The S&P 500 returned 16.4% from January through September 2012. We would normally expect those kinds of gains to happen when the economy was really humming along, but in the November 2012 issue of Investor Advisory Service we marveled at just how disconnected the stock market was from the economy. The domestic economy did seem to be sprouting some “green shoots.” The unemployment rate decreased to 7.8%. Continued low interest rates, combined with falling unemployment, helped the Case-Shiller housing index rally 5.9% through July, although it remained (and remains) far from its 2007-2008 highs.
We would describe those economic numbers as “better, but still not good.” Meanwhile, outside the U.S., the trajectory seemed even more uncertain. China’s reported GDP growth continued to decelerate, from 7.6% in the second quarter to 7.4% in the third. In the Euro zone, the Purchasing Managers Index decreased from an already-contractionary reading of 46.3 to an even more disappointing 45.9.
We advised investors to focus on companies with enough underlying growth to support hard-charging stock prices. Furthermore, we advised readers to make sure their stocks were capable of growing sales, not just earnings. Companies can often grow their earnings without growing sales, especially through cost-cutting or financial engineering. We thought the market was being too indiscriminate, awarding unjustified valuations to companies with little or no “top-line” growth.
Let’s take a look at one of the companies featured in last year’s issue, Fossil, Inc. (Ticker: FOSL), which has grown both sales and earnings robustly since we started following the company in 2008. Fossil is a semi-diversified fashion accessories company that derives about 80% of revenue from the sale of branded watches. Fossil sells its own brand of mid-market watches, and also licenses premium brands, including Burberry, Michael Kors, and Armani. Most of its premium names are actually targeted at the mid-market as well at price points between $250 to $550. About half of sales are to North America, with one-third to Europe and most of the rest to Asia.
Shoppers have recently directed more of their budgets toward accessories at the expense of general apparel. Within accessories, watches have been especially hot. Fossil has benefited to the tune of 15% average sales growth and 20% EPS growth over the last ten years. We modeled 15% EPS growth for the future, expecting sales growth of around 12%. Based on a P/E range of 12 to 21, we modeled the potential high and low prices for the stock as $192 and $55 respectively. Trading at $89.02 at the time of the write-up, our model produced a potential upside/downside ratio of 3.0-to-1. Like most of the stocks we follow, Fossil also boasts exceptional cash flow generation.
This pick didn’t perform very well out of the gate. Q3 2012 sales grew just 6%, which was well below our long-term expectations. GAAP EPS grew 16%, but a lower tax rate was responsible for most of that “growth.” Pre-tax income increased just 1.3%, and swelling inventory made investors nervous that growth may have suddenly hit a wall and caught management unaware. Consumer goods analysts track inventory very closely for any indication that sales are running below projections, which could lead to reduced growth estimates and inventory markdowns. Shares fell 10% the day of the disappointing earnings announcement. The CFO also retired. Fossil named Dennis Secor, previously CFO of Guess?, as his replacement.
The stock soon found its way back into the market’s good graces, climbing steadily in the late months of 2012 and into early 2013. Investors breathed a big sigh of relief when Fiscal Q4 sales increased 14%, with non-GAAP EPS up 21%. Inventory levels also normalized from previously elevated levels. The truth is, growth companies often have to increase their inventories ahead of future increases in customer demand. By March of 2013, FOSL shares had climbed safely above $100, a solid improvement since we showed the stock to investors in our November issue.
Q1 2013 sales continued on the strong momentum from Q4 2012. Sales increased 15%, with EPS up 18%. Sales growth fell off a little in Q2, up 11% year-over-year, but EPS increased 25%. Q2 is seasonally slower, and one interesting bit of trivia about investing in growth companies is that they often see the biggest percentage earnings growth during their seasonally slowest quarters. Shares jumped 15% on the quarter’s release, which even we thought was a little excessive. At a recent price of $116.24, Fossil has gained 30% since the time of selection, outperforming the S&P 500’s 19.4% during the same period. We’ve been quite pleased with how these shares have performed over the past year, although they are now modestly above our buy price of $108.