Portfolio manager Bryan Hinmon discusses Under Armour, HDFC Bank, and more in this month's reader Q&A.
Each month we answer questions from our audience of readers and shareholders. We enjoy doing it, and would love to answer any questions you might have. Please write to [email protected] and let us know what's on your mind! Here are our reader questions for November:
What do you think about Under Armour's prospects going forward? Do you think they will capitalize on their increased spending? Is the valuation attractive now?
This has been a hot topic in our team investment meetings. To set the stage for our readers, Under Armour generated $4.7 billion in sales over the past year by selling mostly athletic apparel and shoes. The company has grown its sales by well over 20% per year, on average, over the past decade. This sort of growth, coupled with a familiar brand and charismatic CEO, has made Under Armour an investment darling – shares are up over 400% in the past decade. But they’ve fallen 25% so far this year. As our astute questioner points out, one of the reasons for this recent poor stock performance is that Under Armour is spending quite a bit to drive its sales growth.
I read your first two questions as business questions, and your third question as a stock question.
First, the business. We believe Under Armour’s brand is more popular than ever. This is a challenging thing to assess. Interbrand – which focuses on sales – does not rank Under Armour among the top 100 brands. However, Interbrand calls out the common hallmarks of the best global brands as having a clear strategy for growth, blurring traditional sectors, aligning with the best partners, and possessing customer-centricity. Without going into too much detail, Under Armour scores very well using this framework: expanding categories and geographies, wholesale/retail + athletic/lifestyle + apparel/technology, alignment with an increasingly relevant group of professional global athletes, and a mission that centers on its customers: “To make all athletes better through passion, design, and the relentless pursuit of innovation.”
The company is spending out the wazoo to carry out its brand building and support growth. For that spending to pay off, it needs to result in both (1) the ability to charge premium prices and (2) mind share that causes purchasers to make Under Armour a default purchase option and thus drives volume. Our belief is that these investments will pay off but we won’t fully see the fruit for years to come. We expect the upcoming generation of athletes to drive the purchase decisions that show the strength of Under Armour’s brand. Demographic trends, the movement toward broad adoption of health and fitness, and the company’s business performance to date give us this confidence.
The stock valuation is tricky, but it’s something we think about. Let’s walk through an extremely simplified, back-of-the- envelope valuation check. It’s an easy thesis to say that Under Armour will follow the path Nike blazed, but because it’s so much smaller, it can grow much faster. Over the past 12 months, Under Armor had $4.7 billion in sales to Nike’s $33.0 billion. Let’s make the bold assumption that Under Armor continues its growth at 20% per year for the next 10 years. Let’s assume Nike, because of its much larger base, can grow at 5%. Ten years from now, Under Armour would have $29.0 billion in sales and Nike would have $53.8 billion. In this scenario, Under Armour’s sales have grown from 14% of Nike’s to 54%.
Today, the market is paying $2.62 for each $1 of Nike’s sales, as Nike trades for a price-to-sales multiple of 2.62. If that multiple stays the same, Nike would have a market value of $141 billion based on those sales 10 years from now. (Its current market value is $86 billion.) Investors would generate a 5% annual return from holding the stock. But what might the market pay for Under Armour’s $29.0 billion worth of sales in 10 years? If it pays the same price-to-sales as Nike, Under Armour’s market value would grow to $76 billion and give investors a 20% compound annual return. We don’t think that is a safe assumption, because the primary diver of the price-to-sales multiple is net profit margin. (Remember that spending on expenses?) Under Armour spends more than Nike does to generate each $1 of sales, so we believe it shouldn’t be valued as richly. If we instead guess that the market might pay 1.52 times sales, the average multiple on Nike since 1990, Under Armour’s market value grows to $44 billion and provides investors with a 13% compound annual return.
Let’s be honest: 20% annual growth for a decade is a big assumption – but is it entirely unreasonable? We don’t think so. Besides, in the simple analysis we’ve run, we counter that big assumption with a conservative assumption about profit margins – we don’t assume Under Armour becomes nearly as profitable as Nike because it will cost so much to achieve that growth. This outlook is implied in the lower price-to-sales multiple. Our financial modelling is much more detailed and focuses on cash flow, but this exercise gets you closer to how we think about the stock’s current valuation. The bottom line is that the future is uncertain, but we think Under Armour may have the right strategy, tailwinds, and management to deliver 13% to 20% annual returns based on its current strategy.
