model, trades at 4.5x and Williams-Sonoma, which has the Pottery Barn brand in its stable, trades for 6.9x.

Bed, Bath & Beyond is coming off an investment program that should soon wrap-up which will increase efficiency and deliver more free cash flow to shareholders from lower capital investment. Even without performance that bests current low expectations, the stock should trade at least at $26 to be in-line with peers.

Buying a terrific brand at a great price is not an opportunity that frequently arises, but it currently presents itself with Hanesbrands (HBI). The North Carolina based company not only owns the Hanes underwear brand but also sportswear brand Champion and the female intimate supplier Playtex. Hanesbrands has enormous supply chain and manufacturing advantages over rivals, with 52 facilities in the United States, Central America, the Caribbean, and China. Its long-held strategy has been to make consistent acquisitions that generate synergies when integrated with this extensive footprint.

The company recently announced a deal to acquire Alternative Apparel for $60 million. The $70 million a year apparel maker currently outsources production, which Hanes can bring in-house. Last year, the large Australian underwear seller Pacific Brands was purchased for $800 million and Champion Europe for about $225 million. In 2015, athletic and logo apparel manufacturer Knight Apparel was bought for $200 million and in 2014 the company acquired the leading manufacturer of intimate apparel in Europe, DB Apparel, for $550 million.

These mostly cash-based acquisitions have left Hanesbrands with a relatively large amount of net debt, $3.6 billion compared to $1.3 billion at the end of 2012. Cash flow has also improved over that time – from $533 million in EBITDA to $926 million today – but still leaves the company more highly levered at 3.9x today compared to 2.4x at the end of 2012. Still, its earnings are relatively stable and it’s currently producing $730 million a year in operating cash flow, somewhat mitigating financing risk. Hanes also has been repurchasing about $300 million a year in stock and paying investors a dividend that amounts to a 3% yield.

When Hanesbrands reported earnings at the end of October, results were in-line with what analysts were estimating. Sales rose 2.3% and earnings per share jumped by 7%. But, weak fourth quarter guidance sent the shares downward. From $25 earlier in the fall, the stock is now down to $19.52. The reaction has been overdone. Hanes now trades for a single digit multiple on next year’s earnings and has an enterprise value to EBITDA ratio of 12x compared to fellow apparel manufacturer VF Corp at 16.7x. Were the stock to trade at a similar valuation, shares would go for $27.

Another company going through a period of digestion following acquisitions is Stericycle (SRCL). The firm is in the waste management business but has traditionally targeted medical waste – difficult to dispose of and highly regulated. Stericycle has coverage and incineration facilities that are unmatched and which allowed it to rack up enviable margins and returns on capital through the years, with returns on equity regularly exceeding 20%. They then took their model and attempted to take it further afield with a $275 million acquisition of PSC Environmental in 2014 and $2.3 billion buy of Shred-It in 2015.

PCS Environmental fit nicely within Stericycle’s portfolio, as a provider of services for the disposal of regulated waste, such as chemical spills and household hazardous waste. The Shred-It acquisition was somewhat bizarre and threw investors a curveball. Shred-It is exactly in the business you would expect from its name: document disposal. Despite the commodified and declining nature of the business, Stericycle was optimistic that it could cross-sell better as well as take advantage of a Latin American footprint.

Sales have predictably expanded, now at $3.6 billion a year, but profitability has not followed suit. The company’s cash flow margin in 2012 of 21% has shrunk to 14% over the previous year.

Missteps aside, the market appears to have overcorrected and missed that the core business at Stericycle is still one with numerous competitive advantages. The stock peaked at $149 a share in 2015 but trades today at just $62.75. It still generates sustainable free cash flow of $400 million a year and net debt, which had grown to $3.2 billion following the purchase of Shred-It, has fallen to $2.7 billion. It is too cheap at 12x free cash flow per share.

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