Value Line: JB Hi-Fi

PORTFOLIO POINT: Consistently strong profits, strong return on equity and room for market expansion all ensure JB Hi-Fi a place in the Value Line portfolio.

Chalk up a win for Blind Freddy. Indiscriminate buying is currently beating Warren Buffett. While some might say that has been the case for the past few years, the reality is that irrationality cannot sustain the share price outperformance of debt-laden, low-return businesses.

As you can see from this week’s table, the invested portion of the Value Line portfolio is strongly outperforming a Buffett-style portfolio, which having commenced on July 1, would currently have all cash and a handful of shares in JB Hi-Fi.

JB Hi-Fi, you will recall, was the only high-quality entrant that was trading substantially below its intrinsic value at the time we set up the portfolio. And while the shares have risen 10.4% in less than a month, averaging out the returns from an all-cash plus JB Hi-Fi portfolio delivers underperformance.

The Blind Freddy portfolio – where money was fully invested on July 1 into the selection of stocks in the portfolio – is outperforming.

In the short term, of course, the focus on high-quality businesses may appear too narrow and may result in the Value Line portfolio underperforming a strongly recovering market, particularly if those conditions reward more cyclical companies.

But a value investor should not intend to chase short-term returns, buying inferior businesses. That temptation is given in to by gamblers like racetrack devotees who believe their win is due to brilliance rather than a rising tide. As we noted in our first column, “Valuations are based on the economic performance of the business but share prices are determined by the rising and falling tides of sentiment.” Unlike some of my peers, I lay no claim to an ability to predict the swings and roundabouts of sentiment.

Superior businesses, the best ones to own, are those that can employ large amounts of incremental capital at very high rates of return. Conversely, the worst businesses to own are those that do the opposite, employing increasing amounts of capital at very low rates of return. In future articles, I will explain precisely how a low-return company loses your money. It will explain why Wesfarmers dropped from $40 to $17, and why it was inevitable that Foster’s, PaperlinX and many others would join the write-down club.

Every company in the Value Line portfolio produces superior returns on capital. Over long periods of time, provided we buy when prices are lower than valuations, owning a portfolio of businesses displaying superior economics should also display superior returns. More importantly, such a portfolio should also reduce the risk of permanent capital loss.

nValue Line portfolio, as at July 28, 2009
Company	ASX	July 1 price	Price today	Est. value	Margin of safety*	Shares bought	Invested capital ($)	Capital value ($)	Divs rec	Total return	Total return
JB Hi Fi	JBH	14.8	16.34	17.68	8.2%	845	$12,500	$13,801	0	$1,301	10.41%
Westpac Banking Corp	WBC	19.68	20.22	18.13	–10.3%	295	$5,811	$5,970	0	$159	2.74%
The Reject Shop	TRS	11.62	13.1	11.45	–12.6%	513	$5,959	$6,717	0	$759	12.74%
Woolworths	WOW	26.16	26.2	22.86	–12.7%	206	$5,377	$5,386	0	$8	0.15%
CSL	CSL	31.81	29.31	25.18	–14.1%	163	$5,197	$4,789	0	–$408	–7.86%
Cochlear	COH	56.36	56.79	48.7	–14.2%	102	$5,744	$5,788	0	$44	0.76%
Reece	REH	17.8	21	12.81	–39.0%	236	$4,209	$4,966	0	$757	17.98%
Platinum Asset Mgt	PTM	4.06	4.42	2.18	–50.7%	854	$3,467	$3,774	0	$307	8.87%
Security Value											$51,191
Cash Value											$51,736
Total Value											$102,927
nSince July 1
Total Return ($)											$2,926.78
Return Invested (%)											6.06%
Total Return (%)											2.93%
XAO Change											5.07%
Outperformance (I) – Outperformance of invested portion											0.99%
Outperformance (T) – Outperformance of total portfolio											–2.14%
nUnder observation
ISOFT	ISF	0.635	0.755	0.038	–95.0%						–18.90%
Amcor	AMC	4.79	5	2.66	–46.8%						–4.38%

JB Hi-Fi is one company that currently displays such economics. It’s a company whose shares I have owned personally and corporately. But perhaps surprisingly, I only bought them in November last year around $8.50. Until that time, they remained stubbornly above their intrinsic value.

Today JB Hi-Fi displays all of the hallmarks the Value Line portfolio seeks, including bright prospects, and its recent performance has defied the talk of economic slowdown. Indeed the company’s recent upgrade suggests $500 million of Kevin Rudd’s $12.7 billion household stimulus went directly to JBH.

Same-store sales growth has grown by more than 10% (in contrast to, say, David Jones, which has declined by a similar amount) and profit at $92 million is estimated by the company to be an astounding 41% higher than last year. There are other contrasts to David Jones: Return on equity is significantly higher. While JB Hi-Fi has grown profits by a compounded 46% pa since 2004 and David Jones by an also-impressive 19%, JB Hi-Fi will produce its $92 million profit for 2009 on equity of just $163 million; David Jones’s $150 million profit is on $620 million of equity.

JB Hi-Fi generates a return on the money entrusted to it by the owners that is more than twice David Jones still-impressive 24%. And while David Jones might have fully penetrated its market, JB Hi-Fi can grow its 125 stores by another 70%, helped along partly by the likes of Westfield, which knows the store brings foot traffic irrespective of location.

Closer analysis reveals that JB Hi-Fi produces lower gross margins than many of its competitors but higher earnings before interest and tax (EBIT) margins. This reflects low prices and tighter cost controls respectively. This virtuous “profit loop” has been a long-term recipe for success for the likes of Wal-Mart in the US and Woolworths locally and there is no reason to believe it will cease delivering for JB Hi-Fi anytime soon.

Many analysts and conventional wisdom suggests that JB Hi-Fi is expensive, based on a price/earnings multiple of nearly 20 times, 2009 profits and amid expectations of a slump in retail sales as unemployment rises and the stimulus from government handouts recedes. Based on conventional wisdom, I agree, but based on the ability of the company to continue generating relatively extraordinary rates of return on incremental equity, the shares are trading around what they are worth

JB Hi-Fi is perhaps no longer a bargain but nor is it expensive. Keep one eye glued to the level of borrowings but otherwise JB Hi-Fi retains a firm place in the Value Line portfolio.

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