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Hedge Funds Disagree With Citigroup On This Upgraded Stock

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Citigroup upgraded luxury clothing and accessories manufacturer Ralph Lauren Corp (NYSE:RLto ‘Buy’ from ‘Neutral’ on Thursday. The bank has a $125 price target on the stock, noting Ralph Lauren’s attractive valuation given the company’s foreign exchange troubles. Shares of Ralph Lauren are flat on the news at a time when the broader market is down by 1%. In this article, we will take a closer look at the luxury retailer and see if the smart money agrees with the Citigroup upgrade.

We mention the hedge fund activity concerning Ralph Lauren because our research has shown that historically their stock picks delivered superior risk-adjusted returns. This is especially true in the small-cap space. The 50 most popular large-cap stocks among hedge funds had a monthly alpha of about six basis points per month between 1999 and 2012; however the 15 most popular small-cap stocks delivered a monthly alpha of 80 basis points during the same period. This means investors would have generated 10 percentage points of alpha per year simply by imitating hedge funds’ top 15 small-cap ideas. We have been tracking the performance of these stocks since the end of August 2012 in real time and these stocks beat the market by 60 percentage points (118% return vs. the S&P 500’s 57.6% gain) over the last 36 months (see the details here).

Ralph Lauren Corp (NYSE:RL)‘s shares are down by 40% year-to-date because of decelerating growth and lower operating margins. First quarter fiscal 2016 revenue declined by 5.3% year-over-year to $1.62 billion. Gross margin fell by 1.2% year-over-year to 59.8% and operating margin dropped by 5.5% year-over-year to 8.8%. The first quarter numbers are very weak compared to Ralph Lauren’s historical annual revenue growth of 10% and historical operating margin of 15-16%.

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Fortunately, Ralph Lauren Corporation’s weak numbers are not due to a drop in consumer demand. Most of the operating margin and revenue weakness can be attributed to foreign exchange issues, by which the rising U.S dollar lowers Ralph Lauren’s international revenues and margins. Eventually the foreign exchange issues will reverse or at least stabilize, and Ralph Lauren will benefit from its international presence. Analysts expect Ralph Lauren’s revenue to grow by an average of 5-6% per year for the next five years as increased capital expenditures and store expansions begin to take effect.

Because of the stock price drop, Ralph Lauren’s shares are firmly in value territory. The luxury company trades at a forward PE of 14 and a trailing twelve-month PE of 15.8, which favorably compares to the S&P 500’s forward PE of 16.5 and trailing twelve-month PE of 21. Ralph Lauren Corporation also pays its shareholders a 1.85% dividend yield.

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