Stick a fork in 'em
A turkey's a turkey, no matter how long you hold it. Toys R Us, Penney, Kodak and Northwest aren't coming back.
By Jim Jubak
When I was 13, my parents bought me eight shares of RCA, at the time one of the bluest of all blue chips at $36 a share.
I'd check the stock pages every day, usually to find that the stock hadn't moved much. I actually read the quarterly and annual reports with their big color pictures of RCA's television assembly lines, the NBC studios, Hertz rental car counters (yep, RCA owned Hertz from 1967 to 1985) and the most recent RCA researcher to discover something revolutionary. Every quarter, management promised that this division or that -- usually the TV manufacturing business -- was about to turn around. Never did, though. I sold the stock about 10 years later at roughly the price my parents paid for it.
"Could have been a lot worse," you might say. "He broke even." I used to think about my first venture into capitalism that way, too, but it's dead wrong. I now figure that this buy-and-hold strategy cost me about $166 over those 10 years. If I'd sold RCA after the first year I owned it, even at a 25% loss, and then reinvested that money in just an average stock (historically that meant an 8.6% annual return for the next 10 years) I would have had $454 instead of $288 -- a difference of 58%.
This is the nasty, dark side of a buy-and-hold strategy. Buy and hold works because a long holding period turns even gentle annual appreciation into a sizable gain. But if you've hitched your portfolio to a stock that consistently trails the market, time now works against you. Holding a stock that goes nowhere for a long time generates the kind of very large opportunity cost that I suffered with RCA.
Knowing when to give up
I don't blame buy and hold as a strategy. The fault, I think, lies with the buy-and-hold investor who decides to hold everything -- even stocks that are clear turkeys. In my last column, "Three dogs with bark," I wrote about not giving up on a good stock that's suffering through a temporary downturn. Now it's time to look at the other side of this coin: knowing when to give up on a stock that you bought for the long haul.
Let me give you four rules that form a kind of checklist that I use and four stocks -- Toys R Us (TOY), Eastman Kodak (EK), J.C.Penney (JCP) and Northwest Airlines (NWAC) -- that I think fail the test for a buy-and-hold portfolio.
A stock that triggers any of these red flags deserves a good, hard look, because it stands a good chance of generating a big opportunity loss. You may decide to stay the course because you believe that a turnaround is near, but you should at least ask, before you decide to keep the shares, whether the return you expect from this stock justifies investing so much time on it. In my RCA example, even assuming an initial 25% loss from selling at the worst possible moment, I would have done better by switching to an average-performing stock by somewhere in year five.
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Is a new class of competitor vastly more efficient? (Toys R Us) RCA had a big problem during the time I owned the stock: Japanese TV manufacturers were eating the company for lunch. In retrospect, it's pretty clear that the best management in the world -- and RCA didn't have that -- couldn't have fixed this problem. Thanks to a protected home market, ridiculously cheap capital and efficient manufacturing, Japanese companies could make and sell sets for less. RCA's attempts to close the gap by cutting jobs here and there or moving factories offshore weren't enough.
I think Toys R Us is now in about the same position with retailers such as Wal-Mart (WMT). That company has created such an efficient, low-cost distribution system and gained such clout with manufacturers thanks to its scale that it can sell virtually any toy for less than Toys R Us and still make more money. Just look at the difference between the return on capital generated by the two companies over the last five years. (Return on capital measures how much, expressed as a percentage, the company earns before interest, taxes and dividends on the total capital invested in the company -- common and preferred stock equity plus long-term debt.) Toys R Us has averaged 9.2% return on capital in that period vs. Wal-Mart's 11.8%. In the last year, the gap has widened -- 15.1% for Wal-Mart and a negative 1.5% for Toys R Us. (Click Investment Returns to the left to see these figures.) I don't think fixing up Toys R Us stores is going to fix this problem.
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Has the technology changed? (Eastman Kodak) Sometimes a new technology simply negates all the market leadership that a company has built up over decades. In the short term, I think Kodak's stock could rise as price pressure in the film market eases. The company is going through another restructuring that should cut $470 million in expenses in 1999 after $720 million in savings in 1998. But the fact remains that the company's core film and film-processing market is mature. Companywide sales fell by 8% in 1998 from 1997.
The future, Kodak knows, is in digital imaging. Here the company has announced new products such as a 1998 deal with America Online (AOL) to deliver digitized photos online or the Picture CD, developed with Intel (INTC), that is now in market testing.
