Gap Bear's Rebuttal
by Louis Corrigan ([email protected])

Fellow Fools, here's your chance to think about why the market works as it does. I say to-may-toe, Yi-Hsin says to-ma-toe. She says khaki, I say wacky. We both look with enthusiasm at the same great story, and yet there remains a major... gap... between our different conclusions.

As I see it, Gap's bottom line just isn't getting fat fast enough to fill its capaciously baggy stock price. And nothing in Yi-Hsin's bull stance persuades me otherwise. To repeat, this may not matter if you plan to buy the stock and hold it for the next 20 years. Still, comparing Gap to Coke seems a little presumptuous given that a 60-cent Coke travels better than a $40 pair of khakis. Also, Gap's difficulties so far in building a profitable international business suggest major challenges ahead, making the sustainability of its rapid growth a lot more suspect than Coke's. Moreover, even long-term investors will do better if they develop a discipline against paying too much.

Yi-Hsin argues that both the company and the stock have performed spectacularly, particularly over the last three years. That's the basic reason why an investor should be cautious. That 483% gain over the last three years began with the stock trading at about 15 times trailing earnings and 13.4 times forward earnings. The stock's current P/E is 46, or about 39 times this year's earnings estimates. This shows the beauty of multiple expansion, but it's also a classic bull market phenomenon that simply won't be repeated in the future. Otherwise, the Gap would sport a P/E of 138 three years from now!

As these numbers suggest, financial results alone don't justify the current price. Indeed, the stock has risen by a compound annual rate of 81% over the last three years while sales over this period grew by 21% annually and net income rose by just 19%. That tells us two things: One, profit margins have actually been shrinking in recent years and, two, the Gap was selling at a bargain PEG of 0.79 in July of 1995. Today, the PEG is double that!

Sure, the multiple expansion is partly justified by the sheer earnings growth. Renewed confidence that the Gap's expansion plans make sense and a robust retail environment add two more admitted positives to the mix. But when Berkshire's GEICO unit paid a split-adjusted $21.90 per share for its stake last year, the Gap sported a P/E of just 20.7. When the Cash-King managers announced they were willing to pay up for the stock, the P/E was 35.6. Recall that the P/E today is 46.

I think the lesson here is absolutely clear. Warren Buffett loves great businesses he can understand, but he likes to buy them when they're trading at a fair to discounted price relative to their prospects. Buffett's investment history should convince us that that discipline works and that most great businesses will fall into that fair price range at some point.

I think an investor hoping to learn from Buffett should include the Gap on a list of stocks to watch. Though GEICO's reported stake is tiny, Buffett's thumbs up means the Gap's business is probably as solid as it seems. In the meantime, you should go look for some other great company that may be trading today at a discount to its growth rate and thus could enjoy its own 483% gain over the next three years.

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