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In investing, often the goal is to "beat the market". And often, the "market" is best represented by the S&P 500 index, which generally offers a good measure of how American business is doing on the whole. It's been well-documented that up to 80-90% of all fund managers fail to beat their benchmark, which is the S&P 500 in the majority of cases. So, one would argue that to merely dump your money into an S&P 500 index fund and then hold your nose for a year would be an effective way to beat 80% of managers. But is there a way to do better? In order to "beat the market" the key may lie in picking the cheapest stocks within the S&P 500 index. Sure, holding the index itself would prove to be a better investment than almost all mutual funds, but you don't necessarily want to own those stocks within the S&P that have high multiples singularly, so why would owning them inside a basket make more sense? It doesn't. So, what if we were to hold only the cheapest stocks within that index? Numerous studies have shown that the cheapest stocks in the market tend to outperform the indexes in general. It's also been well documented that if you were to follow the insiders of companies into a stock when they buy, and out of the stock when they sell, you would experience major outperformance relative to any benchmark. After all, the company insiders know way more than you do about their company and its future prospects. And there's only one reason for insiders to buy stock: because they think the stock price will rise. You would want to buy a business that repeatedly earns returns on capital at a high level, because that would indicate some sort of a durable competitive advantage over its peers, but you wouldn't want the company to be mired in debt, so you would avoid those companies that have inflated ROE due to high debt levels.

So, it would make sense that by holding the 1) cheapest stocks of 2) companies with high ROE 3) that are components of the very index that beats most managers (the S&P 500), and 4) after insiders have made a meaningful purchase, it would compound your chances of winning (4 winning strategies in one). If you were to run a screen for companies within the S&P 500 Index that have PE ratios of less than 15, ROE above 25%, with recent insider purchasing, one stock shows up: Coach, Inc. (NYSE:COH). At a stock price of around $54/share, COH sports a P/E of 14.9, ROE of 47%, and no debt. To boot, Chairman and CEO Lew Frankfort has recently purchased $1 million of COH stock.

So, we've gone over the statistical merits of Coach, the stock. Now, let's look at what makes Coach, the business, great.

Business Quality

In America, most people try to keep up with the Joneses. And Mrs. Jones carries a Coach handbag. But the overlooked truth is that in Asia and even in North America at an increasing rate, Mr. Jones also carries a Coach handbag, although he may say, "it's a satchel".

Coach is one of those special companies that can produce a product and sell it for much more than the cost. Coach sports a gross margin of 73%, which means that, assuming an average price point of $325 per handbag, it only costs them ~$88 to produce and distribute one handbag. How can they get away with such a high gross profit per bag? Brand name. Coach has developed a brand over the years that exudes quality at a reasonable price (the word "reasonable" is relative here). Coach's handbags fit into a category known as "affordable luxury" and the company has carved itself a niche in between the higher end brands such as Louis Vuitton, Gucci, and Prada whose products can easily reach $2,000 per item, and the lower price points of discount brands. This seems to be an enviable spot in the market, nestled in a cozy area between the high-end brands - which are reporting slowing sales - and the lower-end brands which experience lack of brand loyalty due to the price sensitivity of their customers. When's the last time your girlfriend said, "I want a handbag for Christmas, but nothing too expensive … try to keep it under $70." No, chances are, she said "I want a Coach handbag", and price was irrelevant. This preference for brand name speaks to the good job that Coach has done in building this perception of quality or style in the brand name.

Coach's stock has languished, understandably, due to increased competition from other producers such as Michael Kors and Kate Spade. It is estimated that these companies have stolen market share from Coach in the handbag space. But instead of rolling over and dying, Coach's management has successfully kept the growth story going by steering the profits from the high margin handbags into new business development: expanding into international markets, branching into men's accessories, and widening their lifestyle products lines, enhancing brand value. Coach's stated goal is to morph from an accessories brand into a global lifestyle brand anchored in accessories. In doing this, Coach has seen 16% annual growth over the last 2 years in its international business and 50% YoY growth in the global Men's products business (an addressable market in North America of $1 billion, growing at 25% per year). Indeed, Coach believes that with China's growing economy and Asian men's tendency to be more fashion conscious than their Western counterparts, the China handbag business will be its biggest revenue generator in 2014, with an addressable market of $3.2 billion. Coach believes that their Men's product business will reach $1 billion by 2016. If Coach is able to capitalize on this trend and capture market share in the Asian market - especially the men's market - they could ride the crest of a huge tidal wave of growth. 50% growth from around $280 million to around $560 million in 2013 in the men's market is a great sign of the both the health and potential of that business. As mentioned, Coach is expanding its product offerings in line with their goal of being a lifestyle brand by developing watches, footwear, and outerwear. The company's brand recognition should prove to boost these efforts into adjacent-but-related markets. Coach is also expanding its retail footprint, targeting 9% square footage growth (7% in North America via the opening of 20 stores and expansion of another 20, 25% in China via the opening of 30 stores, Japan with 10 store openings, and Europe with 60 store openings). In addition to this, they are focused on increasing traffic at their global e-commerce sites which should increase profitability per sale.

