Investing In Organics: Look Beyond Premium Grocers

by: Charles Lewis Sizemore, CFA

There are times when I question whether I made the correct career choice - like when I see job openings for professional craft beer brewer. Upscale grocer Whole Foods Market (NASDAQ:WFM) is creating its own in-house beers and needs a proper brew master to lend his expertise. I look forward to sampling the handiwork.

I wrote about Whole Foods recently noting that groceries are a rotten business. The business of selling food and basic staples is brutally competitive and tends to have modest margins. Grocers have limited ability to raise prices beyond the rate of inflation, and sales growth is essentially based on population growth. Given the saturation of the market, new store construction is generally limited to new neighborhood construction.

There is one big exception, however: Premium or specialty grocers such as Whole Foods, Trader Joe's or HEB's Central Market. These stores - which often offer organic options and more exotic international or craft fare - have had tremendous success in recent years. Whole Foods - the only publicly traded upscale grocer of any size or scale - is also the only grocer that can compete with Wal-Mart (NYSE:WMT) in terms of profitability (see my previous article).

The rise of premium grocers is backed by overlapping macro trends that should have years - if not decades - left to run.

Let's start with the elephant in the room: the aging of America's Baby Boomers. As a generation, the Baby Boomers have been getting progressively pickier in their dietary choices over the past 30 years as the exigencies of age have forced them to take better care of themselves. Organic foods also appeal to the anti-establishment ethos of the 1960s and 1970s, the decades that shaped the personalities of this enormous generation.

One boomer from across the Atlantic that you might not normally associate with the spirit of the 1960 - Britain's Prince Charles - was actually an early pioneer here. He converted his country estate to organic farming in 1986 and has since created a successful brand of biscuits - Duchy Originals - to be had with your afternoon tea.

But as instrumental as boomer preferences have been, don't underestimate the role that Generation X has played. The rise of the craft brewing being taken up by Whole Foods - and of popular brands like Boston Beer's (NYSE:SAM) Sam Adams or my own personal favorite, the Spoetzl Brewery's Shiner Bock - was mostly a Generation X phenomenon, led by educated, self-described beer snobs.

Generation X's preferences have been the driving force behind the internationalization of American food and for the trendy fusion restaurants that crop up in chic neighborhoods like weeds. The Millennials are starting to make their preferences felt as well, and - like Generation X - they have tended to gravitate toward premium foods to the extent that they can afford them at this stage of their lives.

And finally, you have the issue of rising incomes. Yes, incomes in America have been stagnant since the 1970s when adjusted for inflation, and unemployment remains near generational highs. But for the educated and upwardly mobile - the demographic groups that tend to flock to premium and organic grocers - life in America has never been better. The unemployment rate is only about 4% for Americans with a college degree, and the figure drops to just 2.3% for those with a professional degree.

All of this points to a rosy picture for premium grocery chains. Yet the stock charts paint a very different picture (see Figure 1). I charted the performance of the publicly traded premium grocers - Whole Foods, Sprouts Farmers Market (NASDAQ:SFM), The Fresh Market (NASDAQ:TFM) and Fairway Group Holdings (NASDAQ:FWM) - against that of the ultimate common-man's grocer, Wal-Mart. Since last October, Wal-Mart is the only grocer stock that hasn't seen substantial declines. What gives?

I have one word for you: valuation.

Take a look at the following table:

Company Ticker Trailing P/E Forward P/E Price / Sales
Whole Foods Market WFM 32.09 25.20 1.36
Sprouts Farmers Market SFM 91.70 41.89 2.05
The Fresh Market TFM 32.72 18.37 1.10
Fairway Group Holdings FWM N/A N/A 0.42
Walmart WMT 15.96 13.48 0.52
Click to enlarge

Looking at the price/sales ratio, Whole Foods is almost three times as expensive as Wal-Mart - yes, Wal-Mart, the most successful retailer in history. Sprouts is nearly four times as expensive. The Fresh Market and Fairway are a little more reasonably priced, but they're far smaller and off the radar for a lot of investors.

Based on expected forward earnings, Whole Foods is about twice as expensive as Wal-Mart, and Spouts is about three times as expensive. And again, this is Wal-Mart we're talking about - one of the few large retailers that is consistently highly profitable.

So, is the foul odor coming from the produce sector just another manifestation of the momentum stock rout? The high-fliers of the past year have had high-profile face plants during the past six weeks, with many posting double-digit price declines since the beginning of March.

After the recent declines, are the specialty grocers a buy?

No, or at least not yet. The macro trends are durable and real; of this I have little doubt. But it comes back to the economics of the grocery business. As I noted before, groceries are not a high-margin business. And mainstream grocers have not sat idly while the Whole Foods and Trader Joes of the world have poached their customers. Safeway (NYSE:SWY), Kroger (NYSE:KR) and even Wal-Mart have expanded their premium and organic offerings in recent years. And while premium grocers can charge more for their products, this ability has limits. Grocery shoppers tend to be a demanding and fickle lot.

You want a high margin business that fits the general theme of organic fare? Try Chipotle Mexican Grill (NYSE:CMG). Chipotle practically mints money with returns on equity consistently more than 20%. Chipotle also funds its expansion organically via cash flows and not via debt or share dilution.

Of course, Chipotle isn't cheap by any stretch. It currently trades hands at 48 times earnings. The stock has also been in free-fall for the past month, down about $100 per share. Investors are concerned that rising food costs will erode profitability, and they probably will - at least in the short term.

I don't make a habit of catching falling knives, so I wouldn't recommend buying CMG shares today. But I would be a buyer in the mid-$400s if the share price can stabilize.

What about traditional "health" stocks such as diet products companies Weight Watchers (NYSE:WTW) and Nutrisystem (NASDAQ:NTRI) or vitamin and supplement retailer GNC Holdings (NYSE:GNC)?

I would stay away from all of these and, if you are so inclined, look for opportunities to short. I'm simplifying, of course, but health-conscious Americans have figured out what should have been obvious years ago - if you eat healthier food, you get all of the nutrition you need. Taking a multivitamin pill with your morning coffee won't "undo" the negative effects of the Egg McMuffin you ate with it. And recent research has shown that vitamins and supplements have no real health benefits and may actually be harmful if overused.

Demographically, shrink-wrapped diet products - the sort you might see on the Home Shopping Network - are a product for middle and working class Baby Boomers, which is a socioeconomic group that is declining in purchasing power and in economic importance.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today's best global value plays. This article first appeared on InvestorPlace.

Disclaimer: This is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results.