Key Points

• The Perceptive Investor’s “2-10-10” screen results brought in some strong companies currently undervalued by the market
• Finding value requires exercising patience, ignoring the noise and focusing on the underlying fundamentals
• Hanes Brands (HBI) is my favorite in this group with at least 30% upside under conservative assumptions

Identifying Strong Under-Performers

2016 was a good year for stocks in general. The Dow finished up 13.4%, the NASDAQ finished up 7.5% and the S&P 500 ended up 9.5%. However, there is a short list of strong companies that recently came up on my “2-10-10” screen ( $2 billion market cap,  > 10% growth in EPS and > 10% ROE – detailed explanation here) who are either trading at 52-week lows are are down over 20% from from their 52-week highs. It’s times like this when the we should pause and reflect on why these companies may be trading at these prices and where value can be found in such opportunities. Below is a screenshot taken from the “2-10-10” screen on January 9th, 2017.

The screen, sorted by highest-to-lowest Return on Equity (“ROE”), shows nine companies who fit this criteria. As mentioned in this previous post, ROE is a great measure to understand how a company is creating value from capital injected by shareholders. What I generally want is a company who has displayed a consistent and above-average ability to produce high ROE. Though not a silver bullet for analyzing stocks, it is a key criteria in identifying strong companies.

The list above includes nine such companies with the top two being pharmaceutical companies. We’ll give the pharmaceutical companies a pass as I simply know absolutely nothing about the industry. Rather, I’ll move down the list to the third highest ROE – Hanes Brands (“HBI”).

Now you’re probably thinking, what’s so interesting about underwear!? Quite frankly, nothing. But that is why I like it. It’s a product that is easy to understand, not easily disrupted by technological advances (which seems to be happening just about every other day), entails some barrier to entry (particularly if one is involved in the manufacturing of its own products as is HBI), and most importantly is a product EVERYONE needs and uses, with the exception of hemp-wearing tree huggers, of course. Next I’ll talk about why I like HBI and why it’s important to always separate company fundamentals from what Mr. Market (i.e. stock price quote) is saying.

What’s to Like about HBI

Below is a list of key facts and supporting fundamentals about the business:

• HBI was founded in 1901 and became a separate publicly-traded company (spinoff from Sara Lee) recently in 2006. The point is this company has an extremely long, successful operational history and track record of results.
• HBI specializes in manufacturing and distribution of basically all undergarments and athletic wear (bras, panties, shapewear, mens’/children’s underwear, socks, t-shirts, and other active wear).
• Brands (both organically grown and acquired) include: Hanes, Champion, Maidenform, DIM, Playtex, Bali, JMS/Just My Size, Nur Die, L’eggs, Lovable, Wonderbra, Flexees, Lilyette, Gear for Sports and Knights Apparel.
• 80% of total net sales are derived from the U.S. with the remaining being derived from international markets. Being that exposed to a single market may seem like a risk, but approximately 2/3 U.S. GDP is derived from consumer spending.
• Hanes, by far, is the largest and most recognized brands of HBI. Hanes has successfully positioned itself as a leader in garments and is highly recognized for its comfort, style and value…so much so that 80% of American households have a Hanes product in their home.
• HBI’s largest customers are Walmart, Target and Kohl’s, in that order. Clearly these are the leaders in retail industry and having distribution channels through these retailers provides HBI great exposure to a significant number of customers.
• Finished goods are manufactured primarily by HBI themselves (about 65% of COGS) with some reliance on third-parties. This allows them to leverage their lower production cost manufacturing.
• Implementation of HBI’s “Innovate-to-elevate” strategy (which began in 2013) to provide higher-valued products with lower production costs by integrating brand superiority, innovation and leveraging their lower cost-of-production manufacturing has led to higher ROE and return on invested capital (“ROIC”). They’ve spent nearly $177 million on R&D to improve products. R&D is key to any business these days, especially to remain competitive and valuable in customers’ eyes. The fact they’ve included an R&D spending into their budget is encouraging as it displays willingness to experiment and try new things.
• EPS growth over the past 10 years has averaged 31% and 22% over the past five years. ROIC has been trending upwards the past many years and now in the double digits ~ 12%.
• Expansion of operating margins to 12%. An increase in 3% over three years.
• Positive customer sentiment (as measured by TD Ameritrade) towards the brand is 91% compared to its peers who are in the mid-80s. This is a highly qualitative metric used by TD Ameritrade, but I like it because it provides real-time evidence of consumer’s attitude towards a brand.
• Lastly, how can you NOT like Michael Jordan as the face of their brand – only one of the most accomplished basketball players of all time.

