“Kill your darlings, kill your darlings, even when it breaks your egocentric little scribbler’s heart, kill your darlings.” —Stephen King
“In writing, you must kill your darlings.” —William Faulkner
Kill Your Darlings: In Investing as Well as in Writing
In chapter 20 of the Intelligent Investor Benjamin Graham distills the secret of sound investment into three words; Margin of Safety (MOS). Graham writes adds that “All experienced investors recognize that the margin of safety concept is essential to the choice of sound bonds and preferred stocks.” If the margin of safety is such a critical principle and concept at the time you consider buying into a business, let us state another three words, of equal importance in your ongoing investment process; Kill Your Darlings (KYD). You probably already know where this is heading, right?
Substitute the word writing with investing in the above quote from William Faulkner, and you’ll get one of the most important things when it comes to investing. To continuously challenge your own assumptions and the quality of them, and always do your utmost to try to replace your current ideas with new ones.
If you fail and the business you own fail, you lose money. Conversely, if you succeed and the business fails, you saved a few pennies, pennies that could be invested elsewhere. I’m not saying that it’s easy. I would obey to the words of Charlie Munger; “It’s not supposed to be easy. Anyone who finds it easy it stupid.” Speaking for me myself, I often feel that investment is just too hard. But hey, maybe that makes me “not stupid,” for what it’s worth.
H&M: A Shining Star, But For How Long
One of the stocks I own right now and have had in my stock portfolio since the beginning of 2008 is H & M Hennes & Mauritz AB (H&M). I first bought the stock when it was trading at a market price of SEK 168 (split-adjusted), just to watch it go all down to SEK 126 per share on November 14, 2008. Since then it has appreciated in value and is currently trading around SEK 266 per share, down from about SEK 300 at the beginning of 2016, a change of approximately -12 %.
I have been thinking, as I often do, about the inherent quality of H&M’s business. Retailing is a tough place to be, and even though it is very easy to look back at the fantastic run that H&M has had over the decades (and might keep up even going forward), H&M has seen declining gross and operating margins over the last few years. Some of this due to the ongoing investment program that hopefully will bear fruit in the coming years and decades if it all turn out as, at least H&M itself, expects.
H&M opened its first store in Västerås, Sweden in 1947. At that time under the name Hennes, selling women’s clothing. Today the H&M Group offers fashion for everyone under the brands of H&M, COS, Monki, Weekday, Cheap Monday and & Other Stories, as well as fashion for the home at H&M Home. It is engaged in the design, manufacture and marketing of clothing items and related accessories. The Company’s product range comprises clothing, including underwear and sportswear, for men, women, children and teenagers, as well as cosmetic products, accessories, footwear and home textiles. The Company offers its products in a number of branded stores spread across over 40 markets. Additionally, the Company offers online and catalogue sales in Sweden, Norway, Denmark, Finland, the Netherlands, Germany, Austria and the United Kingdom. In August 2013, it launched an online store in the United States. In April 2014, H & M Hennes & Mauritz AB opened its first store in Australia. (Source: H&M; Reuters)
Bear, Bull… or Just Business As Usual?
No one knows what the future has to offer, we only know what has been. This is especially pertinent in the area of investing. With all the noise out there, it could be hard to just sit on the ass and not run away and buy or sell stocks just because you’ve hear someone say something about any of the businesses you might own for the moment.
Below, a five year summary of H&M financials taken from the most recent full-year report for the year ending on November 30, 2015. As you can see from it top-line growth in revenues has been pretty good. The roll-out of new stores is moving on as it has done for a long time by now. The main question is just for how long H&M is going to be able to grow at such rates. H&M still has its own guidance regarding growth intact (even though it has been some discussions about changing it), and the expect to grow stores with 10-15 % per annum.
Looking further down the income statement, it is obvious that operating profit has lagged revenue growth. Some of it due to the impact of the ongoing investment program that H&M has disclosed—about SEK 600 million in 2016 (the same as in 2015). Also, the ongoing investments in IT infrastructure can be seen in the balance sheet as capitalized intangibles assets (will be depreciated over 10 years according to management). Even though a big part of the decline in operating earnings could be explained by the decline in gross profit, it will be interesting to follow how this plays out in the coming year. What could one expect the long-term normalized gross profit and operating margins to be?
The question of profitability is a highly relevant one. What is a reasonable long-term normalized return on invested capital that could be expected to come from this massive roll-out of stores? Return on invested capital (both including and excluding lease obligations) has been falling in the last couple of years. Will this decline level of in the coming years, or not? Is it reasonable to expect any increase in operating margins, that would favorably impact returns on invested capital?
The roll-out story, so far, has clearly moved on at quite a high speed. The question is for how long it will continue, and also what levels of profitability and returns that will be generated.
Click here for a H&M company fact sheet from Morningstar.
Where Are We Going?
Depending on who you ask about the intrinsic value of any business, you will most likely get a whole set of different answers. Nothing wrong with that, since this is perfectly normal when when talking about the subject of valuing a business.
Last week Morgan Stanley released their updated analysis of H & M. To say the least, they don’t have any high hopes for H & M currently, and they cut the value per share to SEK 160 from SEK 240.
Morgan Stanley’s new price target is by far the lowest among the analysts who follow H&M. From the SME Direkt latest compilation from 11 March, the minimum target price of SEK 235. The highest was SEK 380, with an average of SEK 292. (Source: VA)
According to Morgan Stanley, operating profit per square meter has fallen by half since 2007, when it stood at 10,900 crowns compared to their estimate of nearly 5,200 per square meter last year. “During this period, H & M’s profit continued to increase thanks to the new stores the company opened, but the momentum is not sustainable,” according to Morgan Stanley’s analyst report. Further Morgan Stanley states that H&M is approaching the “mathematical breakpoint”. The decline each year since 2007 is on average 720 per square meter, and if that trend, parallel to the trend of how much new retail space supplied annually, stands up, profits will start to decline this year and have fallen by 40 percent in 2020. (Source: VA)
The H&M saga continues. The question is, at what speed, margins and profitability?
“The investor’s chief problem – and even his worst enemy – is likely to be himself.” —Benjamin Graham
- Chapter 20: “Margin of Safety” as the Central Concept of Investment by Benjamin Graham
- It’s Not Easy, Oaktree Memo from Howard Marks
- H&M: Our History
- H&M: Annual Reports
Disclosure: I have a position in HM-B stock mentioned. I am not receiving compensation for it. I have no business relationship with the company. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.