Stock Bought: ROST

Today I bought shares of Ross Stores (ROST), an off-price apparel and home fashion chain in the United States. The company operates Ross Dress for Less (1,091 locations in 33 states) and dd's DISCOUNTS (115 locations in 8 states), offering brand name and designer apparel at substantial discounts to department and specialty store prices.

I think Ross is well-positioned in the current economic environment because its targeted customers are lower- and middle-income individuals, many of whom are still feeling the effects of the recession. The fact that Ross did not see any declines in revenue or earnings during the recession -- in stark contrast with most other companies -- suggests that people will buy clothes at Ross even when money is tight. In addition, Ross still has plenty of opportunities for geographic expansion, and it was not until late 2011 that it made its initial entry into the Midwest region by opening several stores in the Chicago area. New states for expansion this year include Kansas, Kentucky, and Indiana, all of which have favorable demographics for the discount retail business. I read that the company thinks there is long-term potential for 2,500 locations in the U.S., more than double the current number. Thus, I am optimistic about the company's future growth prospects.

The company's recent growth has been good, with 5-year growth rates of 9.1% for revenue and 27.5% for earnings. Improving margins (operating margin has increased from 7.0% to 12.8% over the past 5 years), good free cash flow, and consistently high returns on equity (currently 47%) suggest good management. Ross has a strong financial position, with debt/capitalization of 9%, debt/equity of 9%, 155x interest coverage, and a current ratio of 1.5. Value Line gives it a safety rating of 2 and a financial strength rating of A. S&P gives it quality and credit ratings of A+ and BBB+, respectively.

The company is a Dividend Contender, having increased its dividend for 19 consecutive years. Its 10-year dividend growth rate is 27.8% and the most recent increase was 21.4%, announced in February. The EPS payout ratio is 21% and the FCF payout ratio is 20%. The company also does substantial share repurchases, reducing its share count by 30% over the past 10 years.

I consider ROST to be fairly valued at the current price. It has a P/E of 17.0, P/S of 1.3, and PEG of 1.3. Its P/E seems quite reasonable given the strong earnings growth. To quote Warren Buffett: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." In a recent article, Chuck Carnevale presented data showing that it has been "historically sound to invest in Ross Stores at a P/E of 17." Morningstar gives a fair value of $64.00 and a 3-star rating, whereas S&P gives a fair value of $62.30 and a 3-star rating. The average of those two estimates is a fair value of $63.15, which implies an 11% margin of safety at my purchase price. The stock price declined over 7% today after the company reported a February same-store sales decline of 1% versus an expected gain of 1%, although overall sales were up 3%. I decided to take advantage of the dip to start a position.

I bought 25 shares of ROST at the price of $56.15 per share, giving me a 1.21% yield on cost. (If I had waited until the end of the trading day I could have got a better price, but if I were any good at intraday timing then I would be a day trader.) At the current dividend rate, I can expect to receive quarterly dividends of $4.25, which will add a total of $17.00 to my annual dividend income. This purchase was made in my Roth IRA, so dividends and capital gains will not be taxed. My forward 12-month dividend total increases to $2,299.

I mentioned previously that I require a minimum yield of 3% for stocks in my Roth IRA. I will amend that statement to say that I prefer a minimum yield of 3%, but I am willing to make exceptions. In the case of ROST, the low yield is the only negative aspect of the stock and it is outweighed by many positive aspects. Even though the stock will not contribute much to my dividend income, I expect it to be a strong total return investment. Two other stocks in my portfolio are good examples of the total return category. I started a position in Hormel Foods (HRL) in April 2012 when the stock traded at fair value with a 2.1% yield. In less than a year I have a 38% total return. I started a position in Canadian National Railway (CNI) in January 2012 when the stock traded at fair value with a 2.0% yield. In a little over a year I have a 35% total return. I do not know what my return from ROST will be in a year's time, but I am optimistic that the stock will be a satisfactory long-term investment.

ROST is the 28th stock in my portfolio (and the 2nd stock in my Roth IRA), giving me more diversification in the consumer discretionary sector. I have enough cash on hand to make one more purchase in my Roth IRA. If ROST continues to decline, then I would consider increasing my position unless there is an alternative opportunity that seems more attractive to me.