Toro: Listen To Phil Fisher And Peter Lynch

Summary

• Phil Fisher and Peter Lynch both advised against selling stocks of good companies simply because they look expensive.
• Toro still possesses many of the characteristics Fisher and Lynch looked for in companies to buy.
• Toro's high valuation isn't a sell signal by itself, but investors should watch the company to make sure it can continue to deliver growth.

Evaluating Toro Like Fisher Or Lynch

Two investing books I still have on my shelf are Common Stocks and Uncommon Profits by Phil Fisher and One Up On Wall Street by Peter Lynch. While Fisher's book was first published in 1958 and Lynch's in 1989, I find them still highly relevant today. I consider myself predominantly a value investor, but both of these books have helped me get more comfortable with "growth" stocks while still avoiding the highflyers that can crash and burn when the market turns. Phil Fisher was an early proponent of using qualitative analysis to help identify companies with potential to increase sales and earnings over time. Warren Buffett credits Fisher for broadening his focus beyond Ben Graham "cigar butt" value stocks. Peter Lynch was best known for his tenure as manager of Fidelity Magellan (FMAGX) in the 1980's where he averaged a 22.5% annual return compared to 16.5% for the S&P 500. Lynch's book focuses on buying lesser-known companies in overlooked industries that still have growth potential. Both investors used qualitative as well as quantitative metrics to judge stocks and were not quick to sell simply because a company has reached a particular valuation.

The Toro Company (NYSE:TTC) has been a well-run company in an unglamorous industry that has continued to grow over time due to innovation (through both internal R&D and acquisitions) as well as good balance sheet management. The company recently reported fiscal Q1 2021 results which showed a recovery in the Professional segment (sales +9.3%, earnings +14.0%) even as the anticipated post-pandemic slowdown in the Residential segment has not yet started. (sales +31.3%, earnings +48.9%)

Despite these great comparisons against the pre-pandemic period of November 2019 - January 2020, Toro did not raise its guidance for FY 2021 which remains at a midpoint of $3.40 EPS. Although the stock sold off on this report, it still looks richly valued at around 28.5 times 2021 earnings. With a growth rate of 12.2% compared to 2020, the PEG ratio is also high at 2.3. These numbers would worry a classic value investor, but Toro has been expensive on these metrics for many years as the share price continued to increase. Relying only on the quantitative metrics would have produced a high opportunity cost of selling, along with the risk of the replacement investment not performing as well as Toro. As a long-term investor it is worth looking at the company through the lens of Fisher and Lynch to decide if it is a hold or an outright sell.

Phil Fisher's "What To Buy"

Fisher offers a 15-point checklist in Chapter 3 of his book to use in stock selection. Toro measures up well on nearly all of these. I won't go into detail on all 15 but the first three dealing with product development and market growth are easy to address in Toro's case:

Point 1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

Point 2. Does the management have determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

Point 3. How effective are the company's research and development efforts in relation to its size?

Landscaping, snow removal, and excavation are not the high growth industries that aluminum, plastics, and television were in Fisher's day. Nevertheless, they do grow in line with home ownership and infrastructure investment. Toro has demonstrated growth over the years, except for a downturn during the housing crash. Since then, Toro has focused on growing the Professional segment with purchases of Boss (snow plowing) and Charles Machine Works (trenching and ditch digging) with government and industrial customers that can grow independently of the housing market.

Source: Toro Investor Presentation, March 2021

Points 2 and 3 are also important to Toro's management, as they track and report R&D as a percentage of sales and also percentage of sales from new products in each earnings slide deck. The company spends 3%-4% of its sales on R&D with notable increases in the last two years. The "Vitality Index" shows that sales of products released in the past 3 years has generally been over 35% of total sales.

One particular area of new product development for Toro is electric powered products, to meet demand for more environmentally friendly solutions. In the Residential segment, this includes the Flex-Force line of batteries which can run mowers, snow blowers, and yard tools. In the Professional segment, Toro offers battery powered landscaping mowers and utility vehicles.

Source: Toro Flex Force Website

Fisher also has a couple of points around "worthwhile" and sustaining or improving profit margins. Toro has maintained gross margin within a couple points of 35% for over 30 years. Net profit margin has been on a steady increase, with a downturn during the pandemic largely due to product mix. Lower margin Residential grew faster than Professional during the pandemic, pulling down the overall margin for the company even though the margin at each individual segment increased. As Professional growth picks up again after the pandemic, company margins should bounce back.

