Why Kirkland's Is No Falling Knife

Nov.22.10 | About: Kirkland's, Inc. (KIRK)

Conventional wisdom in the stock market dictates that investors should not try to "catch a falling knife". Mainstream investors consider catching a falling knife risky, and their mental panic buttons force them to sell stocks in this position. Value investors, on the other hand, can stomach short-term drops because they understand that a lower price equates to lower, not higher, risk. On Friday, Kirland's, a company previously discussed on this site as a potential value investment, (NASDAQ:KIRK) served as a perfect example of this dynamic.

Shares in the home decor retailer fell 17% after the company lowered its outlook for the holiday period. For mainstream investors, this is a signal to stampede for the exits, at no matter what the price. For value investors, however, Kirkland's now represents a very compelling value opportunity.

Despite the company's lowered expectations for the year, the company is still very profitable, as return on equity should come in around 25%. Based on the current price and the company's earnings expectations for the year's final quarter, the stock trades at a P/E of just 8. After subtracting the company's $65 million cash balance (against no balance sheet debt), the P/E falls between 5 and 6. Furthermore, next time the company reports it will have approximately $20 million of cash more than it does now due to the fact that a good portion of its profits are generated during the holiday season.

It's worth noting some of the reasons for the lowered outlook to judge just how temporary the company's problems are. First, higher freight charges versus last year have increased costs and reduced margins. The company imports most of its products from overseas, so freight costs (which have since abated somewhat) can wreak havoc with margins a quarter or two after the fact.

Secondly, while traffic to the company's locations was up, the company saw a lower conversion rate (i.e. purchases per visitor was lower). Management believes its merchandising decisions are to blame for this and has identified the weak areas in which it needs to improve. It is refreshing to hear a management team make candid comments of this nature, rather than the standard approach of blaming the weak consumer environment or other factors beyond management's control.

This "falling knife" example also illustrates the importance of having a list of stocks as potential investments should prices become more favourable. Investors should keep up with stocks that are outside of their buy range so that when the opportunity presents itself, they are ready to take advantage of the situation.

Low P/E and high ROE stocks tend to outperform the market, as eloquently illustrated by Joel Greenblatt. Kirkland's holds a lot of potential in this regard.

Disclosure: Author has a long position in shares of KIRK