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Many investors have a portfolio full of securities considered to be risky, such as futures, options, or even volatile small-cap stocks. It is fine for people to have these securities if they know how to manage their position properly, but I feel as if everyone should have some core holdings. These core holdings are stocks that can generate income continuously over the long run, and are not to be sold off unless something unfavorable to shareholders happens. I believe Costco (COST) is a great stock to be considered for one's core holding. But before I start, here is what I look for in stocks:

  1. Good value
  2. Good growth and fundamentals
  3. Desirable chart
  4. Strong balance sheet

Introduction

Costco engages in the operation of membership warehouses. The company offers branded and private-label products in a range of merchandise categories. It sells all kinds of products, including snack foods, tobacco, beverages, cleaning supplies, appliances, electronics, health products, apparel, jewelry, etc.

The company also engages in the operation of gas stations, pharmacies, food courts, optical dispensing centers, car washes, and many other different businesses. In addition, it provides business and gold star (individual) membership services. As of Sept. 2, 2012, the company operated 608 warehouses, with 439 in the United States and the others overseas. Furthermore, it is involved in online businesses at Costco.com. Costco was founded in 1976 and is based in Washington.

Here is a snapshot:

Price (06.11.2012)$98.79
Market Cap42.72B

Income (2011)

1.71B (P/E: 25.40)
Sales (2011)99.14B (P/S: 0.43)
Book Value Per Share$28.59 (P/B: 3.46)

ROE (Return On Equity)

14.03%
EPS Past 5 Years10.43%
Debt/Equity Ratio0.11
Dividend1.11%
Payout Ratio26.12%

1. Good Value

A stock with a P/E of 25.4 does not seem like good value to most -- at first sight, it does not look good to me either. But this number is near its three-year P/E average of 24.06. The table below shows its P/E values over the past three years. But this number is still generally higher than most of its competitors, such as Dollar Tree (DLTR) with a P/E of 17.42 and Family Dollar (FDO) with a P/E of 18.53. On the other hand, Costco's P/E is lower than that of another competitor, PriceSmart (PSMT), which has a P/E of 37.46.

MonthP/E Ratio

Nov. 2009

24.26
May. 201020.88
Nov. 201022.31
May. 201125.78
Nov. 201125.69
May. 201224.13
Now (Nov. 2012)25.40
Average (3Yrs)24.06

(If you find it a little too richly valued, there is a way to overcome this later.)

Although its P/E is undoubtedly a bit high, its P/B and P/S ratios prove otherwise. Costco has a P/B of 3.46 and a low P/S of 0.43, which is low compared to Dollar Tree's P/B of 5.90 and P/S of 1.29, Family Dollar's P/B of 5.90 and P/S of 0.82, and PriceSmart's P/B of 6.05 and P/S of 1.24.

2. Good Growth and Fundamentals

First, Costco has fast-growing earnings. As seen from the above snapshot, Costco grew at 10.43% year over year for the past five years, a remarkable number for a large-cap like Costco. It is also expected to grow at 13.22% year over year for the next five years. Besides this, its EPS has been growing continuously every year for the past 10 years with the exception of 2009, when there was a severe recession. Its EPS figures are shown in the table below.

EPS 2003*$1.53
EPS 2004$1.85
EPS 2005$2.18
EPS 2006$2.30
EPS 2007$2.37
EPS 2008$2.89
EPS 2009$2.47
EPS 2010$2.92
EPS 2011$3.30
EPS 2012*$3.89

*Costco's fiscal year ends in August.

Second, Costco has a debt/equity ratio of 0.11, which is remarkable and below my personal limit of 0.5. This means that Costco is earning enough to not consistently rely on debt to expand itself. This is also evident due to the fact that its debt/equity number had been maintained under 0.25 for the past 10 years. This ratio shows the proportion of equity and debt the company is using to finance its assets, and the higher the ratio, the more debt, rather than equity, is financing the company. A high level of debt compared to equity can result in volatile earnings and large interest expenses. Below is a table containing Costco's debt/equity numbers.

