Home Depot

There are a lot of very smart people that believe in the theory of efficient markets. Basically, the idea that at any give time a stock price fully reflects all public information, and that no investor has an edge in picking stocks. And risk adjusted performance that exceed market indexes is all luck (basically, I’m wasting my time writing this blog). But, then when you see a stock like Home Depot, you realize the efficient market theory is completely flawed.

By my aforementioned statements, you should realize that I think Home Depot is considerably undervalued. Now, I’m not going to go through a discounted cash flow analysis to prove my point (On this blog, I will never do that). Because most of the time, I feel this type of analysis is useless. You can make your stock go up or down by +-25% depending on what growth rate you chose, what risk free interest rate you choose, etc… Most of the time, you don’t need this nerdy, mathematical analysis to figure out whether something is cheap or not. And also, it’s pretty boring.

Home Depot is undervalued for one reason. If Home Depot kept its earnings steady (~$3.00/share) for eternity, and paid out all it’s earning in dividends, I would still buy the stock today. Because at $37, I would be roughly getting a dividend of 8%. The best I can do is a 6% 16-month cd at Digital Credit Union. This is probably the worst case scenario.

The reality of the situation is that it doesn’t pay an 8% dividend. It is much better. Home Depot is a cash flow machine with a great business. They pay nearly a 2% dividend and buy back almost 4% of their shares and still manage to grow their earnings by over 15% the last couple of years. Pretty incredible.

However, even when I spit out these numbers, there are a lot of skeptics. The biggest complaint that people have is that housing is crashing. Yes, it’s true that housing is cyclical and might crash (home building stocks have certainly crashed). But I don’t think that’s really going to affect Home Depot all that much. If people need to fix something in their house, they will have to go to Home Depot. Sales will be down from people refinancing their house and doing some fancy project like remodeling the kitchen. But overall, it should not affect sales dramatically. Also, this is cyclical and not a long term issue (value investing). The housing crash might have more of an affect on Home Depot Supply, which caters to professional customers (contractors, businesses). However, this again is a short term issue and Home Depot supply is a much smaller contributor to revenue than the do it yourself retail outlets.

The second complaint I get is that, Home Depot will not grow that much since they are everywhere in the US. But based on past numbers (15%), they seem to be growing nicely. I agree that growth will be slow in the do-it-yourself outlets without strong same store sales. However, they are expanding in the professional customers market with Home Depot supply. This is where the real growth will come in the upcoming years. But even if I’m wrong and there is no growth, Home Depot still beats my 6% cd.

My next blog will feature how you can use options to magnify your returns with Home Depot… as much as a 200% return if we are right… I own 500 shares of Home Depot at an average price around $35 and I also have options (next blog)...