When Charlie Munger was asked what it takes to be a great investor, his immediate comment was: “First of all, you must understand your own nature.” He elucidated: “Each person has to play the game given his own marginal utility considerations and in a way that takes into account his own psychology. If losses are going to make you miserable–and some losses are inevitable–you might be wise to utilize a very conservative pattern of investment and saving all your life. So you have to adapt your strategy to your own nature and your own talents. I don’t think there’s a one-size-fits-all investment strategy that I can give you.” (This Munger quote comes from the March 13, 1998 edition of Outstanding Investor Digest.)
I agree that there is no general prescription for investing that can be applied to all individuals under all circumstances. But recognizing that an individualized totality approach is necessary can often be used as a cop-out to evade critical examination. For that reason, I want to share with you how I would go about analyzing how to approach excellent businesses that are overvalued in the present market. I use Dr. Pepper and Nike as my examples.
Although it is rarely labelled as such, I would argue that Dr. Pepper ought to occupy a spot on the list of Top Ten investments that you could have made during The Great Recession. At the time, the stock hit a low of $11.80 in early 2009 and traded in the teens for most of the 2008-2009 period. At the time, the profits, revenues, and share count were all holding steady. The profit margins remained firm in the 8-9% range. Dr. Pepper made $470 million in 2008, and $503 million in 2009. The dividend got hiked from $1.85 to $1.97 (while earnings grew from $2.30 to $2.44).
If you were capable of purchasing individual stocks in 2008 and 2009, Dr. Pepper was an ideal selection. It had been around and profitable for over a century. It has an exceptional long-term record. The debt was on the low side of moderate. The P/E ratio of the stock at the low point was 6x earnings, an absolutely absurd valuation level given its long-term earnings power (the only company today that seems comparatively cheap is energy giant Royal Dutch Shell).
I wasn’t around to write about Dr. Pepper at this time, but Dr. Pepper did catch my attention in 2012 and I first started positively discussing the stock as an investment in 2012 when it traded in the high $40s and low $50s. It was a valuation of 14x earnings–not as good of a deal compared to the financial crisis obviously–but it still selling below my long-range estimate of 17-18x earnings (the reason why I have a lower estimate for Dr. Pepper compared to Coca-Cola and PepsiCo is because I believe that the brands possess slightly lower earnings quality and growth characteristics which results especially from the fact that Dr. Pepper only owns the North American distribution rights to its products and Coca-Cola owns the rest).
It doesn’t get a lot of attention because it has an interrupted history as a publicly traded company (it went private in 1984, became publicly traded as Dr. Pepper 7-UP in 1993, and then became part of Cadbury Schweppes in 1995 before being spun off on May 7, 2008). It also is ignored because of its status as third-fiddle in an industry that has Coca-Cola and PepsiCo. You could perhaps call it number four depending on how you account for Nestle.
Although most people don’t know this, it is actually the fourth-best investment that someone could have made between 1957 and 2003. If you bought it in 1957, then held through until it went private, and then purchased when it became public again, you would have compounded at 18.07% for 46 years (Coca-Cola investors, meanwhile, compounded at 16.02% during the same time frame though Coca-Cola was much easier to identify as a solid investment in 1957 because it was the 83rd largest firm in the world back then whereas Dr. Pepper was the 485th largest at the start of the measuring period).
Yet, we should understand the mechanics of why Dr. Pepper was able to deliver such superior performance–it spent the five decades turning Dr. Pepper into a national brand, and delivered 14.5% annual earnings growth as it executed upon its national expansion strategy. It currently earns 88% of its profits in the United States, with the rest coming from Canada and Mexico. The earnings aren’t really understated–that $3.95 that you see reported as profits is a very close approximation of underlying reality.
Because of its limitations for international expansion, and the difficulties in achieving volume growth in the soda market, Dr. Pepper is looking ahead to earnings growth in the 6% to 8% range.
