In an economist’s ideal world, beating the market should be impossible. In their eyes, new information is immediately reflected in stock prices, making deals virtually impossible to find.
But then there are companies like HanesBrands (NYSE:HBI), a volatile and mispriced firm that proves we don’t live in an economist’s world. Current accounting rules mean that most manufacturing firms report rising costs with a significant lag. And inflationary periods magnify these distortions, creating opportunities for deep value investors to profit.
In January, I named HanesBrands as my top pick for 2023. Shares quickly rose around 30% after that, eliminating the attractive entry point. Now that HBI stock trades in deep value territory again, however, I’m finally adding it back as my No. 1 stock to buy now.
HBI Stock: The Issues With FIFO Accounting
Readers can refer to my initial write-up of HanesBrands to understand the company’s business. In short, it’s a stable, slow-growing industry that has generated profits in 19 of the past 20 years. American shoppers have a long history of buying branded underwear and will gladly pay a couple of cents more for a pack of Hanes over a generic alternative. It’s the perfect “sleeper” stock for conservative investors.
But there is a wrinkle:
Hanes is vertically integrated, which adds complexity that Wall Street dislikes.
In ordinary times, vertical integration can bring enormous benefits. Companies from energy giant Exxon Mobil (NYSE:XOM) to Amazon (NASDAQ:AMZN) have long expanded across the supply chain to reduce costs. HanesBrands has done the same with fabric manufacturing and garment-making. That gives the company far greater cost control than firms that outsource their manufacturing.
But these same benefits can create cash flow and profit distortions during inflationary periods, especially for firms like HBI that use first-in-first-out (FIFO) accounting.
Here’s why it happens. During an initial inflationary period, FIFO companies record abnormally high profits. Hanes will receive a higher value for its underwear and use cheaper “first-in” cotton to calculate margins. Indeed, when cotton and apparel inflation began in 2021, Hanes recorded abnormally strong quarters. By Q3 2021, the firm was generating $234.6 million in operating income, a 24% improvement from the year before.
But these “profits” are a mirage. Six to nine months later, accountants will begin using the “expensive” cotton to calculate profits. That temporarily depresses margins and causes net income to shrink. Analysts expect HanesBrands to lose around $23 million in Q1 2023.
Non-accountants will balk at this arrangement. FIFO accounting can turn steady cash profits into a seemingly wild accrual profit ride; once the high-priced raw materials are sold as garments, a company’s profits will quickly return to normal.
Nevertheless, FIFO accounting is an industry-standard that does its best to match input costs with direct outputs. The rival last-in-first-out (LIFO) method of accounting eliminates inflationary issues but introduces an entirely different set of bookkeeping problems. These firms will have inventory that can never “leave,” creating off-balance-sheet arrangements that accountants dislike even more.
Why Wall Street Overlooks Deep Value Stocks
Long-term investors will immediately realize that Wall Street often fails to understand such accounting subtleties. HBI stock traded as high as $22 in 2021 and trades lower than $5 today, despite seeing no significant changes in its underlying industry.
Investors will also realize that it’s not the first time HBI stock has traded this way. In early 2011, shares saw a similar rise and fall after cotton prices jumped from their historical 75 cent average to over $2. Shares traded as high as $8 before falling under $5.50 as higher costs began to reflect in the company’s accounts. For deep value investors, December 2021 created a fantastic entry point.
But there are some risks to buying a company like HanesBrands.
First, the mismatch in accrual accounting often shows up in cash flows, too. Retailers often stock up or de-stock their shelves anticipating inflation/recession cycles, turning FIFO mismatches into real-life cash crunches. HBI shares fell 27% in February after its board voted to suspend dividends. Sales had dropped 16% in the prior quarter from retailer de-stocking.
Second, stocks like HBI can languish for months as high FIFO costs filter through the system. Buying shares for cheap still involves waiting until Wall Street realizes its mistakes.
Finally, my quantitative research shows that momentum matters, especially for short-term returns. Investors buying HanesBrands today will likely need to wait several months before prices increase again.
HBI: The Ultimate Deep Value Stock
Nevertheless, HBI stock has finally become too cheap to ignore, especially for deep value investors with long time horizons. My quantitative Profit & Protection stock-picking system upgraded HBI stock’s momentum to an “A+” this month after prices began to stabilize. According to historical data, HBI now has a higher probability of outperformance over the next 12 months. Its low 0.27X price-to-sales ratio is roughly a third of its long-run average.
The firm also retains its relatively wide business “moat” in the innerwear business. No major innerwear competitor has emerged recently, suggesting that Wall Street analysts are right to expect a reversion to more normal profits by 2025.
Investing in value stocks never feels easy. If it were easy, everyone would do it!
But contrarian investing also has its benefits. Because when a good deal comes around, these types of investors can set aside what others think and invest in some of the best profit-generating companies around.
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On the date of publication, Tom Yeung did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.