In the ongoing struggle between growth and value investors, today's private-equity purchase of pet retailer Petco (NASDAQ:PETC) illustrates a dream scenario for the value crowd.
I'll let fellow Fool Nate Parmelee walk you through the details of today's transaction, but basically, if you were holding shares of Petco last Friday, you are now more than 40% wealthier on your holding. Holders of archrival PetSmart (NASDAQ:PETM) are also up, but only to the tune of about 4%. For Fools following the industry, Petco had been considered the value company, while PetSmart was the growth rocket.
One of my favorite explanations of the primary difference between the two investment philosophies is that value investors are interested in finding an opportunity that undervalues the past, while growth investors are looking for an investment that undervalues the future. I came across the phrase while reading an article from SmartMoney's James B. Stewart, and it perhaps explains the investment thesis of Texas Pacific Group and Leonard Green & Partners for buying Petco: They believe the market has undervalued Petco's business and are placing their money where their mouths are.
On the growth side, PetSmart has a strong track record of opening new stores and expanding through same-store sales growth over the past five years. Because of this consistency, its shares have performed well over this time frame and its valuation has stayed rather lofty. But with such a valuation, one has to be pretty certain that growth will continue before investing in the name. In other words, as long as PetSmart continues to grow sales and earnings in the double-digit range, shareholders should also be rewarded. They'll have to be more patient, since there is less potential for margin expansion, but all Fools are well aware of the wonders of compounding growth.
The appeal of a value stock is that there is multiple expansion potential. in addition to the opportunity for a business to turn itself around. I think Friday's run in Petco is a case in point -- shareholders saw an instant expansion in the sales, earnings, and cash flow multiples, as Texas Pacific and Leonard Green expressed their confidence that Petco's business model had improved and has even sunnier days ahead.
In practice, it's best to combine both approaches and look for a company that appears cheap but also has robust growth prospects going forward. Since the pet product industry is in a secular upswing -- as consumers increasingly pamper and spend on their pets as they would for a child or family member (indeed, pets are the children in certain households) -- both Petco and PetSmart should be able to benefit. Clearly, the private-equity guys think so, or else they wouldn't have plunked down $1.8 billion of their own capital.
Today's events also illuminate one of the challenges of investing: finding a company that can balance compelling operating fundamentals with an attractive valuation at the time of purchase. On the flip side, one can also discover a struggling company with the potential for huge gains -- provided the firm can stay alive and thrive again.
In an appealing industry with duopolistic characteristics, it may be best to hedge your bets by placing some chips on both leaders. The examples are abundant, be it Coke (NYSE:KO) versus Pepsi (NYSE:PEP), Walgreen (NYSE:WAG) versus CVS (NYSE:CVS), or Betamax vs. VHS. Just kidding on the last one. Sometimes, there is a clear winner (DVD, in this case). Did I mention that investing can be a conundrum?
PetSmart is a Motley Fool Stock Advisor recommendation. Coke is a Motley Fool Inside Value selection.Growth vs.value? What type of investor are you? Talk stocks with other investors and our analysts when you give ournewslettersa try.
Fool contributor Ryan Fuhrmann is long shares of PetSmart and Walgreen but has no financial interest in any company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.
