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Fast
Graphs
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We often write about valuation because we believe it is one of
the most misunderstood aspects of investing in common stocks.
This causes many people to hold what we consider to be unjustified
biases that are based primarily on price action. For example,
the concept of the lost decade, which many almost gleefully point
to as evidence validating that stocks are poor investments, fail to
recognize that the true culprit was overvaluation during the
appropriately labeled "irrational exuberance" days.
However, one of the most misunderstood aspects of overvaluation
is how wide ranging and relative it is. To clarify, one company can
technically be labeled overvalued, but due to other important
factors, still be a good investment or even an above-average
investment. It all comes down to the degree of overvaluation the
market is applying, relative to the potential long-term growth the
business is capable of achieving.
Starbucks Corp. (
SBUX
): Overvalued High Growth
We offer Starbucks Corp. (
SBUX
) as an example of a stock that is technically overvalued, but not
necessarily a poor long-term investment. First of all, by looking
at the earnings and price correlated
F.A.S.T.
Graphs™
below, we discover that the market has historically placed a high
valuation on this high-quality growth stock that has only recently
morphed into a fast growing dividend growth stock. Consequently,
even though you would have had to overpay to invest in the stock,
as a long-term owner you would have made good money. The
reason for this is simple; strong earnings growth would have bailed
you out.
As a long-term shareholder of Starbucks your total annual return
would have been over six times more than you could have earned in
the market as represented by the S&P 500. Keep in mind
that although you would have technically been investing in an
overvalued stock in 1999, strong earnings growth overcame high
valuation in the long run.
The following estimated earnings and return calculator based on
the consensus of 28 analysts reporting to Standard & Poor's
Capital IQ tells a very interesting story, assuming of course it
turns out to be a true story. Currently, Starbucks trades at a PE
ratio above 25; however, the company's 5-year forecast growth rate
is estimated at 18%.
Now here's the interesting part. The 5-year estimated
total return of 13.2% per annum (including dividends) assumes that
the Company achieves the 18% growth rate, but also assumes that the
future price earnings ratio falls to its earnings justified PE of
18 from its current 25. Therefore, this simple calculation shows
that this company could produce a double-digit annualized long-term
rate of return as long as earnings grew 18%, and even though the PE
ratio contracts to 18.
The point is that a 13% compounded annual return is very
healthy, and one that we dare say would be enthusiastically
embraced by most investors. Theoretically, the real risk here
is that Starbucks' stock price would fall to the orange line over
the short run. In other words, there is a potential
short-term opportunity cost of buying it today. That
opportunity cost could be that it's possible that you could wait a
few weeks or so, and be able to pick up shares at their intrinsic
value of $35-$38 per share, compared to today's current price of
$45.87. On the other hand, if this doesn't occur and the
stock continues to rise, you have missed the opportunity of
owning.
In summary, Starbucks is a company that is technically
overvalued today, but has been overvalued through most of its
recent history. Nevertheless, it has generated excellent
long-term returns for shareholders exercising the intelligent
patience to hold on as long as its fundamentals remained intact. On
the other hand, we would argue that the great returns that
Starbucks generated were achieved at a higher risk level than a
more rational market would have facilitated.
Colgate-Palmolive Co. (
CL
): Overvalued Moderate Growth
Our second example reviews Colgate-Palmolive, a moderately
fast-growing blue-chip Dividend Champion with a legacy of premium
valuation. A quick glance at the earnings and price correlated
F.A.S.T. Graphs™ shows that the market typically values this
blue-chip above its orange earnings justified valuation line.
On the other hand, thanks to the great recession and once again in
2010, there were two times in recent history where Colgate could
have been purchased at what technically would be called intrinsic
value (where the price touches the orange line). Clearly,
both of those situations would have been ideal times to invest in
Colgate.
From a performance point of view, even when Colgate is purchased
when it is overvalued, its above-average growth rate and
consistency, coupled with its steadily increasing dividend,
adequately rewarded shareholders. The question the investor has to
ask themselves is, are they willing to take the overvaluation risk
to own this blue-chip dividend growth star?
Colgate-Palmolive appears to, once again, being awarded its
traditional premium valuation by Mr. Market. Nevertheless,
including dividends, long-term shareholders would stand to earn an
annual return of 6.4% per annum. Keep in mind that this
return assumes that the company grows its earnings by the 9%
consensus estimate, but also that the PE ratio rationally contracts
from its current 23 PE to a fair value PE of 15. On the other hand,
if the current PE ratio were to hold, shareholders could achieve a
return in excess of 9% per annum. Once again, as an investor
you must ask yourself are you willing to take this level of
valuation risk to earn those potential rates of return from this
blue-chip dividend growth star.
