Danilo Santiago, founding partner of Rational Asset Management, presented at the Value Investing Seminar last week. Santiago outlined his long thesis on Lowe's (NYSE:LOW) and Home Depot (NYSE:HD). Excerpts from his speech follow:
Quote from Homer's Odyssey: "...he sailed past the island of the Sirens, whose song draws men to their death: Odysseus* bid the crew to cover their ears, while he himself was tied to the mast, so that he might listen, yet not be seduced."
Like Odysseus, Rational seeks to avoid the siren’s call… In our case, the cycles of fear and greed and the short term noise of the equity market
Investment Ideas: Lowe's and Home Depot
Current opportunity should not be ignored: Rational's knowledge base has a high number of companies with significant potential for appreciation, which is reflected in the number of long positions currently in the portfolio.
Rational's back testing analysis shows that undervaluation relative to the proprietary "fair value" is a strong indicator of future performance.
Market's overly simplistic approach to valuation: When we superimpose the share price of a stock and the average NTM EPS (Next Twelve Months EPS) estimates from sell-side analysts it is clear that “the market” is using an over-simplistic approach to investing –it uses an almost constant multiple over a short term forecastAlthough this is clearly a wrong approach to investing, it offers a lot of good opportunities for the rational and methodical investorOur analysis indicate that both Lowe’s and Home Depot are currently more than 50% under-valued.
Lowe's margins should rise in the future: The current recession –which has been focused on the housing sector –has obviously impacted LOW’s margins, but we have good reasons to believe that they will increase from the current low level.
Rational's equivalent square footage concept: When analyzing a retailer’s growth dynamic it is necessary to adjust calculations of sales and costs (per square foot) given the average age of the storesAt Rational we do what we call an “equivalent square footage” calculation –it shows how many “mature” square feet would be necessary to replicate the current sales level. When a retailer stops an accelerated growth pattern, the increase in their “square footage age” will provide a strong tail-wind for margins.
Summary: Lowe’s and Home Depot are probably experiencing the worst downturn on their sector they will ever face. Nevertheless, current market valuation provides a significant margin of safety for both companies even assuming (i) a small increase on real same-store-sales (we actually think that our base-case might be too pessimistic on this driver), (ii) gross-profit per equivalent square foot below long-term historicalsand (iii) room for increase in SG&A per total square foot. As both Lowe’s and Home Depot stop new store expansion, margins will increase due to a tailwind provided by the increase in average age of their stores since “equivalent square footage” (that driver gross-profit dollars) will grow faster than “total square footage” (that drives costs). According to our proprietary analysis both Lowe’s and Home Depot are more than 50% under-valued.
Access the full presentation (.pdf).
About Danilo Santiago
Mr. Danilo Santiago is a founding partner of Rational Asset Management, a long-short hedge fund, which he co-manages with Mr. Cláudio Skilnik (CBS ’02). The fund operations started in April 2008, focusing on publicly traded, liquid US equities. Rational has also firmed a partnership with Turim Investimentos, one of the biggest multi-family offices in Brazil. Rational core strength is its proprietary company analyses – differently from most funds, Rational’s knowledge base is quasi- static, which provides the fund with an extra edge when triggering a new long/short position.
Mr. Santiago has an MBA from Columbia Business School (CBS ‘01) and a bachelor degree in Electrical Engineer from the University of São Paulo (class of 1994). Before founding Rational, Mr. Santiago worked for three years on a multi-billion dollar, fundamental focused hedge fund in New York City. Prior to that Mr. Santiago spent six years at McKinsey & Co, the majority of which at the Corporate Finance Practice, also in New York City.
Disclosure: No positions