The Deep Discount Strategy is a Value investing approach to buying select stocks at a price below their fair value. The basis of the strategy is as follows:
- Quality: Choose only the highest quality companies with a stellar record of consistently high growth across a number of metrics.
- Value: Determine the fair value of the company based on anticipated future growth and a minimum desired compound annual return of 15%.
- Target: Buy and hold the company only when the share price is below a margin of safety, set significantly lower that the fair value price.
- Enhance: Purchase additional shares if the stock price moves lower while the fair value remains the same.
In this article we will apply the Deep Discount Strategy to rue21 (RUE) to develop a valuation and target purchase price. Rue21 is a clothing retailer targeted at teens, with stores across most of the United States. Stores are located primarily in small towns where there is less competition, yet the company offers very fashionable clothing items and changes themes frequently to keep "fresh". The company currently has over 800 stores and is expanding at a rate of more than 100 stores per year. The company is also remodeling many of its existing stores to a new format that features a bigger emphasis on high margin items such as accessories, footwear, and fragrances.
This strategy borrows heavily from methods taught by Phil Town in his excellent book, Payback Time. Numbers used in this analysis are sourced primarily from MSN Money.
In the context of the Deep Discount Strategy, quality is defined by the company's ability to meet a number of criteria with respect to consistent growth and return on capital. Specifically, we look at the following metrics:
- Return on Invested Capital > 10%
- Earnings per Share growth > 10% annually
- Sales growth > 10% annually
- Equity growth > 10% annually
- Long term Debt < 3 years of current earnings
Companies that are able to meet these criteria consistently over a long period of time are likely to be more predictable, and this is key to being able to develop a proper valuation of the company with a strong degree of confidence. Let's see how rue21 measures up.
ROIC for last year was 21.5%. This far surpasses our minimum requirement of 10%. ROIC is an important number because it tells us how well the company's management is putting money to work.
The following table shows EPS growth over the past several years:
|Year||EPS ($)||EPS Growth (%)|
EPS growth surpassed our minimum requirement of 10% / yr for every year except for 2007. Average EPS growth over the past five years is 35.5%. This is excellent from the point of view that the EPS is growing very consistently, and at a high rate.
The following table shows sales growth over the past several years:
|Year||Sales (millions)||Growth (%)|
Sales are growing at a rate that exceeds our minimum requirement of 10% / yr for the past several years. Average sales growth over the past five years is 27.7%. This is excellent from the point of view that sales are growing very consistently, and at a high rate.
The following table shows equity growth over the past several years:
|Year||BVPS ($)||Growth (%)|
Equity is growing at a rate that exceeds our minimum requirement of 10% / yr for the past several years. Average growth over the past four years is 137%. This rate of growth is not sustainable over the long term, as evidenced by slowing in the past couple of years, however the company is still growing very consistently year after year.
The company currently has zero long term debt, which is excellent.
Rue21 meets all of our criteria for a high quality company that will allow us to calculate a valuation in a predictable manner. EPS, sales, and equity are all growing year after year at a rate that exceeds our minimum requirements. This is a result of management putting capital to good use, as evidenced by the high ROIC. Finally, the company is able to achieve this without relying on external financing (zero debt).
The value of rue21 for our purposes is determined by the expected future EPS growth for the next five years, an estimated future PE ratio, and finally a minimum acceptable rate of return (MARR) that we desire to achieve. Also required is the trailing twelve months EPS number to use as a starting point. We use these numbers to calculate the future value (FV) of the company.
Future EPS Growth
Analyst consensus is that EPS for rue21 will grow at a rate of 17.5% over the next five years. Does this make sense? EPS growth over the past five years averaged 35.5% and grew 28.1% last year. EPS growth, while still excellent, is definitely slowing as the company becomes larger. Sales and equity grew at average rates of 27.7% and 137% respectively over the past several years. 17.5% seems like a very conservative estimate of growth for the near future. It is important to be conservative with this number.
Future PE Ratio
The future PE ratio is most easily determined by looking at historical values and trends. The following table summarizes the average PE ratio for each of the past several years:
The average PE ratio for the years shown is 23.8, which is higher than the current PE (as of today) of 15.6. An alternate method is to use double the future EPS growth rate to estimate future the future PE ratio. Using this method, a future PE ratio of 35 is calculated. We will use the more conservative of the two methods, and settle on an estimate of 23.8.
Future and Present Value
To calculate the future value, we also need to determine the EPS for the trailing twelve months, and our MARR. Rue21 earned $1.63 per share over the past year so we will use this number as the starting point in projecting future earnings. We will use a MARR of 15% as this is the compounded return we aim to achieve using the Deep Discount Strategy. A 15% annual return doubles the original investment in five years.
Our inputs to the value calculations are as follows:
- EPS ttm: $1.63
- Future EPS growth rate: 17.5% / yr
- Future PE ratio: 23.8
- MARR: 15%
Plugging the EPS numbers into a future value equation, projects an EPS of $3.65 in five years time. Assuming our future PE ratio of 23.8, this results in a predicted future share price of $86.89 in 2017.
The final step is to calculate the present value of the stock. To achieve our MARR of 15%, we must purchase the stock at a price of $43.20 per share or lower, using a standard present value calculation and the future share price determined above.
