Reversion to the RET.Ailing mean…

reitmans logo

I should probably preface this post by saying that a company such as Reitmans (RET.A, RET) is not my usual territory. However, before you throw the baby out with the bathwater, hear me out. There is a method to my madness…

Anyone that was invested in equities this year would have been impacted by (or was at least watching) the December selloff. The Dow, TSX, and TSX venture are all (currently) looking significantly uglier, and many investors have felt the pain, me included. To add insult to injury, tax loss selling came into full swing in December, causing further weakness in share prices. I suspect many people rounded out the year with marginal gains at best, or were simply in the red.

Which is where the rather unsexy story of Reitmans comes into play. While I watched the markets, I realized that many companies were taking a beating, and that there was sure to be some opportunities. Initially, I started looking at another Canadian retailer (Le Chateau) ,as I noticed the shares trading at historic lows. However, despite having made a very significant return off of Le Chateau (a long time ago…), I gave it a pass, as unlike Reitmans, it has neither a compelling balance sheet or positive cash flow. That being said, I’m not suggesting that Reitmans was one of the only opportunities (there were many), but it simply provides a mechanism to demonstrate how reversion to the mean can sometimes provide reasonable, short term, low risk opportunities. Lastly, before we get into the details, I should be clear that while many of the markers that I typically look for (low debt, good cash flow) are present in this analysis, others are not. Unlike some of the other companies I have written about, which tend to be very small, Reitmans is significantly larger. This being the case, the way I view this investment is somewhat different than how I might view an investment in a much smaller micro or nano-cap.

So what exactly does that mean – “reversion to the mean” ?  I’m sure you’ve probably heard the term bandied about by either some talking heads on BNN, or someone with a mathematical bent. In the context of a companies share price, it simply means that over the long term, shares will tend to trade around a long term average of a particular valuation parameter, or parameters. The one that is spouted most frequently is the PE ratio. Quite often, you will hear a market prognosticator state that “ABC corporation typically trades at 11 times earnings, and right now, at 8 times earnings, we believe it provides compelling value”. What that guy (or gal) is essentially saying is that, all things being equal, the price of ABC will move back back to the long term average of 11 times earnings, and anyone buying today is getting a bargain.

So what made Reitmans appealing ? Well, since the PE ratio is so well ingrained in our collective psyche, it makes sense to start there. If we take a look at the past 10 years, we see the following:

Reitmans 10 year PE.PNG

The astute reader will notice that I have included two sets of “averages”, 10 year averages from 2009-2018, and a shorter time frame of 4 year averages from 2015-2018. The reason for this is that Reitmans today is not the same Reitmans of yesterday. In late 2014, Reitmans decided that it was bleeding cash too heavily, and slashed the dividend quite significantly. So, I think it’s fair to say that you probably have a different group of investors holding shares today than you did prior to the dividend cut. Because of this, we show the full 10 year averages to get a sense of where things could go, but we only use the more recent averages to drive out where we think the shares probably will go. The more recent 2015-2018 averages are more conservative, and are therefore more realistic.

One can see that the PE ratio at the time of our analysis (10.9 x), at a price of $3.60, is well below the average high, low, and absolute average PE ratios. Essentially, although I can’t state what the exact probability of a loss might be, we can make the inference that it’s low. Even if one assumes reversion to the low end of the spectrum , the result (average PE multiple of 12.08 x estimated earnings of $0.33) results in a gain of almost 11%, excluding any dividends.

But using a single criteria to buy or sell is foolish! If you finished reading that last paragraph with this thought on your lips, I would wholeheartedly agree with you. In the case of Reitmans, it’s even more appropriate, as earnings have been negative in 2 of the last 4 fiscal years. In this case, it’s even more appropriate to bring in other valuation metrics. Since many folks who consider themselves value investors focus on book value, I thought that might be a logical next stop:

Reitmans 10 year BV.PNG

Our snapshot of the price/book ratios tells a similar story – it would be unlikely that one would lose money, and even at the low end, one could end up with a double-digit return. Additionally, our snapshot of the price/book ratios also gives us another signal, in that over the last few years (2017 – today) book value has actually been increasing, which is a good sign.

