One of my all-time favorite investment books is Benjamin Graham's The Intelligent Investor. In it, Graham outlines seven criteria that the Defensive Investor can use to select common stocks. These include:
- Adequate size of the enterprise
- Sufficiently strong financial condition
- Earnings stability
- Dividend record
- Earnings growth
- Moderate Price/Earnings Ratio
- Moderate Ratio of Price to Assets.
Graham gives specific guidance that is helpful to us in evaluating potential investments, but is often criticized because his criteria tend to be surprisingly restrictive, particularly when the market is reaching record highs.
I was surprised, therefore, to discover that Cato Corporation (NYSE:CATO), a relatively small chain of women's retail apparel stores appears to meet Graham's criteria for investment. CATO is based in Charlotte, NC and operates 1372 stores in 32 states, primarily in the southeastern US. It's stores are relatively small, averaging about 4500 square feet, and are typically located in strip centers, often anchored by a large grocery or super-center chain, so that there is good traffic flow and ample parking. CATO describes its product set as predominately private-label, high-quality, value apparel, generally priced below comparable merchandise offered by department stores or mall-based chains, but more fashionable than the product offered by discount stores. The company aggressively discounts slow-selling product to avoid carrying over merchandise to the following year.
Like many brick and mortar retailers, CATO had a challenging 2016. On February 2, 2017, CATO reported January 2017 same store sales were down 15%. While CATO has not yet released its full year financial statements, the February 2 nd press release did indicate that full year sales decreased 5% to $947.4 million on a same store sales decline of 6% for the year. CATO also stated that full year diluted EPS will be within the range of $1.66 - $1.70, down from $2.39 a year ago. Not surprisingly, the stock has traded down over the past year, dropping from about $38 last April to a current price of just over $25.
So, is CATO stock an appropriate investment for one of Graham's Defensive Investors? Let's work through the criteria.
Adequate Size of the Enterprise
Graham suggested a minimum of $100 million in sales. But the most recent edition of The Intelligent Investor was published in 1973. Assuming 3% annual inflation, Graham's $100 million in the early 1970s is about $350 million today. CATO announced that full year 2016 sales will be $947.4 million, so CATO is of adequate size to meet this threshold.
Sufficiently Strong Financial Condition
Graham used the current ratio (current assets divided by current liabilities) as the test for all firms except utilities and financial institutions. He set the threshold at 2:1. CATO's balance sheet at the end of its October quarter indicated total current assets of $442.9 million and total current liabilities of $154.0 million, a ratio of 2.88x, easily meeting Graham's criteria.
It is worth noting that $210.2 million of CATO's current assets are comprised of marketable securities - primarily tax-free bonds. That equates to almost $7.86/shr, or roughly a third of the price of CATO's stock. The company's marketable securities holdings has doubled over the past decade. Is CATO really 1/3 tax free bond fund; 2/3 apparel retailer?
It is also worth noting that CATO has two classes of common stock. The shares we can buy or sell, trading under the CATO symbol, are the Class A shares, having one vote per share. The Class B shares are held by the Cato family and are entitled to ten votes per share. Therefore, John P.D. Cato (age 65) controls 41% of the voting power of CATO shares. There are certain protections afforded the Class A shareholders, including equal or greater dividends than the Class B shares, and a $1/shr liquidation preference over the Class B shares, but the cache of tax-free bonds and CATO's dividend policy (see below) strongly suggest that you are investing alongside the Cato family, for better or worse.
Graham required that stocks for the Defensive Investor show no losses in the past ten years. CATO has been consistently profitable for the past decade. While 2016 results will be down compared to a year ago, CATO remained solidly profitable for the year, and meets Graham's criteria for earnings stability.
Graham required "uninterrupted payments for at least the past 20 years". As best I can tell, CATO has paid a dividend every year since at least 1993. The diligent (and sharp-eyed) among you may note the aberration in CATO's dividend record in the 2012-2014 period. In an effort to avoid the proposed tax increase on dividend income slated for 2013, CATO paid its entire 2013 dividend in a lump sum at the end of 2012. It then paid only the $0.05/shr quarterly "increase" in the dividend in 2013, before resuming its regular dividend arrangement in 2014. Therefore, the progression from $0.88/shr in 2011 to $2.98 in 2012, to $0.20 in 2013 and $1.20 in 2014 is not really as choppy and inconsistent as it first appears. In fact, this was arguably a courtesy and benefit to long-term holders of the shares (and the Cato family). Regardless of the motivation, CATO has made "uninterrupted payments for at least the past 20 years".
