Popular themes are, typically, well known to the market. The popular stocks in those popular themes are priced to perfection leaving just the discount rates for the investors. There might be other stocks which are not yet identified with the theme but might be hiding divisions which gain from it. This is the direction to look for mispriced opportunities.
“Vikram, I think it is impossible!” I exclaimed. It was another morning at the Vikramaditya residence in Mumbai and it was time for breakfast like every day. Last night, I had been reading articles from various prominent advisors in the US. Practically all of them had emphatically made the case that all the information about stocks available to all investors was already priced in. They had cited Nobel-prize winners and their research to prove their cases. Before going off to sleep I had decided to confront Vikram with this in the morning.
“You mean finding mispriced stocks and generating excess returns over the benchmark?” Vikram asked with a slight twist to his right lip—a characteristic Vikram smirk when he felt superior, which was most of the time.
“Yes, I mean…” I was stunned. I had not said anything about stocks. “How the hell did you know I was talking about mispriced stocks?”
“Whittle, you don’t want me to carry out the frivolous, show-off techniques of both Dupin and his copycat Sherlock on how to read the mind now, do you?” said Vikram.
“Honestly, it is all very well in fiction. But I don’t understand how one does it in real life.”, I said, unable to stop myself.
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“Alright, Whittle. Last night when we left after our late-night discussion we ended with a discussion about Berkshire, Buffett, Bogle and Benchmarks. In the morning you came to the breakfast table as usual with you tablet. You turned your head towards the bookshelf on my left. You scanned the books, resting a little in sequence on the following titles “The Intelligent Investor” by Benjamin Graham, “Common stocks and Uncommon Profits” by Phil Fisher, “The Aggressive Conservative Investor” by Martin Whitman. Then you shook your head, looked at your tablet then back to the bookshelf, then a brief smile popped on your lips, again a slight nod of the head as you compared the number of books available on your tablet v/s the amount of shelf space physical books take. You punched something which I couldn’t see, but from the results I could see that you were a bit taken aback. I knew that the SP 500 had jumped quite a bit unexpectedly yesterday and this would be natural for you to check first thing in the morning, and it wouldn’t surprise me to see you surprised with the quantum of the gain given that last night SP 500 was struggling a few percentage points below its previous close. Finally, your eyes again scanned over the earlier mentioned titles but your pupils dilated when they came across “Irrational Exuberance” by Robert Shiller. Then you looked down to your right and furrowed your brow showing that you were trying to think hard about a situation, which in this context was, effectively, ‘It was all fine 100-50-30 years back for Graham, Fisher and Whitman, but in today’s bubble market which can go up so much in half-a-day on someone’s tweet, it is impossible to find a mispriced stock!”
I was tongue-tied listening to this real-life demonstration of Dupin and Holmes’s art of mind reading. I had never expected to see it live. I was completely spooked. Anyway, “Th-That’s a-amazing, V-Vikram!”, was all I could manage.
“Whittle, to address your doubts on finding mispriced stocks, let me share an example with you which is from one of the most well-known, popular trends in consumer fashion in the US, athleisure. Athleisure is currently more than $350 billion and expected to grow to more than $0.5 trillion over next 5 years.”
“Now before I start talking about specific names, I would like to caution that any names I discuss do not mean that they are on my buy, sell or hold list. I, or my clients, might be holding them, or planning to buy them or might be selling them or we might have nothing to do with them. I am just trying to illustrate a point to address your original question. Now that my compliance avataar has had its say, we can move further in the discussion.”
“Some of the most popular stocks in the athleisure category are Lululemon, Nike, Adidas, Puma, Under Armour etc. From the high PE ratios 40 to 100+ it can be inferred that Mr. Market loves them. If I stop here, I would have proven your point.”
“Exactly, Vikram. With these kind of valuation ratios, it is unlikely that anyone can generate any excess returns from these stocks. One would be happy to get the discount rate, meaning the minimum equity risk premium above risk-free. Probably 7% or so at this stage.”
“What if I told you that there is an athleisure firm hidden in plain sight—the purloined stock? Of course, the stock is not purloined, as in stolen, but rather, it is a steal. I refer to the purloined stock as an allusion to Auguste Dupin’s “hidden in plain sight” principle.”
“This firm is part of a company which has 4 Billion-Dollar brands. All put together the company does normal sales in a non-covid year at around $16 billion. It has two brands which are quite popular with boomers and Gen X but are now losing appeal. It has one brand, targeted towards the millennials, which is likely to cross $10 billion soon, growing at high single digits. However, the hidden athleisure firm I am interested in is the brand which is directly competing with Lululemon. The consumers know it and many easily substitute it or even prefer it. It is growing at mid-teens growth rates and has already crossed a billion dollar in sales. However, investors somehow don’t see it that way, probably because it is the smallest revenue contributor in the company and is getting overshadowed by all the others.”
“If you applied valuation metrics of Lululemon to it, it would be valued at the market capitalization (around $13-14 billion) (or the enterprise value, since the long-term operating leases on both asset and liabilities side can be excluded) of the whole firm. Of course, this is an aggressive valuation metric. But if that were applied to it, the other three multi-billion-dollar brands would be absolutely free! Talk about Mr. Market’s myopia!”
“You can slice different ways, you could value the older brands and take them out of the picture as a spin-off or sell-off to some private equity firm, and you would be left with two amazing, fast-growing firms which are targeted to millennials and riding on this high-growth, athleisure theme and are available at a large discount to their intrinsic values and much larger discounts to what Mr. Market would value them each on a standalone basis. Hiding in plain sight.”
“Where I can learn more about this, Vikram?”
“Vikram, now I see how even large-caps in one of the most scrutinized markets like US can be hiding in plain sight. Interesting—the purloined stock indeed!”
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[This is an authored article by Dr. Vikas V Gupta, CEO & Chief Investment Strategist at OmniScience Capital. All views, opinions and expressions are personal and limited to the author.]