Trade of the Day: Costco (COST)

The last time we recommended Costco (COST) was just after its last special dividend paid in late 2012. The stock had formed an ascending triangle and we recommended buying the breakout at $105 per share. The stock has moved higher an additional 50% since that time and a similar setup has appeared again. Considering the fact that he fundamentals have also improved, we are renewing our recommendation for new entries on COST.

Costco’s management/board announced a special cash dividend of $5 per share on Jan. 30. The stock has rallied on the news and broke out of an ascending triangle at $145 per share. The cash-rich company is in a situation where returning additional value to shareholders makes sense but why not just buy back shares like everyone else seems to be doing?

There are pros and cons to a share-buyback. On the plus side, a share-buyback helps protect an investor from the tax consequences of a dividend. We think this is a weak argument because tax benefits are not uniformly available all shareholders who may own the stock as an institution or individually in a tax-sheltered account. We prefer dividends over share-buybacks for two reasons.

1. Managers tend to be overly optimistic about the future for growth. Surprisingly, studies have shown that management is worse at predicting their future stock price and growth than investment professionals – which isn’t saying much. As a result, buybacks tend to take place at share-price highs, when the stock is overvalued. While we don’t think this is the case with Costco right now, buy backs tend to be long term programs that keep buying as the stock price rises.

2. Buy backs create a conflict of interest between management, who is largely compensated through shares, and long-term investors. Management has an incentive to buy back their own shares and drive the price higher in the short-term. However, in the long-run, reinvesting that capital or returning it directly to shareholders has been shown to provide better returns on average.

Costco has engaged in buy backs over the last several years, but not to the same extent as many other similar firms, which we think is the right way to provide flexibility to their shareholders. Interest rates are extremely low, which has refocused investors on the benefits of dividend income. We believe that investors will ‘overvalue’ the potential for regular dividend increases and special dividend-events from COST in the future, which should be good for new buyers who step in before earnings are released next month.

Fundamentally, Costco is a very interesting firm. It is a “warehouse club” that charges membership fees to individuals and businesses to access their stores. They offer a limited number of SKUs from high to low-end brands, but have similar pricing power with their suppliers to companies like Wal-Mart (WMT) who carry a much larger spectrum of products. The company is laser-focused on efficiency and customer support, which has allowed them to build a significant economic moat.

Between Costco’s growth in its private label brand (Kirkland) and its ability derive 75%+ of its net profits from membership fees, we think COST is in an incredibly secure market position. A stronger dollar has also helped to shore up their margins on new products that are turned over at an industry leading rate. Its little wonder that the company has been able to grow top line revenue and bottom line profits for the last five years.

From a technical perspective, Costco looks compelling. As you can see in the next chart, the stock broke out of an ascending triangle this week following the special dividend announcement. The one disadvantage is that the stock broke out so quickly that the initial price-objective has already been reached. While we still recommend the stock for new entries, it could pause in the short term and retrace in February if general market conditions worsen. That actually could be a good thing for investors looking for a more conservative entry.

Quick upside breakouts like this are often retraced back to the breakout point that then acts as support. This is exactly what happened with the big breakout last September (highlighted in the chart), and following the last special dividend in early 2013. As an alternative to an immediate entry, we would suggest opening a position if the stock returns to support at $145 and bounces again. Obviously, this increases the risk of an opportunity loss, but it may be a higher-probability entry for more conservative investors.

Click to Enlarge

Costco (COST): Chart courtesy of eSignal


As market volatility rises, it is looking more and more like a ‘stock pickers’ market where strong fundamental performance and dividend-income is the priority. We like Costco because it is taking advantage of its strong cash-flow to return value to shareholders in a low interest rate environment. We think this gives the stock a short-term edge to the upside.

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