The Worst Companies Can Make You Money

 | Jul 28, 2014 | 3:11 PM EDT
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You want to go negative. You want to get conservative, and then the market keeps finding new ways to make you money, and you just pretty much have to let things ride.

Over the weekend, the air was thick with geopolitical risk and a sense of global mayhem. The backdrop is just ugly, and it seems to get uglier by the day.

But it just can't seem to translate into stock market selling, because so many companies are trying to create value, and that valuation creation isn't taking a break just because the Israeli army is fighting in Gaza, the Russians are shelling Ukraine and Libyan embassies are being evacuated.

In the old days I would say, "What does all of that have to do with the price-to-earnings ratio of Bristol-Myers Squibb (BMY)?" And that's still operative. In fact, I liked the Bristol-Myers quarter.

Now, instead, you have to ask yourself, what does this worldwide strife have to do with the combination of Dollar Tree (DLTR) and Family Dollar (FDO)? Or what does it mean to the new online real estate colossus created when Zillow (Z) buys sworn enemy Trulia (TRLA)? The answer, of course is very little, and these deals define why it's so hard to keep this sucker down.

First, let's drill down on Dollar Tree's purchase of Family Dollar for $8.5 billion, or $74.50 in cash in stock. Right off the top, you have to love a deal that sends both stocks flying. But it should, because there are really only three dollar stores out there, Dollar General, Dollar Tree and Family Dollar, all of which had big expansion plans and want to take share from each other. But when you have only two dollar chains, they can split up the country and no longer need to compete.

Right now, Dollar Tree and Family Dollar are very different animals. Dollar Tree is an extremely well-run, mostly suburban strip-mall operator with a strict $1 price point. Family Dollar, on the other hand, is a variable price player with a lot of merchandise selling for more than a dollar in stores in poorer neighborhoods. In fact, it should be the other way around. Dollar Tree knows all of these markets and can figure out where it needs more of each type and no longer has to bash in the head of the other competitor. It is no wonder that the stock has run.

Plus, everyone knows that Dollar Tree is the better operator, and while current Dollar Tree management has agreed to let current Family Dollar management run the show, I can't believe it would be willing to pay that much for the status quo. The synergies are huge when it comes to suppliers, but the real gains will come when Dollar Tree injects its fast-moving, smart DNA into the dowdy -- some would say hapless -- DNA of the current Family Dollar operations.

On a personal note, stores from both of these operators are near my place down the shore. I have been inside but would never again step foot in the awful Family Dollar store, and I actually never miss going into my Dollar Tree, where the manager knows me and is unfailingly polite, while keeping his store clean as a whistle, something that could never be said about its rival store. If some of Dollar Tree's cleanliness brushes off on Family Dollar, it is a huge win. Family Dollars, even newer Family Dollars, look old, and their dowdy and ugly private-label products make you feel poorer the moment you put them in your cart.

There's something bigger at work here, though, a new theme we have seen developing in the marketplace: We are in the phase where the worst operators may now be making for the best investments. For years, I had thought that the mission of Dollar Tree and fellow rival Dollar General was to wipe out the other member of the trio by swooping in and putting up a rival store to steal Family Dollar's customers.

In the old days, when there was a hobbled competitor like Family Dollar, you got short it and stayed short it, betting that it would just go away.

No more. Now you have to own the worst, betting it gets a bid and recognizing that the darned thing simply isn't going to go as low as you thought. A bad earnings report just makes is even larger takeover bait.

Now how about Zillow buying Trulia? We've liked Zillow forever here and have marveled that so many people trusted in a particular small short-selling consultant who kept telling people that Zillow was, somehow, losing traction or falling apart or about to fall apart because there was so much insider selling.

We liked Zillow because it answered every objection. Shoddy service in New York? It bought the much better Street Easy. Slave to the desktop? It created one of the best mobile apps out there. Opposition from the entrenched real estate industry? It has won over the big firms because of some terrific returns in investment.

But my biggest worry when we sat down with CEO Spencer Rascoff this spring in Seattle, where the company is headquartered, was Zillow's need to ratchet up ad spending because its competitor, Trulia, has committed to spending tens of millions of dollars on ads to take share from Zillow.

After first acknowledging that Trulia's ads were good for the overall online real estate business, Spencer said he was confident that he could spend money to be No. 1 in each market and that the listing dollars would in the end all go to the biggest-circulation player, just like it did in so many two-newspaper towns when advertisers realized they really only needed to advertise with the biggest one. Ultimately that meant the No. 2 wouldn't make it.

If you heard that interview, you wanted to short Trulia nine ways to Sunday, as Rascoff seemed hellbent on destroying its smaller rival.

But like the case with Family Dollar, in the end Rascoff realized that better than beating them was joining them, or, more accurately, buying them. The result? Two companies at war for the same ad dollars are now one company with no more price wars and no more need to spend aggressively to build market share. Zillow has won the war, and that is why its stock can fly here, again, despite the repeated screeds from the short-selling consultant that the edifice is teetering.

Now there are worrisome signs in this market. This morning, Cummins (CMI), the engine company, reported a remarkably good number, but, like many of the industrials these days -- by far the worst-acting group in the marketplace -- it got clobbered.

You never want to see a market that's not satisfied with even the best set of numbers. Second, housing has gone from a tailwind to an out-and-out headwind in this economy, as Armstrong World (AWI), the flooring and ceiling company, reported a very weak number right on the heels of a miserable number from Owens Corning (OC). New and used home prices climbed too far too fast, and credit availability remains too tough to allow this important part of the economy to continue to grow.

Finally, interest rates remain stubbornly low, in part because of those geopolitical tensions, and that keeps the banks from advancing.

Those are not enough, however, to deter buyers from leaving this market. Sure, if the Family Dollar and Trulia buys were isolated needles in a haystack, that would be one thing. Instead, though, these kinds of deals have become almost daily occurrences. If even the worst and weakest of companies in sectors can make you money, why not stay long for the ride? 

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