When looking for value in a stock, there are three important questions to ask yourself. Has there been a move that, in the natural way of markets, has been overdone? Are there fundamentals that are being overlooked as momentum takes hold? Is the expectation of bad news now priced in?
When the answer to all three of those questions is yes, then there is value in the stock. The problem is that when these three conditions are met it usually means trying to pick a bottom for something that is falling, which has inherent risk. For that reason, I also like to look for some kind of established floor in recent price action. Bed Bath & Beyond (BBBY) now fits the bill on all four counts.
In some ways, even considering the purchase of BBBY seems crazy coming off of two consecutive quarters of disappointing earnings and, more importantly, downward revisions of guidance. The home furnishings retailer looks to be a company in decline and, even despite some recent wobbles, growth is still in vogue with buyers. When we consider the above questions though, the stock looks like a rock solid buy at these levels.
Has there been a move that, in the natural way of markets, has been overdone? Absolutely there has, and, better yet, it is a reaction to an overdone move in the other direction.
The above chart represents 18 months of trading in BBBY. It is clear that the roughly 25% drop in the stock since the beginning of this year is not an isolated thing, nor is the formation of a base at around $60 illogical; it approximately equates to a level of resistance before the rise began.
Bed Bath & Beyond spent 2013 keeping track with the broader market and adding around 30%, but did the performance and prospects of the company really improve by 30% during that time? Not really; results for the last four quarters were at or just below expectations. BBBY, it seems, was swept along as stocks in general had a good year but then as reality intruded with downbeat guidance at the start of this year, quickly fell out of favor. The question remains, though, does a roughly 10% cut in guidance justify a 25% drop in the stock? I don’t believe it does when we consider the second question.
Are there fundamentals that are being overlooked as momentum takes hold? It certainly seems that way. It is not as if Bed Bath & Beyond is struggling to make money. They have a return on assets of nearly 16% and on equity of 25.49%. They have an operating margin of over 14% and free cash flow of around $1 billion. I understand that sales and profits have declined somewhat, but then, as a result of lower guidance, so have analysts’ estimates for the next year, so a forward P/E around 12 looks cheap.
This depressed P/E gives us the answer to the third question; is the expectation of bad news now priced in? I would say it is. If, over the next couple of months, same store sales disappoint a little there will be an element of “told you so,” but is it really likely to trigger more selling or does it simply justify the actions of those that have already bailed? At these levels, especially given the proximity of support, the latter is more likely, limiting the downside potential. Any good news, however, is likely to cause a sudden reaction to the upside
There are also macro reasons to believe that those forecasts may yet prove to be overly pessimistic. The housing recovery has been anything but smooth, but taken over time it does still seem to be taking place. As people move, they buy new stuff for their new home. Even if Bed Bath & Beyond is losing market share to some extent, growth in the overall market could well offset that.
Lastly, the proximity to the $60 level which provided resistance on the way up 18 months ago and support on the way down just a few weeks ago makes buying BBBY even more attractive. That particular level is almost too close to prove an effective stop loss. Any general market volatility could see it breached in the next couple of days, but the lows of early 2013 just above $54 constitute a logical stop level that would limit potential losses to around 10%.
No trade is ever foolproof, but BBBY looks cheap at these levels. As I have pointed out before, cheap doesn’t necessarily equate to value. When a move down is an over correction that has got past fundamental valuations and sentiment and price combine to limit downside, however, it does. By that measure, BBBY is cheap and value.