As the chief investment officer of a wealth management firm for nearly 20 years, I have found that success in investing comes when one remains disciplined and continuously searches for value, especially during difficult and volatile markets. Many investment professionals like myself believe the U.S. stock market is more than fairly valued. A number of large money managers believe the market is in a bubble as a result of the ultra accommodative posture of the Federal Reserve these last number of years. 

But when investors dig beneath the averages, they will find that stocks are not a monolith and that there are varying degrees of under/(over) valuation. So even in the current environment, I continue to find stocks that are potentially undervalued and that have limited downside risk. One stock that fits this approach is Barnes & Noble (BKS). 

The company reported weaker than expected sales in its fiscal first quarter, with comparable store sales down 6%. While operating earnings came in ahead of consensus estimates, the company still recorded a loss and is showing continued signs of struggle to stabilize its financial performance.

So Why the Optimism?

I am not betting that the company can turn itself around on a dime. Nor do I believe that sales and earnings are on the cusp of reaching an inflection point in the near term. But these are not reasons to avoid the stock. Some of the longer term fundamentals for the industry are improving and management has a number of strategic plans to drive higher traffic and sales. 

Positive #1 - Valuation

The stock is trading by many measures at distressed levels. The price-to-sales ratio according to Yahoo is hovering around 0.22. The enterprise value-to-EBITDA ratio based on the low end of management's guidance for fiscal year 2017 is approximately 4.5X. Both of these measures are well below the average for a retail stock.

Positive #2 - Dividend

With an annual dividend of $0.60, the yield is slightly over 5%, much higher than the average stock in the S&P 500 and quite compelling vis-a-vis the yields on most fixed income securities. Some might say that the high dividend is a sign of a potential value trap. However, the company's financial position is rock solid and the business has relatively modest capital needs. Unless sales take a turn for the worse, I see the dividend as safe.

Positive #3 - Management Strategy 

Like many retail store chains, the company has been challenged by the secular trend of shoppers favoring experiences over "stuff." While it may be difficult for retail chains like WalMart (WMT) and Target (TGT) to create compelling experiences, Barnes and Noble has plans to create an increasingly relaxing, engaging and enjoyable experience for patrons by including enhancements in its decor and food and beverage offerings. Management hopes to create an environment that encourages customers to spend more time (and money) in the store. 

Positive #4 - Easing of Competitive Pressures

With the closing of most of its large chain competitors over the last number of years (e.g. Borders, Walden Books, B. Dalton, etc.), Barnes & Noble is by far the largest "brick and mortar" chain in the industry.  While industry powerhouse Amazon.com (AMZN) represents a formidable competitive threat, Barnes & Noble is the only chain that has a national footprint, an experienced management team and a strategy to compete effectively. 

Upside/Downside?

I see the downside in the stock price as fairly limited at this point. The stock is trading as if retail conditions will continue to worsen meaningfully and that the turnaround is in the distant future. I believe that if and when this company achieves an inflection point, earnings will turn up sharply and the large valuation gap vis-a-vis the retail sector, as well as versus the stock market overall, will close sharply. 

I bought the stock for my growth oriented client portfolios last Thursday at $11.50. Should sales stabilize, I believe that profit margins will move up to the low-to-mid single digit range. Our minimum price objective in that scenario would be in the $18-$24 range.