When Overvaluation Becomes Long-term Dangerous
Thus far, we have shown examples where stocks were technically
overvalued, but not dangerously so. With our first two
examples the real risk was that stock price could temporarily fall
to fair value before it advanced long term based on its earnings
growth potential. From our perspective, we believe this kind of
overvaluation simply means taking a higher risk than is rational,
in order to earn a rate of return that is less than fundamentals
justify. This implies that it would be possible to find
alternative companies with similar fundamentals that could be
purchased at more rational valuations.
With our next examples we will illustrate overvaluation
situations that were long-term devastating. In addition to
providing a vivid and quintessential picture of overvaluation and a
true bubble, we are also provided with incontrovertible evidence
that the stock market is not always sufficient. In other words, it
would be nothing short of absurd to try to argue that the market
was correctly pricing EMC Corp. (
EMC
) during the timeframe 1999 -2002. A quick glance at the earnings
and price correlated graphic on EMC defines the term "irrational
exuberance."
Although EMC was technically overvalued in 1997 and 1998,
valuation went to the extreme in 1999 and 2000. Therefore,
any purchases of the stock in 1998, 1999, 2000, 2001 or 2002 proved
disastrous both in the short run and the longer run. Unlike
the moderate overvaluation we looked at previously, this dangerous
overvaluation would have resulted in significant long-term
losses. The point is that, as previously postulated,
valuation is a relative thing. Clearly, and admittedly a
"duh" statement, but there is overvaluation, and then there is
dangerous overvaluation, with many variances in between.
To drive this point home, an investment at the beginning of 2001
in EMC would have resulted in devastating losses over the next
decade and beyond. However, of equal importance, is the fact that
EMC Corp., the business, actually performed rather well, especially
from calendar year 2003 going forward. Dangerous
overvaluation can completely negate a good business. It might be
interesting to point out that most tech stocks suffered from the
same dangerous overvaluation during the years 1999 -2002, to
include stalwarts such as Microsoft (
MSFT
), Intel (
INTC
), Cisco (CSCO), Oracle (ORCL) and many others. In other
words, all of their graphs look very similar to EMC regarding price
action.
With our next example, Wal-Mart Stores (WMT), we see another
iteration of the risk associated with dangerous
overvaluation. In some ways, the EMC example above was
merciful in that the overvaluation was running out rather quickly,
albeit with a vengeance. When Wal-Mart became dangerously
overvalued during the irrational exuberance era, its price action
created an insidious slow death, so to speak. It took
approximately 8 years as Wal-Mart's stock price drifted sideways
and then down, before it moved back into earnings justified
intrinsic value (the orange line).
What's perhaps even more interesting about this example is how
well the company performed as a business as its stock price
underperformed. Wal-Mart grew its earnings and dividends at
above-average rates every year during this time, but because their
share price was so massively overvalued, it was all for naught.
Once again, we see another clear example of the market
mispricing a great business.
Summary and Conclusions
Perhaps the most important message that we are attempting to
convey with this article relates to the importance of having a
solid perspective regarding valuation. This is especially
important to those that are either near or currently in their
retirement years. We contend that all this talk about how
dangerous it is to invest in stocks is overblown. The
evidence clearly confirms that if you invest in great businesses at
sound valuations, long-term risks are relatively low and returns
more than adequate to meet your needs.
To put this into another context, although it does happen, the
failure of a great business is a relatively rare occurrence.
However, market mispricing, especially when it overvalues a great
business, is much more common. Moreover, the biggest losses
will generally occur more from overvaluation than any failure on
the business behind the company's part.
On the other hand, it's also important to distinguish between
the various levels of overvaluation. In some cases, a slight
or even a moderate overvaluation of a company's shares, even a
great company, will moderately increase risk while simultaneously
lowering long-term return. However, in the long run these
situations may not be devastating, especially for best-of-breed
companies.
In other words, a moderately overpriced stock of impeccable
quality can still generate an adequate, or even more than adequate
long-term rate of return and a growing dividend income stream.
However, when valuations become too excessive, they can be
devastating. It's important to also note that valuations tend
to be very high during times when greed has kicked in. Greed
spawns overconfidence, thereby blinding investors to the grave
danger like lambs being led to the slaughter.
In conclusion, it's important to have a sound perspective on
valuation. Calculating current and future earnings yields are
a straightforward and simple method of accomplishing that
task. When the earnings yield on stocks, which is the inverse
of the PE, is very low it should be obvious that there is not
enough return being generated by the company's fundamentals to
compensate for the risk you are taking by owning them. This
situation occurs most often when the stock is experiencing great
price momentum. The more the stock rises, the more it
attracts investors as the greed response takes hold.
Disclaimer:
The opinions in this document are for informational and
educational purposes only and should not be construed as a
recommendation to buy or sell the stocks mentioned or to solicit
transactions or clients. Past performance of the companies
discussed may not continue and the companies may not achieve the
earnings growth as predicted. The information in this document is
believed to be accurate, but under no circumstances should a
person act upon the information contained within. We do not
recommend that anyone act upon any investment information without
first consulting an investment advisor as to the suitability of
such investments for his specific situation.