In summary, we have determined that the current fair value of rue21 is $43.20 per share. If purchased at this price, we predict that we will achieve a compounded annual rate of return of 15% over the next five years.
In the preceding section we determined that rue21 is currently valued at $43.20 per share. Our goal using the Deep Discount Strategy is to purchase equities at far less than their fair value. This does two things for us. First it provides a margin of safety, as the future EPS and future PE ratios used in the valuation calculations are an educated guess. Purchasing stock for a lower price reduces the risk that we were not accurate in the estimate of these numbers. Secondly, buying at a discount has the possibility of magnifying our returns greatly, resulting in a compounded rate of return significantly higher than our 15% stated minimum.
Ideally we set a target price based on a 50% discount to fair value. This provides a very large margin of safety if our predictions are wrong, and has the possibility of increasing our returns exponentially. The downside is that for high quality companies, it may be a very long time (or perhaps never) for the share price to reach this level. Therefore, we will also accept a discount of as little as 25% to fair value.
The following table summarizes target purchase prices for rue21 based on the range of acceptable discounts, and also calculates the overall (simple) return based on a future value of $86.89 per share.
|Discount (%)||Purchase price ($/share)||Future Return (%)|
Rue21 is currently trading at a price of $25.41/share (07/28/2012), which is already a significant discount to fair value. We will set our target price for the initial purchase at $23.76 which represents a 45% discount to fair value and is 6.5% lower than today's price. If the predicted future share price of $86.89 is reached, this will represent a simple return of 266%.
The second aspect of the Deep Discount Strategy that seeks to improve our returns is with respect to position sizing. We attempt to reduce the effects of bad market timing by only allocating a portion of our capital to the initial purchase, and then add to the position over time, particularly if the share price drops.
For this exercise we will assume that we have $100,000 that we wish to invest in this company. We will allocate 25% of our capital to the initial purchase, or $25,000. At the target price of $23.76 this translates into a purchase of 1,050 shares.
We will add to the position based on two triggers:
- If the share price continues to move lower, we will add allocate an additional 25% ($25,000) of capital to purchasing additional shares for every 10% drop in share price. For example if our initial purchase is at $23.76, our next purchase will be at $21.38 for an additional 1200 shares. By allocating the same amount of capital to each purchase, a larger quantity of shares are purchased at the lower price, which lowers our average cost and maximizes return. (One important note: Fair Value and subsequently the discount price must be re-evaluated prior to each purchase. The purchase is only made so long as the purchase price is below the new target price.)
- If no purchase is made within one month of the initial purchase or any subsequent additional purchase, fair value and a new discounted target price will be recalculated. If the current share price is less than this target price, an additional 25% allocation will be purchased. This trigger allows us to add to the position over a period of time if the share price does not move lower.
When implementing any investment strategy, it is imperative to have an exit plan in place. This is to ensure that profit is maximized and to limit losses in the event that conditions change or the numbers used to determine present value were so far off that the margin of safety is not able to protect us.
There are just two situations that will trigger us to exit all or part of our position in this company:
- We exit 50% of our position when the share price increases to fair value. In this case, assuming no change in company valuation we will plan to sell when the price reaches $43.20 per share.
- We sell our entire position when the share price increases to a level 20% above fair value. Again, assuming no change in company valuation, we will close out our entire position when the price reaches $51.84 per share.
An important clarification is required here. It is very possible (actually quite certain) that the valuation of the company as determined by our method in the preceding sections will change over time. It's important that the above triggers be applied to the current fair value of the company, and not the original fair value when the shares were initially purchased.
Example 1: Rue21 becomes valued at $60 / share based on better than expected EPS growth using our valuation method. Our target price to exit 50% of our position is now $60 and we will exit our entire position at $72.
Example 2: Rue21 becomes valued at $20 / share caused by a huge earnings miss (which lowers the EPS for the trailing twelve months and affects our valuation). Our target price to exit 50% of the position is now $20 and we will exit our entire position at $24. This is a situation where we may actually end up with an overall loss. In this case our exit price will quite possibly be less than our average cost per share.
Following is the plan set out by the Deep Discount Strategy to purchase, manage, and profit from rue21 (assuming $100,000 total capital):
- Fair Value: $43.20 / share
- Target Initial Purchase: $23.76 (1050 shares)
- Target 2nd Purchase: $21.38 (1200 shares)
- Target 3rd Purchase: $19.25 (1300 shares)
- Target 4th Purchase: $17.32 (1400 shares)
- Alternative entry: One month following previous entry, if current price is below $23.76
- Target Partial Exit Price: $43.20 (50% of position)
- Target Final Exit Price: $51.84 (entire position)
If capital is allocated to this investment in accordance with points 2 - 5 above, we will hold 4,950 shares at an average cost of $20.17 per share and will have invested a total of $99,877 excluding commissions. If the fair value of rue21 remains at $43.20 / share, and we exit in accordance with points 7 - 8, we will achieve a profit of $135,224 or a 135% simple return. Our strategy will begin to realize a loss if the fair value we determine drops to $20.17 which is 53.3% lower than our current valuation.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.