Since I began covering stocks in 2011, almost every company imaginable has gone through an unpopular period. People didn’t want to touch Johnson & Johnson for a while, as a string of manufacturing recalls punished the stock in the $60s. An inability to deliver sales growth concurrent with price increases kept Procter & Gamble stagnating for a few years. A decline in the price of energy companies sent ExxonMobil and Chevron stock down 30% or more. General Electric, possibly the greatest industrial giant in the world, saw its price hover in the teens before recently becoming more appropriate priced around $28. Poor short-term news at Wal-Mart has sent the stock currently down to the $60 range. AT&T, with a century of dividend payments and a platform that will grow profits from $13 billion to $20 billion over the next five years, is currently unfashionable. Coca-Cola, Exhibit A for blue-chip investing, has been stuck in the $40s as the company figures out its next growth strategy. Even Facebook, the current darling of the financial media, saw its price decline from $42 to $17 before entering its current rise.
These are some of the best companies of the world, almost all of them with stodgy histories dating back a half century or more, and even they have worked through periods of unpopularity. That should brace you for years of stagnation: If, in the past four years of a healthy economy, it is possible for the best companies in the world like ExxonMobil, Coca-Cola, and Johnson & Johnson to become unpopular, then anything is on the table.
Instead of thinking “If this stock becomes unpopular with the financial world”, you should modify that in your brain to “when this stock becomes unpopular with the financial world.” If you have any intention of owning the same companies for decades on end, you have to embrace yourself for periods of unfashionability. Heck, even Warren Buffett’s famous conglomerate Berkshire Hathaway fell in price by 50% or greater on four separate occasions, and he has grown book value by 19.7% annually for fifty years.
But still, this illustrates the point in the chain in which well-meaning investors become vulnerable to poor decision-making: An excellent company with great history works through some temporary troubles, and these temporary troubles correspond to a lower than unusual share price. Then, the investor sells the stock at this low price point in search of greener pastures. The problem is that the greener pastures are often overpriced, and could represent a company performing at peak conditions.
I have recently seen an uptick in investors plowing money into Chipotle Mexican Grill, if message board behavior is an indicator of real-world action. Why would you do that now? There have been plenty of times since McDonald’s spun off Chipotle that you could buy the company for under 20x earnings. That’s what you’d expect from a fast-growing, fast-casual dining chain. Two days ago, the price of the stock was over $700 per share compared to $16.32 in annual profits. That is a valuation of 43x earnings.
When you make an investment like that, you are effectively saying: “Everything must go right. My expectations cannot be disappointed. Otherwise, my returns will dramatically.” It’s okay if you feel that way about some things–I wouldn’t criticize anyone for plowing money into Visa stock each month–but you better be aware of the conditions that are necessary for satisfactory returns.
The problem is that, far too many times, the expectations attached to a stock trading at 43x earnings cannot be met indefinitely. It’s not in the nature of most things to keep growing at 10%, 15%, or 18% without a hitch. Chipotle investors met that hitch yesterday–seeing that same-store sales were growing at 3.5% across the country. That’s nothing to be ashamed of, and is even a nice growth figure for a maturing restaurant, but it is a huge problem when you get 3.5% same-store sales growth from something that is trading at 43x earnings. The valuation demands much more than that.
And that is why you have seen a selloff in the stock to $664 in short trading period since the news came out. You can’t say it is time to put your value hat on and buy some shares because it is still valued at over 40x earnings. This price decline is entirely justified, and it would even be justified for the company to fall further. Honestly, this is what I consider to be the hardest part of investing–it’s not figuring out which companies will deliver the greatest earnings per share growth, but rather, you got to find a way to square that against the expectations that are ingrained in the stock.
Now, the fun thing about value investing is that you can also find companies that have low expectations, and buy them knowing that it only takes so-so news to send the stock higher. Did you see what happened to eBay today? The stock shot up 9% on its earnings report. Why? There wasn’t anything particularly special about the earnings report–it lowered expenses by 5%, grew its active buyers by 5%, moved revenues up a bit on a constant-currency basis, and is on pace to retire 7% of the stock this year. That is decent, but not great, performance results.
The interesting thing, however, is that people left eBay for dead after the much sexier PayPal spinoff. The valuation came down below 13x earnings. This, despite having 157 million customers, revenues that grow every year, and $8 billion in cash on hand. The no-dividend policy and low reinvestment requirements mean that eBay can retire lots of stock each year without threatening the core business. The 9% pop today was entirely justified, and is a product of low expectations. When a stock is only trading at 13x earnings, and the business is growing over the long term, good returns lay ahead.
I had this compare/contrast between Chipotle and eBay on my mind when I saw today’s results from American Express. It revised 2015 profits downward to $5.35, lower than previous expectations of $5.60. American Express made $5.56 last year. If true, this will be the first time in the past twenty years that the company has reported lower annual profits other than the steep drop that occurred during the financial crisis when profits fell in half before catapulting upward in 2010.
Am I worried? Nope. The reason for lower guidance is two-fold: The company is still recovering from the loss of its lucrative exclusive contract with Costco, and has been spending heavily to deliver new branding opportunities outside the United States to offset this loss. This cost expenses to rise 7%. Meanwhile, as international sales have managed to become almost two thirds of the business, the strength of the dollar has caused significant swings in reported earnings. It reported 11% revenue declines, but revenue is up 4% on a constant-currency basis. That’s the figure I care about–American Express is growing in its markets, it’s just currently being understated due to the conversion from foreign currencies to the U.S. dollar.
People act like credit cards have become a Visa and Mastercard world, and to some extent, they are right.You know how highly I think of Visa’s business model. And even Charlie Munger recently opined: “The moat at American Express is not as strong as it once was.” These statements are true, but it is not also true that American Express stock is a bad investment at this point. That seemingly reasonable leap is where a lot of investors get into trouble.
Here is what I see: American Express is a company that usually trades at 17x earnings to 21x earnings, but is currently trading hands at 13.5x earnings. Four years ago, 29.7 million people had American Express cards across the globe. Now, that figure is up to 35.2 million people. The average customer spent just under $13,000 on their card in 2011, and now they are spending $16,000 annually. And while it is true that the credit quality of the customer base is not as prestigious as it once was, American Express still reports an industry leading 0.2% default rate.
You have more American Express cards in circulation, more money being spent on them, and the default rate is low. The management team expects 12% to 15% annual earnings per share growth once the Costco and strong dollar speed bump is fully cleared. And yet, there are people out there discarding the stock because 2015 profits won’t be as high as 2014 profits. It’s an asinine way to behave.
Impatience is a great character trait to possess if you want to be a disastrous investor. The two biggest mistakes are as follows–buying a growing company that is actively growing profits, and then selling it because the price of the stock goes down. And the second mistake is owning a company that is presently producing suboptimal business results, and then selling it on the theory that the poor performance will keep continuing. It ignores the high probability that expectations are so low that the return of satisfactory news will deliver better than expected returns.
Selling a stock as soon as it becomes unfashionable is a great way to run out of money quickly. If it ever becomes a core part of your internal programming, you will eventually become broke. Don’t fall for that temptation. You must erase recency bias from your mind because your future success as an investor depends upon it. The beginner stage of successful investing is recognizing that a business can be doing great even while its share price is not. The intermediate stage involves recognizing that lackluster business performance does not mean a stock should be sold, as the low valuation may be an attractive springboard for high returns even when future results are only moderate. The specific companies and specific reasons are a little different each time, but the story theme is the same.