Weekend Watcher: Knowing When a Sector Is Rotted Through

 | Jul 21, 2012 | 2:30 PM EDT
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You know, I haven't eaten a syrup-filled fruit-salad cup since elementary school. It's weird how things deemed good for you to eat in the 1980s -- or whenever -- are now considered borderline poison, or so says WebMD. But there I was, at home, reflecting on those simple fruit-cup-eating years in between researching fruit-and-veggie companies for Monday morning's edition of "TheStreet Hits the Street." Then it dawned on me: Dole (DOLE), Fresh Del Monte (FDP) and Chiquita (CQB) are pretty rotten, stinky investments, and have been for quite a while. The reason is the sector in which they operate.

Sector analysis is overlooked by the average investor, in my experience, as folks have been trained like robots to read financial filings and then look at this "multiple" stuff. Moreover, when analysts discuss the key factors of the sector in which their stock picks reside, this kind of study is unlikely to be in the commentary ingested by book-talkers. This is a major problem. It leads you, the potentially unknowing investor, to try and differentiate sector winners that could be dogs with fleas, given a sector whose dynamics are atrocious.

No, I am not suggesting you board a plane to Africa to walk around and take notes on Dole's fruit-picking efficiency and then extrapolate those findings to Fresh Del Monte and Chiquita. First, you may not come back in one piece. Second, it's an unrealistic exercise. What you should be doing, before you read any 10-K SEC filing or proxy statement, is to sit back and visualize the positives and negatives on the sector. Oh, and don't be a naughty student and try to one-up the teacher (me) by consuming the boilerplate nonsense in the risk-factor section of the 10-K. Most of that information is outdated jargon cut and pasted from the prior year's filing, and often irrelevant to the present.

Here is some simple guidance, based on my segment preparation:

Commoditized Business

No company will come out and say it's selling items with no potential for pricing power. But, hey, you shop the fresh food aisles in the supermarket -- and hopefully avoided disastrous earnings warnings à la Supervalu (SVU) -- and notice a few things:

  1. Lack of innovation (bagged lettuce is not innovation)
  2. Tons of competition
  3. Deals on products into which fresh-fruit-and-veggie companies have pumped a ton of marketing (which sets the stage for return on investment disappointment)

A commoditized sector comprises a minefield of companies that could blow up in your face if you don't obsessively research them on a daily basis.

Persistent Inefficiencies

All of the fresh-fruit-and-veggie companies are attempting either to sell noncore assets or to restructure operations. For example, Dole is actively marketing property in Hawaii. The fact is that, through the years, businesses build up inefficiencies in process and capacity -- and you have to determine whether that's a broader sector attribute. In this particular space, eating habits have evolved and changes to climate have caused food companies to seek new sources of supply. In a commoditized business that is persistently trying to restructure and shed assets, be mindful that earnings are forever at risk of letting down the Street. This could come from bad pricing and excess capacity, which together add unnecessary costs and expenses.

Bow to the Master

Suppliers to large retailers such as Wal-Mart (WMT), Target (TGT) and Kroger (KR) lack full control over their businesses. If Wal-Mart's stingy buying team can't score a deal on soup from Campbell (CPB), it will go elsewhere. So I pose this question: Do you know the major customer of the company you own and that company's strategies? For example, owning Toro (TTC) makes it necessary to know Home Depot's (HD) inventory-planning strategy.

As for which stock I picked from the fruit-and-veggie sector, you will have to tune in Monday morning on TheStreet. (Clue: I taped this segment on Thursday morning, and the stock skyrocketed that evening in response to earnings -- darn timing.)

Term of the Week: "Margin Protection"

No, this is not a product sold in the aisles of CVS (CVS). It is classic finance jargon, usually hurled by CEOs at investors already trying to ingest too much information. When a CEO states the company has opted to "protect its margins" during periods of weak demand, it could be a good sign that products haven't been given away to drive sales. That, in turn, keeps the product valuable in the eyes of the consumer and benefits the company when stronger demand returns.

On the flip side, when demand for a product is strong and a company is telling you it "protected margins," it may have decided to lower prices in order to compete with rivals doing the same. That would be a signal to you, the investor, that the company may be selling a commodity product that won't help facilitate robust future earnings growth.

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