Having listed many of the things going in favor of HBI, the Perceptive Investor is never blind to the risks entailed with purchasing a company. Below is a list of key items we should be cautious of:

• HBI’s distribution channel is limited to a few primary partners with the top 10 partners making up 56% of net sales. If one or more of these customers goes out of business or cancels their contracts, HBI may have to spend significant time and money to find new channels.
• Recent acquisitions (and increase in debt to fuel these acquisitions) come with integration risk, meaning the more companies HBI buys, the more challenges they face in successfully integrating company culture, retaining talent and extracting positive synergies.
• HBI only recently (in 2013) started issuing dividend payments to shareholders. Lack of sufficient history of consistent dividend payments, particularly during tough economic times makes it difficult to gauge management’s ability to manage its business and finances under duress.
• HBI manufactures and manages storage for a significant amount of product. Any inability to properly forecast customer demand may result in mis-management of inventory resulting in overhang or shortfall. This can be dangerous during acquisition of other companies as well, as HBI needs to learn to manage and integrate someone else’s inventory and systems.

Consistency vs. Mr. Market

Sometimes Mr. Market disconnects with the underlying fundamentals of a company and therefore prices it below its intrinsic value. It is times like these when the Perceptive Investor should be patient, conduct his due diligence and act accordingly on these opportunities when they arise. Regardless of what the daily price quote is saying, HBI executive management has demonstrated a strong record of both consistent and incremental earnings growth, ROE and ROIC. As mentioned earlier, earnings has grown significantly averaging 22% over the past 5 years with ROE and ROIC also seeing incremental gains (see table below).

Price Outlook (Intrinsic Value Estimate)

Our internal model points to 37% upside in the current price to a price per share  of $30. However, one should not go and blindly purchase. I recommend building in a margin of safety in every stock purchase. A risk averse approach I like to take is to apply a 75% discount to intrinsic value to identify my target purchase price – in this case, $22.66 /share or lower. Buying at a significant discount to intrinsic value allows the investor a safe buffer in case macroeconomic conditions or any other negative events turn the price against us.

Hedging Against Uncertainties and Risks

Regardless of one’s own analysis, an astute investor should remain humble and allow margin for error. If you (as an ordinary non-institutional investor) are planning to purchase HBI to add to your portfolio, here are a few rules I suggest prior to pulling the trigger:

• Never risk money you can’t afford to lose
• Never allocate  more than 20% of your portfolio to a single company
• Always have at least four companies in your portfolio (and extra cash on hand to make strategic purchases)
• Buy as if you plan to hold forever (think 10 years plus)

Conclusions

The undergarment business is undoubtedly a bit boring, but that can be all right as good things can come from boring investments – an opinion shared by one of the greatest, whose portfolio consists of  similarly “boring” companies such as: Duracell, Heinz, See’s Candy and Fruit of the Loom just to name a few. Any guesses as to who that investor could be!?

In the end, I believe there is tremendous value to be had from one of the world’s most widely-recognized garment brands and current prices are providing a unique oppurtunity to enter into a very profitable long-term investment at a bargain price.

When it comes to investing, just as in anything else such as basketball, remember:

“The minute you get away from the fundamentals…the bottom can fall out of your game, your schoolwork, you job, whatever you’re doing.”

– Michael Jordan

A wise man he is indeed.

Now for the last bit of business – in case you were like me and worshiped the guy and tried to imitate his moves as a kid, you’ll appreciate this video:

Michael Jordan’s 10 Greatest Plays 

Disclosure: I did recently buy shares of HBI at ~ $22/$23 per share and plan to continue to purchase additional shares at current prices.