It is conventional wisdom in the financial services industry that clients should harvest their tax losses each year by selling their positions that are underwater. While this is generally a prudent strategy, there are a few legitimate reasons why this may not always work out in an investor’s long-term favor. Keep in mind that in order to avoid a ‘wash-sale,’ (which would nullify your ability to claim the loss on your tax return) you cannot have bought the security (or a “substantially idential” one) at least thirty days before the sale, and you cannot buy it back until at least thirty days after the sale. Given this limitation, the possibility exists that during the exclusion period, the security that was sold could appreciate substantially, thus leaving the investor with perhaps an expensive opportunity cost.
The way that most investors typically approach this dilemma is to use the proceeds of the sale to buy shares of a security that, while not “substantially identical,” may not be perceived to be all that different from what was sold. The classic example that I have used with my clients is a transaction involving shares of AT&T (T), and Verizon (VZ). Both companies are in the telecommunications industry, and both are products of the breakup of the Bell system in the early 1980s. Judging by 3-year trailing returns, neither company has really traded too far beyond the relative performance of its peer:
Given these results, it could be said while AT&T or Verizon did outperform one another for periods of time, a seller of one who subsequently bought the other probably would not have regretted the transaction all that much. After all, going back to November of 1983, both have delivered similar results: 11.48% average annual returns for AT&T, and 10.86% average annual returns for Verizon.
However, it would be a mistake to think that similar results would occur in other industries that, quite honestly, aren’t as oligopolistic as telecommunications. To demonstrate this, I looked at results for three pairs of companies in the same industry that on the surface may seem very similar: CVS and Walgreens (retail pharmacy); Home Depot and Lowe’s (retail hardware / home improvement); and Target and Wal-Mart (general retail / grocery).
In the table below, I have listed various valuation and performance metrics for each of companies studied, and I’ve color-coded the pairs by industry for ease of comparison:
What stands out to me is that with the exception of Home Depot – Lowe’s, the valuation metrics for each company are not too different from its industry peer. Given the similarity in valuations, a value investor might be tempted to select the company that is currently discounted versus its peer. While buying less ‘expensive’ stocks is generally a winning strategy, it likely would not have been in these cases: going back to 1982, the company with the higher average annual return traded at a premium valuation (using trailing twelve month price-to-earnings) to its peer the majority of the time: 67% for Home Depot; 73% for Walgreens; and 74% for Wal-Mart (going back to 1982).
This got me to thinking why should two seemingly similar companies yield such vastly different results? While I can’t offer any definitive answers, I think a case-by-case analysis might give some clues.
Here below is a chart of three-year rolling returns of Wal-Mart’s excess performance versus Target:
One can see that Wal-Mart dominated the late 1970s, while Target was the superior investment in the 1980s and early 1990s. However, Wal-Mart has had the better of Target for much of the last two decades. One possible explanation may be that Wal-Mart adapted better to an increasingly globalized economy during the last twenty years. While Target has locations only in the United States and India (it recently shut down its Canadian operations), this map of Wal-Mart’s global presence shows just how dramatically Wal-Mart has thus far won the global war (from Wal-Mart corporate):
Furthermore, it would appear that Wal-Mart has been out-executing Target from an operations standpoint. Writing for Investopedia.com, analyst Elvin Mirzayev, CFA, observed last year that while Target is slightly more profitable than Wal-Mart, Wal-Mart requires 25% less time to turn its inventory, and it leverages its assets more successfully, generating “$.14 per dollar of asset from operations versus Target which generates $.11 per dollar of asset.” So, while the two companies are similar on the face of it, Wal-Mart operates more efficiently, and it seems to be winning globally.
In the retail pharmacy space, Walgreens has more or less dominated CVS since the data set began in 1972:
It is not uncommon anymore to see both a CVS and a Walgreens in close proximity to each other; per Google, CVS operates 9,600 stores, while Walgreens operates around 8,200. Given that only in the last couples years has either company ventured out into the global economy, it is somewhat surprising that Walgreens would so vastly outperform CVS over a period spanning decades.
Part of the explanation is almost certainly explained by a difference in business model. Walgreens started off as a dedicated pharmacy retailer, but in order to expand its appeal to consumers, it expanded its offerings, and gradually added other items such as food and golf balls, CVS (once known as Melville Corporation), on the other hand, was for much of its history a general retailer, adding pharmacy operations to its stores only in the late 1960s. CVS likely suffered operationally from trying to be everything to everyone, adding companies such as Kay-Bee Toys and Linens ‘n Things to its portfolio in the early 1980s. In the early 1990s, after disappointing results, a turnaround was designed, and non-core assets were sold off while under-performing stores were closed. The slimmed down, pharmacy-focused company has outperformed Walgreens for a good portion of this century, but its advantage of late has disappeared. The future performance of these two companies will be interesting to watch as both have recently jumped headlong into the global economy by acquiring operations overseas.
Finally, let’s examine the performance of Lowe’s and Home Depot. I will admit this data set may be slightly unfair to Lowe’s as it preexisted Home Depot for many years, and my data go back only to Home Depot’s IPO in late 1981. That being said, here are relative three-year trailing returns of Home Depot and Lowe’s:
Clearly, from its IPO through the early 1990s, Home Depot dominated Lowe’s, its closest competitor. Part of the explanation is that Home Depot revolutionized the hardware / home improvement business. With their desire to provide not just merchandise but also expertise at their stores Home Depot grew rapidly. That is in stark contrast to Lowe’s, that was for most of its history a traditional hardware store in local communities. However, threatened by Home Depot’s success, Lowe’s switched to a similar store layout and business model in 1989, and the results showed during the rest of the 1990s as it handsomely outperformed Home Depot. It’s been a back-and-forth since then, but Home Depot has had the advantage for most of the period. Interestingly, both Lowe’s and Home Depot have similar global profiles, with both operating in Canada and Mexico, in addition to their US operations (Home Depot recently shut down its small China operations).
Perhaps the simplest explanation for Home Depot’s superior performance is that it truly disrupted the existing home improvement industry, and as it expanded rapidly, it built a loyal base of customers (both do-it-yourselfers and contractors) along the way. Lowe’s has narrowed the gap substantially, but Home Depot’s much wider margins suggest it operates more efficiently, and it has already generated almost twice as much sales via e-commerce than Lowe’s. So far, the market has rewarded Home Depot with a considerable premium to Lowe’s in terms of valuation multiples, but it will be interesting to see if that will persist.
I suppose the takeaways for this exercise may be that despite appearances, companies are not always as similar as they might appear. Oftentimes, seemingly little things such as supply-chain management, inventory turnover, and growth at a reasonable pace matter more in the long run than we might think. Investors should favor companies with clear and achievable objectives that don’t don’t fritter away resources on non-core endeavors. Just as with Home Depot in China, investors should cheer when companies do not reinforce failure. Finally, investors should always be on the lookout for new entrants with a different and potentially superior way of doing business. In the long run, these things add up to dramatically different results.
Disclosure: Past performance is no guarantee of future results. Both the author and clients of Fortune Financial hold positions in some of the securities mentioned.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Fortune Financial Advisors, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Fortune Financial Advisors, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.