Someone recently asked me this: With the stock market seeming to break new records on a regular basis, why isn’t it wise to sell a stock that has become slightly overvalued?
There are two reasons why it is not intelligent to sell of a company that happens to be of good quality. The first is that you do not know when the stock the stock will go up or down. That’s all fine and well, you might say, but that doesn’t answer the question: What’s the point of holding something that is currently trading at a share price worth more than the underlying reality?
And the answer to that is this: Some companies are relentless at growing their profits, intrinsic value, and dividends on a near-annual basis.
Let’s use Wal-Mart as an example. I’m currently reviewing seventeen years worth of data for the retail giant, and it looks to me like Wal-Mart’s intrinsic value never stops increasing: every year, Wal-Mart is generating more cash flow per share than the year before. Every year, Wal-Mart is increasing its earnings compared to the year before. Every year, Wal-Mart is returning shareholders a larger dividend than the year before. And this only alludes to the company’s stock buyback program, which is substantial; every year, Wal-Mart has fewer shares outstanding than the previous one, allowing the growing profits to be distributed among a smaller group of owners that can now lay claim to a larger amount of profit.
Right now, Wal-Mart trades at $77.43, and generates $5.20 per share in earnings. That means the company trades at 14.89x earnings. Personally, I think that’s about fair value, but let’s stipulate for a moment that I’m of the opinion that Wal-Mart is currently expensive—it’s real price should be somewhere around 11x earnings (for a share price of $57.20 per share).
While you are sitting there waiting for Wal-Mart’s stock price to come down to what you think its fair value should be, Wal-Mart will be doing something else: increasing profits and returning more and more of them to shareholders. For 2014, Wal-Mart is expected to earn $5.65 per share. By 2017, Wal-Mart is expected to earn $7.00 per share in total profits. Within 36 months, it’s entirely possible that Wal-Mart will be earning the amount of profits that will justify the current price of $77 in your mind.
If a company is overvalued, there is no rule that says it must decline in price to reach its fair value. Rather, as the profits increase, the share price could gently slope upward in price to reflect those increases rather than experiencing “a decline”; meanwhile, you’d be missing out on the growing dividend that Wal-Mart would have paid to shareholders along the way.
Some people do try to follow the Benjamin Graham model of selling a stock as soon as it reaches or exceeds fair value. They’d effectively say, “I’m not going to sit around for three years while waiting for Wal-Mart to grow profits to its current price; I’ll put that money to more productive use elsewhere.” Some people are good at that kind of strategy; and if you make a lot of money doing that, more power to you.
But I decided pretty early in life that I didn’t want to be renting stocks, buying and selling securities whimsically, spending my life trying to pick up a buck here and there by getting into and out of stocks at the right time. I find that strategy to be incredibly difficult to execute.
On the other hand, buying and holding excellent companies is something that does not require particularly savvy intelligence. Wal-Mart has grown everything for just about seventeen years running. If I showed you a history of its profit figures, you’d conclude that it is a no-brainer to own. Everything grows each year. Cash flow. Earnings. Dividends. Heck, 70% of its inventory is sold before Wal-Mart even has to pay the bill. They have a sweet set-up going on. Why not just kick back and collect the growing dividends while the profits grow each year? In the immediate-term, you get cash put in your pockets every ninety days. In the longer term sense, you see your net worth grow nicely at a rate in excess of inflation without having to do anything additional to making your initial purchase and monitor to make sure that the company isn’t going out of business.
A lot of it has to deal with style. Do you want to spend your life trying to predict stock prices and always getting into and out of securities? A much easier approach is all about focusing on the businesses that reliably grow profits over almost every five-year stretch. Finding the excellent businesses is easy. If you need help, look to companies that have been raising their dividends every year for forty or fifty years. If a company can do that, it’s probably fertile ground for researching a long-term investment opportunity. And plus, with these excellent businesses, they keep growing their profits in such a way that they “grow into” their valuation soon enough. In 2003, Wal-Mart earned $2.03 per share and paid out $0.36 per share in dividends. In 2013, Wal-Mart earns $5.20 per share and is returning $1.88 per share in cash to shareholders. When profits and dividends keep rising, why not treat such a company as an asset to cherish and as it sends more cold, hard cash your way each year?