As you can see, Coach has multiple opportunities for growth. Granted, it would be difficult to put all of these growth areas into a quantifiable valuation for Coach, but all speak to an upside from these levels.

Management

Lew Frankfort has been CEO of Coach since 1996, when he hired Reed Krakoff to oversee products, advertising, store design, and merchandising. Since then, these two have overseen the company's growth from around half a billion $ in sales to over $5 billion. Earlier this year, Krakoff left the company to pursue his own brand. However, Coach has made a great hire in Stuart Vevers, who has had great success with other leather goods companies and should be expected to achieve success with Coach as the Executive Creative Director.

Business Economics

Coach does not depend on access to capital markets to continue operations, evidenced by their self-funding from strong cash flows and non-existent debt levels. Neither does Coach depend on large cash outlays for capital expenditures (only around 15-17% of Cash Flows from Ops is spent on capex) or for R&D (not a penny has been spent on R&D in the last decade). This leaves major room for not only return on capital in the form of business expansion, but return of capital to shareholders in the form of dividends and buybacks. Coach has reduced its shares outstanding by about 5% over the past 2 years, buying back about 15MM shares. The BOD plans to buy back around 13MM more, having recently approved a $700 million buyback. The current dividend yield is 2.5% with a payout ratio of 35%, leaving room for growth in dividends as well. Annual return on equity for Coach has dipped below 40% only ONCE over the past decade; the other years experienced growth over 40%, with 2012 reporting 58% ROE. Don't overlook this - this statistic means that Coach can reinvest earnings back into its business and basically double their invested cash every 2 years. Man, it's great to be a shareholder of companies who can do that. These are mouth-watering returns on capital, especially without the massive debt levels that normally accompany high ROE.

Valuation

Coach's economic characteristics are top-notch, yet COH can only boast of a very warmish valuation right now, for reasons mentioned earlier about competition. Coach is trading at only about 82% of its average P/E ratio over the last 4 years (14.9 vs 18.3). If the smoke clears on Coach's business prospects in Asia and men's markets, a rerating of the stock to previous valuations would provide a 20% upside to today's stock price. Even if Coach continues to lose domestic market share in handbags, the international growth story remains largely unaffected. But if Coach can right the ship on handbags for their next few collections, the company would be firing on all cylinders, in which case a much higher multiple would be warranted, given the correction in their flagship handbags offerings and multiple growth opportunities. If we model a Base scenario in which the North America market stays flat over the forecast period (assuming lost market share in women's handbags but gains in men's products and other accessories), our international business still grows at the same rate of the last 2 years of 16%, operating margins and taxes remain constant, I come up with EPS of around $4.00/share, factoring in the stated $700 million in buybacks. A multiple of 15 yields a share price of $60.00, which is about 11% above today's stock price.


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I readily admit that this is not an eye-popping opportunity for a home run, but with today's markets and their ever-increasing valuations, it's becoming harder and harder to find a bargain. When you add in the 2.5% yield from these levels, you could realize an annual gain of nearly 14% while you wait on the market to re-price your stock. But, in a Bull case, if Coach can right the ship on handbags for their next few collections, the company would be firing on all cylinders, in which case a much higher earnings multiple would be warranted, given the correction in their flagship handbags offerings on top of their aforementioned multiple growth opportunities. Perhaps a multiple of 20 wouldn't be unreasonable, given the fact that their 4-yr average is 18.3, their ROE is over 40%, and their growth opportunities abound.

With the above-mentioned growth areas, Coach has many levers to pull in order to drive revenue growth and profitability. I do not see any brand dilution coming from proliferating their product lines into adjacent markets, but alas, I'm no retailer. But I am willing to invest alongside someone who is a retailer and who is betting on Coach's success with his own money, CEO Lew Frankfort. His $1 million bet tips the scales for me and turns this proposition from a "pass" to a "buy and hold". As mentioned, this stock is no double, but its fundamental statistics (cheap stock, good business), historically consistent returns, and insider buying convince me to make it a small holding until I can find something that offers juicier returns.

Sources:

Source: Coach, Inc. - A Hidden Growth Story Amidst Market Share Erosion