Whether you own a stock or are just contemplating a purchase, it can be a useful exercise sometimes to review whether it makes sense to buy, hold, or sell the shares — especially when a company is a major player in its industry and there is a fair amount of market volatility.
And that brings us to Home Depot (HD -1.56%). Shares of the largest home improvement retailer have tested investors’ patience this year, dropping by 6.7%. By contrast, the S&P 500 increased by 14% during this time. What should investors make of these divergent paths?
It’s time to roll up our sleeves and see the best course of action.
A strong market position
Home Depot has by far the largest reach in the home improvement retail space with over 2,300 stores throughout the U.S., as well as Canada and Mexico. Its nearest competitor, Lowe’s, has about 1,700.
This large size and dominant market position bestows certain advantages to Home Depot. Its ubiquitous presence makes it a convenient, cost-effective choice for do-it-yourself and professional customers. It also offers customers access to professionals.
Home Depot has been confronting a strained consumer, and that has resulted in weaker sales. Its fiscal second-quarter same-store sales (comps) fell by 2% due to lower traffic. This period ended on July 30. Management expects comps to drop by 2% to 5% for the year.
The retailer blames macroeconomic factors such as high inflation. And it’s not just Home Depot that’s been affected. Competitor Lowe’s also had weak sales, with comps falling by 1.4% for the quarter, and it expects a 2% to 4% decline for the year.
Home Depot’s results fluctuate with the economic cycle, but its strong market position puts it in an ideal position when times inevitably get better.
You can wait out cycles since management returns a lot of cash to shareholders. After investing in the business, it prioritizes growing its dividend and repurchasing shares with excess cash. Fortunately, Home Depot generates plenty of cash flow, totaling $10.5 billion in the first half of the year.
The company returned a majority of that amount to shareholders via dividends and share repurchases. During this span, dividends totaled $4.2 billion, and it spent $5 billion on share repurchases. The board of directors has increased dividends annually since 2010. The stock has a 2.9% dividend yield, nearly double the S&P 500’s 1.6%.
Management’s approach has generated a high return on invested capital (ROIC). Historically, Home Depot’s ROIC has been better than 40%. For the 12 months that ended on June 30, ROIC was 41.5%. By comparison. ROIC for Lowe’s has ranged from the high-20% to mid-30% level over the last few years. It was 27.8% for the recent period.
The stock’s sell-off means it trades at a better valuation. The shares sell at a price-to-earnings (P/E) ratio of 18, down from over 20 a couple of months ago. Major competitor Lowe’s has a 26 P/E multiple.
Meanwhile, the overall market, measured by the S&P 500, trades at a 24 P/E. While rising interest rates and a potentially slowing economy could impact Home Depot’s near-term sales, investors get to collect an above-average dividend yield in the meantime.
With Home Depot’s better valuation, strong dividend growth, and dominant market position with few meaningful competitors, patient investors should get handsomely rewarded. That adds up to a buying opportunity.
Lawrence Rothman, CFA has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Home Depot. The Motley Fool recommends Lowe’s Companies. The Motley Fool has a disclosure policy.