Unfortunately for Kodak, competitors already have staked out important pieces of the high ground in digital imaging. The Picture CD, for example, will enable consumers to order a CD at the same time as they get their film developed. Pop that CD into a PC and a consumer can edit prints, enlarge favorites and print out extra copies. Kodak will make extra revenue on the CD, of course, but the rest of the revenue stream from this product goes outside the company. The software for manipulating the images belongs to Adobe Systems (ADBE). The printer for making copies is likely to carry the logo of Hewlett-Packard (HWP), Epson or Canon (CANNY). And some of the images coming out of that printer once would have gone to a photo lab to be printed on Kodak paper. I think Kodak has to move into the digital age or die, but the transition won't be easy on profits or the stock price over the next 10 years.
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Is an entire market segment getting squeezed? (J.C. Penney) Sometimes the stock market sends a pretty clear message. The Gap (GPS) trades at a price-to-earnings ratio of 47. Wal-Mart trades at a P/E ratio of 55. And J.C. Penney trades at a multiple of just 16.5, about half that awarded to the average stock in the Standard & Poor's 500. I think the market is saying that J.C. Penney is going to lose the battle for the bread-and-butter middle-income shopper to companies with stronger brands (The Gap's Old Navy, Gap and Banana Republic chains) or lower prices (Wal-Mart and Dayton Hudson's (DH) Target chain).
If only Penney was struggling, I'd say that new management or better marketing could turn this situation around. But it's not just Penney. Sears, Roebuck (S), Dillard's (DDS) and The Limited (LTD), to name just a few, all are having trouble getting customers into their stores. Leslie Wexner, CEO of The Limited, has even talked about closing all of the stores in the company's flagship chain because a turnaround would cost too much and the results are too uncertain. I think Penney's management acted on its own version of this conclusion when it bought the 2,800-store Eckerd drug chain in 1997. There's value in Eckerd and Penney's big catalog operation, but the brick-and-mortar stores that anchor big malls seem to be an asset with diminishing value over time.
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Is the company a weak sister in a consolidating market? (Northwest Airlines) Autos, airlines, retailing, oil -- you name it. A wave of mergers is turning big global companies into bigger global companies. Not everyone is going to get invited to this dance, however. In autos, it's clear why Ford Motor (F) would want to buy Volvo (VOLVY). In oil, it's clear why Exxon (XON) would want to buy Mobil. In airlines, it's clear why United's parent company UAL Corp. (UAL) would bid for America West Holdings (AWA). Each combination gives the acquirer new products to sell (Volvo), marketing efficiencies (Mobil) or market share (America West). But in a consolidating industry, some companies don't bring much too the table, and these weak players are likely to become even weaker as stronger competitors make deals.
Northwest has one of the oldest fleets in the air, so no one would buy the airline for its planes, even in the midst of an industrywide equipment shortage. Northwest controls hubs in Detroit, Memphis, Minneapolis-St. Paul, Osaka and Tokyo. The Japanese routes might be attractive to an airline looking to challenge United over the Pacific, but buying the routes is more attractive than buying the entire company.
None of this would be quite so important if Northwest was making money right now and carried less debt. Thanks to long-term problems and a bitter 15-day strike, however, the company lost $400 million in the last two quarters of 1998. That compares to more than $600 million in profits at American Airlines' parent AMR Corp. (AMR) in the same period. These are flush times for most of the airline industry. Total long-term debt at Northwest came to about $6 billion in the quarter before the strike. Makes me wonder what will happen when the inevitable down cycle hits.
None of these stocks is attractive to me as a long-term investment. Each, I think, has too many negative trends to swim against. But that doesn't mean that short-term investors can't make money on these stocks. Even stocks that are in long-term, downward trends will show life from time to time. In the period that I owned RCA, it traded as high as $40 and as low as $29. You could have made a decent profit by trading during those swings -- as long as you remembered that you didn't want to hold this stock for the long term.
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Don't kill the cockroach strategy
I had been worried that Citrix Systems (CTXS) was getting too expensive, but the company and the Securities and Exchange Commission have fixed that. Following recent SEC guidelines that have cracked down on how big a write-off an acquiring company can take all at once after buying a smaller firm, Citrix restated all of its 1998 financials. (As far as I know, Citrix did this in response to new rules from the SEC and without targeted prompting.) That resulted in adding $24.8 million in revenue to annual results for the year -- enough to drive earnings per share to $1.34 from 79 cents. Citrix's 12-month trailing price-to-earnings ratio drops to 59.5 from 97.6. Going forward, of course, Citrix now faces some hits to earnings as the company writes off its acquisitions over a longer period. According to the company, this will amount to $15.1 million in 1999, $14.7 million in 2000 and $13 million in 2001, or 35 cents, 34 cents and 30 cents a share per year respectively. Wall Street analysts now are projecting that Citrix will grow earnings per share by about 40% in 1999.
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