In fact, this same story plays out if one looks at operating cash flow yield…

Reitmans 10 year Cflow.PNG

..and when one looks at the dividend yield…

Reitmans 10 year Div.PNG

In the context of the dividend yield, it should be noted that 2014 was excluded, as the dividend cut (late in that year) skewed results. With the current dividend significantly reduced, and as a much smaller percentage of cash flow, it would take some very bad business decisions (or situations) to result in another dividend cut.

At this point, I could go on with more of the same, but I’m guessing you’ve seen enough. While I could have drowned this post in charts & other stats, suffice to say that when I review a company I typically look at and maintain a 10 year history of:

  • Price to revenue
  • Price to earnings
  • Price to book value
  • EBIT return on capital
  • EBITDA return on capital
  • Enterprise value to EBITDA
  • Dividend yield
  • Dividend as % of operating cash flow
  • Long term debt trends
  • Long term gross margin trends
  • Operating cash flow yield (including and excluding working capital)

I may have missed something in that list, but you are probably glad that I didn’t decide to flood this post with all of this information, as it’s a lot to sift through. That being said, it is an invaluable tool when analyzing companies like Reitmans , as companies such as this have a history long enough that one can derive long term valuation metrics, but small enough that coverage is often very limited. While there is an army of analysts providing opinion (and valuation metrics) around Apple & Google, the fact is that this sort of activity makes the prices of those companies reasonably efficient. As I’ve said before, price inefficiency lives in the weeds where small companies are, which is why data such as this can be so useful.

So if one were to buy at this price, what is a reasonable expectation ? While the data suggests that one could make a tidy profit, one also has to include a few other factors, namely dividends and tax impacts. Before buying into a position, this is something I always assess, as I’m really interested in what the real, after tax, return will look like. For the sake of this exercise I have made a number of assumptions, as follows:

  • For the sake of conservatism, I have chosen the lowest outcome for each category. So, the lowest average low price ($3.99), the lowest total average price ($5.21), and the lowest average high price ($6.78).
  • Since I am investing in Canada, I will assume all values are in Canadian dollars.
  • I will also assume we are investing outside of a tax sheltered account.
  • I will assume a combined federal and provincial tax rate of 40%.
  • I will apply taxes to dividends.
  • I will include the impact of the Canadian dividend tax credit.
  • I will assume the purchase of 5,000 shares.
  • In the examples below, any cash outflows show as red (negative) numbers, whereas cash inflows show as black (positive) numbers.

 

Reitmans low avg hi scenarios.PNG

So, after holding for one year, and with all tax impacts included, it would not be unreasonable to expect an after tax return of ~ 13% at the low end of the spectrum. Of course, if you are in a lower tax bracket (or tax sheltered) ,the returns would be better, and one does not necessarily have to hold for a 12 month period.

In summary, an investment in something like Reitmans is significantly different than an investment in the other companies I have profiled. Those companies (Pioneering Technologies, Titan Logix, Total Telecom) provide exposure to large movement in share price for a relatively low “ticket price”. A movement in share price for these companies of 100% or more would not be unheard of. While their balance sheets are clean, one must be able to stomach significant volatility in the interim, as results rarely occur overnight. However, in a portfolio of these, those that do spectacularly well will make up for those that either muddle along or never recover.

By comparison, an investment in a company like Reitmans provides for much more muted returns, but given that one is purchasing at the low end of a valuation spectrum, the probability of a very reasonable return in a relatively short period of time is quite high. A purchase of these shares is simply a way to put idle money to work – it is unlikely to fail catastrophically, you are paid to wait, and there is a high probability of a solid return. At such time when a price target is reached, it’s probably not a bad idea to sell, as I’d suggest that something like Reitmans isn’t a “hold forever” type of investment, nor is it something likely to provide spectacular micro-cap returns. Once the share price has “reverted to the mean”, the easy money is gone, and it may be time to move on.

As always, these are only my thoughts & opinions. In writing this post, I was hoping to elicit some feedback, specifically:

  • Do you find “reversion to the mean” to be a useful part of your investment toolkit ?
  • If so, do you typically compare valuation metrics across numerous years ?
  • In doing so, do you pay for 3rd party data, or do you “crunch” the data  ?

If you have comments on these points, or if you have other questions, I can be reached at greyswan2@gmail.com.