Two Similar Companies; Two Very Different Results by Lawrence Hamtil, Fortune Financial

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:

AT&T & Verizon

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:

AT&T & Verizon

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:

AT&T & Verizon

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):

AT&T & Verizon

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:

AT&T & Verizon

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:

AT&T & Verizon

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

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