Source: Seeking Alpha TTC Charting page - Gross Margin

Source: Seeking Alpha TTC Charting page - Net Income Margin

Fisher has another point on avoiding dilution from equity issuance. Contrary to this concern, Toro has been a steady buyer of its own shares. While buybacks were put on hold during the pandemic, they have resumed in FY 2021 and the current authorization could reduce share count around 5%. Even after paying off some debt this year, the company has excess liquidity it built during the pandemic it can apply toward buybacks.

The rest of Fisher's points focus on management and employee integrity and behavior, factors often ignored in analyzing companies today. These are harder to quantify and each investor will have to judge for him or herself. Still, I found from listening to the earnings call that management is humble and non-promotional even after performing better than expected in the pandemic. My impression on the company not raising guidance this quarter is that it is more out of a sense of conservatism and desire to not overpromise and less about any real worries about the rest of the year.

The Perfect Stock - What A Deal!

The above heading is the title of Chapter 8 of Lynch's One Up On Wall Street. Lynch's writing style is a bit more irreverent, but he also offers a 13-point list of characteristics to look for. Just touching on a few of them in Toro's case:

(2) It Does Something Dull

(3) It Does Something Disagreeable

I think helping grass grow and cutting it fall under the heading of "dull" and digging ditches can be "disagreeable". Certainly not glamorous like cryptocurrency or cloud-based software delivery.

(11) It's A User Of Technology

I discussed the adoption of battery technology above. Toro is also getting into automation with the purchase of Left Hand Robotics, a developer of autonomous navigation technology for turf and snow management.

(13) The Company Is Buying Back Shares

As noted above, they have been for a long time and have the liquidity to resume buying at a faster pace after pausing during the pandemic.

I should also touch on Lynch's sell criteria from Chapter 17 of One Up On Wall Street. The rules are different for different styles of stocks and there can be some argument over which one best fits Toro. I will be generous and call it a "Fast Grower" base on the last 20 years of performance. The main rule for this type of stock is to sell when the growth path is clearly at an end, such as when a retailer or hotel chain has expanded all over the world and is starting to show poor same store sales growth. Toro doesn't exactly fit this model, but it is clear they can still grow by opening up new channels such as they did over the last couple years expanding into Tractor Supply (TSCO) stores. Lynch's final point does touch on a valuation criterion:

The stock is selling at a p/e of 30 while the most optimistic projections of earnings growth are 15-20 percent for the next two years.

This is another way of saying PEG ratios over 2 are a sell signal, which does apply in Toro's case. However based on Q1 performance, I still think Toro has a good chance of raising full year guidance next quarter, which would increase 2021 earnings and bring the PEG ratio under 2 based on the 2020 - 2021 growth rate.

One Last Valuation Concern

Fisher and Lynch didn't really talk about valuation metrics like Return on Average Invested Capital or Return on Equity the way Buffett and Graham did. They were a bit more qualitative, or perhaps they just didn't want to talk over the heads of their readers. Still it is worth reiterating what I mentioned in my last article. ROIC and ROE have been on the decline for the last two years, which can be especially dangerous for a 28.5 P/E stock.

As I mentioned last time however, the denominator of the ROIC and ROE formulas increased due to holding extra liquidity for the pandemic and not conducting buybacks. The greater return of capital to shareholders in 2021 along with earnings growth should get these metrics back on track.

Conclusion

Phil Fisher and Peter Lynch are still useful resources to consult when a strong market makes nearly all stocks look expensive, not just the super high growth and momentum plays. If the qualitative reasons for your original purchase are still intact, and management is still running the company the same way as when you bought, an expensive stock can still be a Hold. In Toro's case, the company is expanding into adjacent Professional markets with Charles Machine Works and growing retail distribution with Tractor Supply. Toro is also working on R&D to deliver innovative electric and autonomous products that the market wants. Q1 results show that the company's margins and profitability metrics are recovering from a dip in 2020. While Toro did not raise guidance this time, the Q1 results suggest they are being conservative and not necessarily anticipating another downturn. That leads me to continue my long-term hold of TTC. For those looking to buy, I would look for a pullback to a PEG of 2, either through an earnings estimate increase or a drop in the share price.

Analyst’s Disclosure: I am/we are long TTC. 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.