Michael Santoli

Home Depot: Is It the World’s Most Important Stock?

Michael Santoli

Is Home Depot Inc. (HD) currently the most important stock in the world?

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Reuters

Its shares have blasted higher by 120% over the past two years, making it by far the best-performing member of the Dow Jones Industrial Average, which itself is up 25% over that span.

The Atlanta-based home-improvement chain embodies every theme that is now animating the current run by major U.S. stock indexes to fresh all-time highs.

First, Home Depot is a huge beneficiary of America’s housing rebound – which is viewed worldwide as the key source of economic growth over the next couple of years. The S&P Case-Shiller home-price index covering 20 big cities rose more than 10% in the past year, and the number of existing homes sold has climbed for 22 straight months.

A crucial investable growth theme

With growth in erstwhile boom countries China and Brazil far weaker and Europe stuck in a grinding recession, the U.S. housing-led recovery is considered the crucial investable growth theme on the planet. Two investment strategists at New York firms last week reported independently that, in visits to clients in Hong Kong and Indonesia, investor questions centered on the turnover of houses in Phoenix and Miami.

The latest Bank of American Merrill Lynch survey of global fund managers found the highest percentage betting heavily on U.S. real estate-related stocks since 2007. Given Home Depot’s hefty $117 billion market value – dwarfing that of all American homebuilding and lumber stocks combined – it is among the few bellwethers large and well-known enough for foreign investors to own as a housing play.

Home Depot also illustrates another dominant theme of this market cycle: It has managed to convert slow consumer-spending trends and middling revenue gains into hefty profit growth, by controlling costs tightly and employing some popular financial engineering among big companies today.

Last year the number of transactions with Home Depot shoppers was only 4.5% above 2010 levels. Net sales grew 3.5% in 2011 and 6.2% in 2012, lifting total net profits 5.5% and 6.1%, respectively. Yet through the magic of stock buybacks, the modest profit progress translated into per-share earnings gains above 20% in each of the past two years.

A vast number of big companies are using plentiful cash on hand and the cheap debt produced by rock-bottom interest rates to buy piles of their own shares, in order to goose per-share reported profits and give remaining shareholders a bigger proportional slice of the company.

A major driver

This sort of financial engineering has been a major driver of the market’s climb in recent years, making profits look better despite slow overall growth, and cashing out shareholders who can then recycle the money in other stocks.

Home Depot has been among the most aggressive, repurchasing a total of $10 billion worth of stock in the past three years, reducing its outstanding share count by some 10% in the process. This kind of balance-sheet management makes good sense when a company’s stock is undervalued and other high-return projects are unavailable.

Yet Home Depot is an expensive stock by most any measure, at 20-times the average of the next two years’ forecast per-share earnings, versus less than 15-times for the broad Standard & Poor’s 500 index. Home Depot’s stock-price-to-sales ratio, a common gauge used for retailers, is over 1.5, among the highest in an industry where the likes of Costco Wholesale Corp. (COST), Target Corp. (TGT) and Home Depot rival Lowe's Cos. (LOW) have ratios below 1.

[See related: Retail Reports: The 3 Things to Watch for in Costco’s Earnings]

One reason Home Depot is pricey, of course, is that its management has done an excellent job of improving store-level performance and taking market share from the likes of Lowe's, which is struggling – all while maintaining strict financial discipline. When stocks become as popular as Home Depot has, it is never entirely accidental or undeserved.

Home Depot has also, to a lesser degree, sent cash back to investors through dividend payments, which rose by 11% last year over 2010 levels. As with the market in general, for most of the rally a central argument for owning stocks has been their dividend yields, which have broadly been those of Treasury bonds. Yet this case is now weaker, with the rally compressing the dividend yield and the bond-market selloff lifting Treasury rates.

This week the S&P 500 yield, near 2%, fell below the 2.15% yield on the 10-year Treasury for the first time in quite a while. Home Depot’s yield is right in line with the index at 2%.

This doesn’t automatically thwart the upward trend in the market, or in Home Depot. But it removes one important verse of the bulls’ favorite song.

Combined with valuations that are no longer cheap, with much credit for a multi-year housing recovery already priced into stocks, both Home Depot and the market as a whole have less margin for error should any cracks appear in the economic picture.

Perhaps this is why Home Depot is listed by Goldman Sachs (GS) market analysts as among the top 10 “very important short positions for hedge funds,” which have placed relatively heavy bets against the stock – likely because of its stretched valuation, or as a hedge against the multitude of other current investments that hinge on the pace of the housing boom, cheap credit and consumer stamina.

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