Brandeis Capital Newsletter (Market Recap and Research on Costco)

Stock Market Summary

As the 3^rd quarter comes to a close, it is a good time to look at the bigger picture, especially considering the lack of significant news last week. Year to date, the S&P is up about 5%, the Dow 8%, and the NASDAQ is essentially flat. All the indices have recovered since the May correction and have performed extremely well in what is typically the weakest period of the year. This year’s 3^rd quarter was the strongest for the markets in 9 years. Most important, and lost in all the Dow noise, was that the S&P made a higher yearly high, and the Wilshire 5000 total return index has reached all time highs.

The key question at this juncture is whether there is still buying power left to start a new leg up on the proverbial wall of worry. There is reason to believe there may be, as the AAII (a sentiment indicator) % bearish is still at above average levels of 32.9% and the 10 moving average of % bearish is still a very high 39.1% (at the last market bottom in 2002 it was 43%). Short interest is also at all time highs, though this may be more indicative of absolute return strategies. Therefore, should the bullish outcome continue to unfold, a longer rally is possible.

The Transportation sector remains an interesting battleground for the bullish and bearish cases. After a summer technical breakdown, the DJ transportation average has been recovering. It remains unclear whether the recovery is a trend reversal and a signal the economy remains strong, or if it is simply benefiting from perceptions of much lower oil prices.

While BCM continues to feel cash is king because of issues such as a private equity bubble (to be discussed in future newsletters), housing and inflation, it is important to be cognizant of things that could prove this thesis wrong. If 3Q earnings live up to expectations and housing declines moderate, it may be time to reconsider our intermediate time frame outlook in November after midterm elections.

Stock Pitch of the Week- Costco Wholesale Corporation (COST) - Charts (long term, comparison)

Costco is a membership wholesale retailer that operates about 500 warehouses mostly in North America. They sell everything from staples such as groceries, apparel, alcohol, prescription drugs and automotive supplies to luxury goods such as jewelry and electronics. Their average markup is 15%. While, costs are kept down through a simplistic store layout, Costco pays workers better than competitors, so as to minimize turnover and shirking. They offer free samples to give customers a more premium experience. Customers buy membership cards, ranging from $50 for individuals and $100 for businesses as well as an “executive” version that offers 2% cash back to drive turnover.

Costco uses its market power to push accounts payable for up to 30 days from the sale of goods, while receiving cash for the goods on the spot. This generates a float, and with their $3.30 billion in cash ($4.77/share) they generate roughly $140 million in interest income, which has helped to finance consistent growth. Costco also carries very little long term debt.

We believe these factors will help insulate the impact of a recession on Costco’s profitability relative to other retailers. Membership revenue is likely to remain constant in a downturn as people are unlikely to not renew memberships even if they shop less. It also makes earnings less volatile. Costco’s bottom line shouldn’t be affected exponentially like other wholesalers and retailers who finance the goods upfront and don’t receive cash until the customer or credit card company pays them. Furthermore, while the lack of debt may lower maximized value in good years, Costco’s impeccable balance sheet would give them added flexibility in a recession.

A negative we see impacting Costco is that the street is already giving them a premium multiple of 22 versus competitors at 19. This premium is deserved because of the company’s future prospects, excellent management, and the additional advantages outlined above. However, since Costco has some of the lowest margins in the industry and is a company that competes on cost, it has added risk of margin erosion. Costco pays its employees a 42% premium over its closest competitors and pays 92% its employee healthcare costs versus about 75% at other retailers. The concern is that as competitors like Wal-Mart bridge the quality gap Costco enjoys, Costco will be competing solely on price with a higher cost base. There is also concern over whether growth is slowing at Costco, particularly whether membership of 47 million households is near saturation.

The club’s conclusion was that while we like Costco’s long-term prospects, we have concerns that growth may be slowing. However, Costco does retain the ability to maximize shareholder value in the future through increased debt and cutting labor costs. We are concerned about the US economy, and thus the retail sector. However, we feel Costco is well insulated from an economic downturn because of its focus on selling staples to middle and upper class consumers. We feel Costco should outperform the retail industry, particularly in an economic slowdown or recession. Thus, we will look to build a position in the next few weeks.

Stories/Links

Dow 1000 or 100,000? Ok, ok, how about Dow 36,000?

It is important to keep a few things in mind about the Dow. First, the breadth of the performance since the last high is very poor, with the median Dow stock down 39%. This doesn’t get into the point that adjusted for inflation, the Dow is still well off its highs. Most importantly, as this Graham and Dodd investor points out, the Dow is by nature a selected index, so it is more representative of crowd psychology, than the overall economy.

The Tickersense sentiment indicator from Birinyi Associates hit an all-time bearish high. It’s unclear if this should be seen as a contrary indicator, as the indicator is relatively new.

Quantitative Theory + Psychology= A Master Trader

An expert technician sees potential trouble in the madcaps that could have more broad market implications.

Bill Cara suggests that Oct 17-18 could be a bull bear market inflection point, with so many data points coming out.

If its midnight and you’re still at work, bring in the bullpen.

Meetings

We are going try a new meeting time this week, because feedback reflects that by night time no one wants to hike back to Sachar. We likely are just going to have an official meeting Thursday afternoon. This should work well because there is often a speaker in the late afternoon on Thursdays, so people interested could go to that afterward. There are also no econ or finance classes then, so professors can drop by. When we decide on a room and time, we will send out an announcement.