Debt/Equity 20030.21
Debt/Equity 20040.20
Debt/Equity 20050.17
Debt/Equity 20060.06
Debt/Equity 20070.25
Debt/Equity 20080.24
Debt/Equity 20090.23
Debt/Equity 20100.20
Debt/Equity 20110.17
Debt/Equity 20120.11
Debt/Equity 2012 Latest Quarter0.11

Third, Costco has been buying back shares over the past 10 years, with its total shares outstanding decreasing from 457.48 million in 2003 to 432.35 million today, representing a 5.50% decrease over the past 10 years. This is beneficial to shareholders as shareholders do not own the whole company -- they only own part of the company. Share buybacks will enable the shareholders to own a larger part of the company without owning more shares. Below is a table with the number of shares outstanding Costco has had over the past 10 years.

Shares Outstanding 2003457.48M
Shares Outstanding 2004462.64M
Shares Outstanding 2005472.48M
Shares Outstanding 2006462.28M
Shares Outstanding 2007437.01M
Shares Outstanding 2008432.51M
Shares Outstanding 2009435.97M
Shares Outstanding 2010433.51M
Shares Outstanding 2011434.27M
Shares Outstanding 2012432.35M

Fourth, Costco had been increasing its dividend every year since 2004, when it initiated a dividend of $0.20 per share. Since then, the number has risen to $1.10 per share every year, which equates to a dividend yield of 1.11% at the moment. The chart below shows the dividend payments Costco has made to its shareholders since it initiated the dividend.

Click to enlarge images.

Fifth, Costco's days inventory numbers have also been decreasing steadily over the past 10 years, which means goods stay in the inventory for a shorter period of time. Days inventory is a measure of a company's performance that gives investors an idea of how long it takes the company to sell its goods in the inventory. This is another positive point about Costco as this is a sign that sales are improving. Below shows the days inventory numbers over the past 10 years.

Days Inventory 200332.70
Days Inventory 200431.60
Days Inventory 200531.60
Days Inventory 200631.60
Days Inventory 200731.60
Days Inventory 200829.00
Days Inventory 200931.60
Days Inventory 201030.30
Days Inventory 201131.20
Days Inventory 201229.80
Days Inventory Latest Quarter22.90

Lastly, Costco maintained a high ROE (return on equity) over the past 10 years, and locked in an ROE of 19.50% in the latest quarter. A high ROE indicates that a company's management is using shareholders' money more effectively, which is good both for the company and its shareholders. The definition of ROE is the amount of net income returned as a percentage of shareholders' investments. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Below shows a table that includes Costco's ROE number over the past 10 years.

ROE 200311.00%
ROE 200411.60%
ROE 200512.00%
ROE 200612.10%
ROE 200712.60%
ROE 200814.00%
ROE 200910.80%
ROE 201011.90%
ROE 201111.60%
ROE 201213.70%
ROE 2012 Latest Quarter19.50%

3. A Desirable Chart

Costco's weekly chart:

Source: Stockcharts.com.

A quick look at Costco's weekly chart shows its strength and its strong, impressive uptrend over the past two years. It has risen about 80% over the past two years and has gained quite a fair bit of momentum. Additionally, it rested on its 20-day SMA before making a move higher many times before. At the moment, it is resting on its 20-day SMA once again and, in my opinion, this presents another good buying opportunity. It has also been outperforming the general indexes over the past two years, with its relative strength (vs. the S&P 500) rising from 0.05 to 0.069 in just two years.

Costco's 10-year chart:

Costco's long-term chart also illustrates a very strong uptrend, similar to its previous weekly chart. Shares have appreciated in price rapidly over the past 10 years, with its stores gaining popularity and its management managing the company effectively.

From the above 10-year chart, it is also evident that Costco is somewhat recession-proof. It had declined around 40% during the recession of 2008-09, when many other companies were losing 50% or more of their market value. But even if it drops in the future, I would still view it as an opportunity to buy a stock that has fabulous fundamentals and a good, increasing dividend.

4. Strong Balance Sheet

Before I continue, you can take a look at Costco's balance sheet here.

First, Costco's assets grew faster than its liabilities over the past three years. From the year ended Aug. 29, 2010, to the year ended Sept. 2, 2012, Costco's total assets had increased from $23.815 billion to $27.140 billion, an increase of 16.6% over three years. On the other hand, its total liabilities had increased from $12.986 billion to $14.779 billion, an increase of only 13.8% over the past three years.