The current price of nearly $95 puts the stock at 24x earnings for a true valuation. That’s problem–the current incarnation of Dr. Pepper has always traded between 12x earnings and 17x earnings, and regularly traded under 20x earnings during the years between the 1995 and 2008 spinoff from Cadbury Schweppes PLC.
In 22 years out of every 25, you’re probably can’t go wrong picking up shares of Dr. Pepper. The growth is usually nice for the low valuation that almost perpetually exists because Dr. Pepper is not Coca-Cola and has international growth concerns. But this is one of those three years.
Analysts expect Dr. Pepper to make $5.15 in 2020. If the stock trades around 17x earnings then, the price should be $87.55. It will take five years of dividends for you to break even under this scenario. Sure, maybe the valuation will be higher than historical, or earnings growth will outperform expectations, but the odds are heavily stacked against you if you make a Dr. Pepper investment right now. You are forcing yourself to rely on a lot of things to go right for Dr. Pepper to perform well from a $95 price point in 2015–the 29% price premium is troublesome considering that growth is in the single digit range.
Nike, like Dr. Pepper, is expected to earn $2.13 over the next twelve months. It, too, is trading at an elevated P/E ratio well above its historical norms. But here is what distinguishes Nike from Dr. Pepper: the earnings are substantially impaired by the strength of the U.S. Dollar, and Nike is growing earnings at around 15% annually on a constant-currency basis.
If that growth rate continues, Nike will be making around $4 per share in 2020 (for what it is worth, Nike has grown earnings at almost 20% annually since 1984. It’s worst ten-year growth period since becoming a publicly traded company was 2000-2010 when earnings only grew by 12.5%, as Nike’s growth was in the high single digits during the financial crisis).
Assuming $4 per share in 2020 profits, and a P/E ratio of 21, Nike stock should be trading at $84 per share. That compares to $64 at the current quotation. You’re talking about roughly 6% compounding towards capital appreciation, plus an additional percentage point for the dividend, and you’ll be looking at annual returns of 7% over the next five years. Clearly, Nike is becoming overvalued at this point, but the total return potential offered by Nike is still greater than Dr. Pepper even though Nike’s P/E ratio is more elevated than Dr. Pepper’s (Nike compensates for this with superior growth).
My inputs assume that the business performance at Dr. Pepper and Nike is largely similar to its past (with perhaps some recognition that Nike has a better chance of maintaining its lofty status quo than Dr. Pepper). From there, I calculate the effects of some P/E ratio reversion over the long term. In the case of Dr. Pepper, the P/E compression will be so substantial over the next five years that it will eat up all of the earnings growth and give you a total return that consists largely of the dividend payments. With Nike, the earnings growth is still superior enough that you ought to receive mid-to-high single digit gains even though the business itself is projected to perform better than that.
I would most certainly not add to Dr. Pepper at this price, and it’s possible to find something that looks better than Nike at the current quotation. If I already owned both stocks, I would feel much more comfortable owning Nike over the next five years compared to Dr. Pepper because of how projected earnings growth will interact with expected P/E compression.
When you try to figure out how to approach overvalued stocks, there should be the following elements to your analysis: (1) Do you already own the stock?; (2) How extreme is the overvaluation?; (3) What are the tax consequences of selling? (4) What are the natural growth characteristics of the business?; (5) What is your best alternative idea; and (6) How much better are the results from your best alternative compared to the net-of-tax results if you had to sell the original stock to accomplish it?
If you already own the stock, the presumption to hold should be much stronger (i.e. there should be a definable price range at which you would not buy a stock but you would hold it if it were already part of your portfolio). When the natural growth characteristics of a business are north of 10%, you should be very reluctant to sell. Even if the business is a large multinational, you shouldn’t consider selling until the price approached 40x earnings. If the business is overvalued by more than 20%, and the expected growth rate is in the single digits, then making a decision to sell seems more advisable. These are the factors I’d work through in trying to figure out what to do with an unusually pricey blue-chip stock.