During the past three weeks in my weekly newsletter EPIC Insights, we have purchased shares in companies that boast an outstanding operating franchise, yet sell at a wide discount to fair value. Our purchases of Allstate (ALL), K-Swiss (KSWS), and Procter & Gamble (PG) have gained an average of 2% while the Dow has fallen 6%. With proof that outstanding companies purchased at cheap levels will lead to positive portfolio performance, we focus on another company which boasts brand recognition and efficient management, yet has lagged its peer group and sells at a discount to fair value-Tiffany (TIF).
TIF epitomizes the boom and subsequent bust that has devastated the economy and the markets. During the great debt binge, many consumers increased their purchases of discretionary products. This led to the infamous aspiration shopper who looked toward the mass-affluent brands which carried cache yet were not out of reach. TIF rode this wave perfectly as its share price rose from the low $20s in 2002 to above $56 in 2007. Then the bottom fell out. TIF's price collapsed as aspiration shoppers disappeared, and the stock now trades at roughly the same level it did in 1999.
As always, I look for this devastation to provide us opportunity. During 2009 and over the past twelve months, TIF has badly trailed both its peer group and the broad market. Therefore, we must assess whether the market has correctly forecast the company's problems. If not, opportunities exist for opportunistic investors.
TIF's financial statements present a mixed message. The balance sheet is sound, liquidity is strong, and operational ratios continue improving. However, as a retailer that focuses on specialty jewelry, the majority of TIF's asset base is composed of inventory. Given the nature of the business and the quality of the product, I am not alarmed by this fact, but we must remain aware. With inventory levels 25% above the prior year and twice what they were in 2004, TIF has reached a critical juncture. Inventory levels must decline or investors should expect future weakness.
Turning to the income statement, we see a much brighter picture. The shares trade for a forward price/earnings (PE) multiple of 15 versus a three-year average of 21. Despite the current state of the economy, the company remains profitable with a well-covered dividend. Therefore, we can expect TIF to weather the current consumer retrenchment and emerge stronger when the recession ends.
Looking at valuation, a variety of methods converge on a fair value estimate of $28. Given last week's sell-off, we can now purchase the shares at a 15% discount to my fair value estimate. Also, with a dividend yield of 2.82%, we will receive income as the economy bottoms and the market recognizes the higher fair value.
TIF offers an opportunity to continue our recent trend of buying strong companies with decent dividend yields at a discount to fair value. Because this approach enables us to create a portfolio that earns income while we amass positions in excellent companies. I recommend a position in TIF as this week's fundamental trade.