Stein Mart Gets an X-Minus

In a previous column, I discussed a categorization scheme to help identify different types of companies based on the work of Bennett Stewart in his book The Quest for Value. Although the X, Y, Z scheme is not as well known as Peter Lynch's six company types (fast growers, stalwarts, slow growers, cyclicals, turnarounds, and asset plays), it can play a valuable role in understanding a company's investment story.

This value-investing Fool finds the X, Y, Z concepts helpful in identifying turnaround candidates. In X, Y, Z parlance, this means finding X-minus companies that are trying to upgrade their status to at least an X. This type of company isn't earning its cost of capital on a regular basis but has potential under the right management and reorganization plan.

Stein Mart (Nasdaq: SMRT  ) is a typical X-minus company. The retailer, which dramatically expanded its store base in the 1990s, finds itself now struggling to compete with the likes of Marshall's, TJX's (NYSE: TJX  ) TJ Maxx, Ross Stores (NYSE: ROST  ) , and Federated (NYSE: FD  ) . The result is a paltry 4.5% average return on invested capital (ROIC) over the past five years.

The results would be worse, but in 2002, Stein Mart's management implemented several initiatives that shifted focus from growth to productivity. The store count has been flat since then, and the invested capital has fallen because of the aging of existing operating leases. These recent actions have helped margins rebound so that Stein Mart currently has $614 million in invested capital versus an enterprise value of $616 million. However, unless Stein Mart can increase its ROIC by another 300 basis points, I don't think the retailer can maintain its current valuation levels.

As for valuation levels, using Stein Mart's stock volatility as a backdrop, it is useful to weigh the company's value based on the productivity of its invested capital. When Mr. Market voted Stein Mart's shares to $25 last year, the warning signs of overvaluation should have been there. Conversely, when pessimism was rampant in 2003 and Stein Mart traded at a significant discount to its invested capital, there were signs of a potential bargain.

Still, if Stein Mart can't continue to improve its operating conditions, the turnaround will fail to materialize, and its valuation will fall. Holding X-minus companies such as Stein Mart as a long-term investment, more often than not, will lead to disappointment, since even great turnaround plans can be stymied by the bad economics of the business.

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Fool contributorMatthew Crewswelcomes your feedback -- really! He has no financial position in any of the companies mentioned. The Motley Fool has adisclosure policy.

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Related Tickers

10/26/2016 3:31 PM
SMRT $6.23 Up +0.04 +0.65%
Stein Mart CAPS Rating: ***
TJX $74.23 Up +0.61 +0.83%
The TJX Companies CAPS Rating: ****