Graham required "a minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end". In his commentary on Chapter 14 of The Intelligent Investor, Jason Zweig points out that Graham seemingly set a low hurdle, as this criteria equates to only a 3% average annual increase. Zweig suggested a more stringent 50% or 100% increase over the ten-year period, equating to a 4% or 7% average annual increase. How has CATO faired on this metric?
|2004 EPS||$1.11||2014 EPS||$2.19|
|2005 EPS||$1.41||2015 EPS||$2.44|
|2006 EPS||$1.62||2016 EPS||$1.68|
|3 Yr Average||$1.38||3 Yr Average||$2.10|
Using the midpoint of the 2016 EPS guidance in the February 2 nd press release, CATO's average EPS for the last three years has been $2.10/shr. The three year average from ten years ago was $1.38/shr. The current three year average is 1.52x the average from ten years ago. Therefore, CATO's earnings growth meets Graham's threshold of "a minimum increase of at least one-third", and would also meet Zweig's 50% increase. It would not meet Zweig's 100% increase threshold.
Moderate Price/Earnings Ratio
Graham stated that "current price should not be more than 15 times average earnings of the past three years". As we noted above, CATO's average EPS for the past three years is estimated to be $2.10. Applying a 15x multiple to that figure would require a stock price of less than $31.50. CATO is trading today (February 8, 2017) at $25.85, well below the $31.50 maximum. Therefore, CATO meets Graham's moderate price/earnings ratio criteria.
Moderate Ratio of Price to Assets
This requires a little more math. Graham wrote, "Current price should not be more than 1 ½ times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5."
At a price of $25.85, CATO is trading at a multiplier of 12.31x its three year average EPS ($25.85Price / $2.10 3YrAvgEPS = 12.31).
Using CATO's 10/29/2016 (most recent) balance sheet, I calculate a book value per share of $15.40. At a current market price of $25.85, CATO is trading at 1.68x its book value.
Since this is not less than the 1 ½ times last reported book value noted in the first part of Graham's guidance, we must look to the rule of thumb in the second part.
The product of the earnings multiplier (12.31) times the ratio of price to book value (1.68) is 20.68 which is less than the 22.5 maximum. Therefore, at its current price, CATO meets Graham's criteria for a moderate ratio of price to assets.
At this point, some of you have stopped reading and already hit the "buy" button on your computer. Others, particularly those who are long-time students of Graham's writings, are saying, "Hey, wait a minute. You forgot a test."
I didn't forget the second test in Graham's evaluation of a sufficiently strong financial condition, but it does pose a bit of a conundrum when evaluating CATO (or most any other retailer). The second prong of Graham's financial condition test was that "long-term debt should not exceed the net current assets (or "working capital")."
On the surface, this seems like a no-brainer. CATO has no long term debt and oodles of net working capital as we discovered when calculating the current ratio above. So what's the issue?
CATO operates 1372 leased stores. They pay roughly $70 million per year in rent. Is it proper to ignore this obligation simply because the stores are leased rather than owned and financed? I find no guidance from Graham in The Intelligent Investor with regard to the treatment of recurring lease expense. I can speculate that this is because leasing was much less prevalent in the early 70s than it is today. Given Graham's penchant for tangible assets, I can speculate that he would feel it more prudent for management to own their stores and build equity in the underlying real estate than to pay rent allow the equity to accrue to the benefit of a landlord, but this is only my opinion, and there is clearly value in being able to close a store and walk away from an underperforming location at the end of a lease term as opposed to having to hold and market a property in a poor location.
Interestingly, in CATO's most recent 10K, they note that "pending changes to lease accounting standards will require lessees to capitalize operating leases in their financial statements in the future. These changes will have a major impact on the Company as a retailer with numerous leased locations…These changes could lead to the perception by investors that we are highly leveraged and would change the calculation of numerous financial metrics and measures of our performance and financial condition".
I'm not qualified to attempt to quantify what the impact of the change in accounting standards will mean to CATO's balance sheet, but I believe that a general rule of thumb is to multiply the annual rent expense by 6-8x in order to obtain a proxy for the corresponding liability. Applying this rule of thumb to CATO's $70 million in annual rent expense would result in an implied "debt" of $420 - $560 million.
You will recall from our calculation of CATO's current ratio that CATO's October balance sheet reflected total current assets of $442.9 million and total current liabilities of $154.0 million, resulting in net working capital of $289.9 million.
So, does CATO's long term debt exceed its net working capital or not? Your answer to that question will determine whether or not you believe CATO stock meets Graham's criteria as an acceptable investment for a defensive investor.
Post your comments below.
Disclosure: I am/we are long CATO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.