Second, Costco has more current assets than current liabilities. As of Sept. 2, 2012, it had $13.53 billion in current assets and $12.26 billion in current liabilities. This is a good sign as the company is able to pay off its short-term liabilities if it is obliged to pay all of them off at one time. Costco had also $3.528 billion, or $8.16 per share, in cash as of Sept. 2, 2012.

Third, Costco has no preferred stock, which is a good sign for the company and its shareholders -- it does not need to pay extra special dividends, which would only drain its cash reserves faster. A company that has preferred stock also shows how cash-strapped it is to have to borrow money from its shareholders, technically, at higher interests than normal (special dividends, etc.).

Catalyst to Push Earnings Higher

Costco is in a very good position to benefit as many consumers turn to discount retailers, given the economic conditions now. Many will try to scrimp and save for times of hardship, and therefore try to frequent discount retailers like Costco and Wal-Mart (WMT) instead of going for more expensive options. Thus, this could be a potential catalyst to push earnings higher.

Key Risks/Flaws

Every company, regardless of how perfect it seems, is bound to have some flaws. Here, I will list some of Costco's key risks and flaws.

First, it operates in a highly competitive environment. Some of its largest competitors are Wal-Mart and Target (TGT). These two companies combined have 11,911 stores and $19.24 billion in income over the past fiscal year, which is much more than Costco's 608 warehouses and $1.71 billion in income. With all these companies also expanding the stores they operate, I have to reiterate that Costco operates in a highly competitive market.

Second, its profit margins are low compared to other competitors. It has a 1.78% profit margin, which already looks bad by itself. Furthermore, compared to Wal-Mart's 3.69% profit margin and Target's 4.12% profit margin, this number looks even worse. The definition of profit margin is how much out of every dollar of sales a company keeps in earnings. This is a sign that Costco spends quite a large amount of its revenue for other uses and that Costco needs to control its costs better.

Third, Costco insiders only own 0.59% of its shares outstanding. A stock with a lot of its float owned by insiders of the company usually performs better, as insiders, who own shares, would strive to govern the company as well as they can to prevent the stock from depreciating in value. A company whose stock is not widely owned by insiders may perform worse as insiders may not give their best, as their money is not involved in the company.

Even though I say this, I want to clarify that I do not mean that a company will definitely perform badly as long as insiders do not own much of the shares outstanding. This is only a possibility.

To Enter the Position: Selling Puts

There are many good ways that one can accumulate shares for a great long-term investment. Here, I will describe my favorite strategy of accumulating shares by far -- selling put options. This method can lower one's entry price. (This is the method that can help if one finds Costco's valuation a little too high at the moment.) In the table below, I show a few put options that I am considering selling.

Strike PriceExpiryPremiumEffective Entry Price
$95Dec 2012$1.30$93.70
$92.50Jan 2013$1.22$91.28
$92.50Apr 2013$2.67$89.83
$90Apr 2013$2.04$87.96
$90Jan 2014$5.55$84.45

The December 2012 and January 2013 options are for investors who want to get into the position sooner; the April 2013 and January 2014 options are for investors who can and want to wait long term. There actually also are Costco options expiring only in January 2015. They offer higher premiums, but waiting two whole years is just too long for me. I described this method of selling puts more in depth here; the article describes how to enter a McDonald's (MCD) position, but it can also be applicable when it comes to Costco.

Do not sell the December 2012 and January 2013 puts for below $1.05; do not sell the $92.50 March 2013 puts under $2, and the $90 March 2013 puts under $1.60, and the January 2014 put for under $5.

A Few Benefits of Selling Puts

The put selling option strategy is one that is good in a number of ways:

1. It can effectively lower your entry price.

2. It provides a good cushion, as you can cut your losses considerably if the stock plunges. On the other hand, you can also increase your gains considerably if the stock jumps.

3. You are not required to monitor your position too often.

The Takeaway

Overall, Costco is a great stock to buy over the long term. Although it has some flaws, like any company has, I believe that all of its merits make up for it flaws and make the company a good investment over the long term.

Source: Costco To Reward Shareholders Over The Long Run