At what point or valuation would you consider adding to a position like HDFC Bank?
A good question with a nuanced answer.
As HDFC is currently a top-five holding in both the Independence Fund and Epic Voyage, and around 4% of each portfolio, we’re a little constrained by our concentration limits (that is, we can’t invest more than 5% of the portfolio in any single company without creating the need for other filings and disclaimers), so we’d need to see a material decline in the shares before we considered adding to our holdings.
However, in a (metaphorical) vacuum, I’d say the shares are roughly fairly valued – on the Indian stock exchange. (Remember that qualification.) The bank is currently trading at 4.3 times book value, which sounds ridiculous until you consider that it generates returns on equity around 20% and is – in our humble opinion – one of the best run banks in the world, let alone India. Given the apparent competence of HDFC’s competition, we think the growth opportunities for the bank are enormous as India – a country of more than 1 billion people, most of whom are underbanked – gradually climbs the wealth ladder.
Here’s why I told you to remember the “Indian stock exchange” qualification. India has strict limitations on foreign ownership of domestic companies. This rule creates scarcity when it comes to the shares of HDFC that investors outside India can own. And this scarcity means the American depositary receipts (ADRs are proxies for the domestic shares, which are traded on American stock exchanges) currently trade at a significant premium to the domestic shares.
Let’s say HDFC trades for 1,250 rupees per share (which is roughly what they’re trading for as I write). With a foreign exchange rate of roughly 67 rupees per dollar and the fact that each ADR represents three shares of HDFC, the ADRs should trade for about $56. As of this writing, the shares are trading for almost $71. That’s a 27% premium.
Of course, that premium probably won’t ever disappear completely until India changes its foreign ownership rules, but it does fluctuate, so that’s one more thing to consider when looking to buy shares of HDFC – at least for non-Indian investors.
So to answer the question (finally!), I’d be looking for some margin of safety from the current Indian-listed price – Warren Buffett likes 20%, but you’ve got to determine your own comfort level – and a material closing of the ADR premium, ideally of around 10% or less, but that might be fanciful.
Where can one find a current list of holdings in FOOLX?
We publish full holdings for each of our mutual funds every month on our website, www.foolfunds.com. (You can find FOOLX here.) Many mutual funds publish their holdings only quarterly, but we have nothing to hide and value transparency, so we update our site monthly.
What's the best manner to find the best high-growth stock for a portfolio?
Fun question, and thank you for asking. First, I’d refer you back to the question above about Under Armour. You can get a solid understanding of our criteria there. That said, there is a big caveat, so keep reading: A high-growth stock should be early in its life cycle, have a large addressable market, have products or services that customers increasingly value, have multiple avenues to success, and have the financing and leadership to carry out the plan. If I had to pick one metric to screen for, it would be accelerating sales growth.
And now for the caveat I promised you. Those things don’t mean squat unless (1) you’re great at market timing or (2) the business is fundamentally good. If you’re good at market timing, you can find a growth stock riding the hype cycle, buy it to ride the wave of popularity, and sell out before the tide turns. I’ve never met anyone who can do this reliably. Investing this way involves making lots of decisions and increases the chances you mess up. If the business is fundamentally good and it’s a growth stock, you may be able to buy and hold your way to fantastic returns – making fewer decisions and compounding capital in a tax-efficient way. So what makes a business fundamentally a good one? Well, we think it should capture a healthy part of the value it creates for customers, and it should be enduring. Our favorite metric for measuring these factors is an increasing return on invested capital – the ratio of how much the company makes to how much it invests.
We assess “goodness” by analyzing four dimensions: management, culture, and incentives; economics of the business; competitive advantage; and the sustainability and trajectory of those first three dimensions. This framework dives deeper into the how and why of whether a business will be able to capture a healthy part of the value it creates for customers and whether those circumstances will persist. Ultimately, we only care about growth if it’s attached to quality and is available at a reasonable price.