When you study Wal-Mart stock as a potential long-term investment, there are two conflicting pieces of evidence you have to resolve: (1) The dominance of Wal-Mart’s historical returns which have been over 20% annualized since 1972 as Wal-Mart has become a mega-firm that makes just shy of $15 billion in profits per year, and (2) the history of American retail reads like the rise and fall of empires because consumer retail “loyalty” isn’t really brand affection but recognition of how efficiency leads to lower prices that save them money. When that status quo changes, people will happily move on to the next offering.
Wal-Mart stock had a rough 2015 from a stock price and business performance point of view. It lost a lot of stock value, going from a high of $91 to a low of $58 and now trading at $63 per share. From March 2, 2015 through January 8, 2016 Wal-Mart stock has declined 25% including dividends while the S&P 500 index has declined 8%.
The decline at Wal-Mart is worth examining: Is it a good deal? If you do buy it, for how long should you hold it? Under what conditions should you sell it? What should you do with the dividends received?
Part of Wal-Mart’s issue is that even customers that want the cheapest prices possible still have customer service expectations. No one has ever accused Wal-Mart of overinvesting into store layout, and it staffs the minimum amount of people possible for checkouts and inventory replacement. I believe it continues to overestimate the willingness of customers to switch to substitute goods when the desired item is unavailable on the shelf, although Wal-Mart claimed in the most recent quarterly report that sold-out items are being replaced at a 30% faster rate during times of non-holiday traffic.
Based on 2015 profits of $4.50 per share, Wal-Mart’s current valuation of $63 per share is 14x earnings. Wal-Mart does about a third of its business in the United States, and has not yet disclosed the extent to which 2015 profits were affected by the strength of the U.S. dollar. My own calculations indicate that Wal-Mart’s “true” profits are probably in the $4.80 range, if you neutralize the effects of currency translation.
When you factor in stock buybacks, which are sizable because Wal-Mart only pays out a dividend in the 30% to 45% range in most years and thus has been able to reduce the share count from 4.4 billion in 1999 to 3.2 billion entering 2016, the company expects to grow revenues per share in the 5-7% range. Wal-Mart itself, meanwhile, projects 3% revenue growth for the next five years. When you sell almost half a trillion worth of merchandise per year, it’s difficult to move the needle. The company offered a wide band estimate of 5% to 10% annual earnings per share growth between now and the end of 2018.
What I like about Wal-Mart stock right now is how the dividend payment will interact with low valuation to provide adequate returns even if Wal-Mart performs at the low end. If you get 5% earnings per share growth, a 3% dividend, and just a bit of capital appreciation, you are looking at the possibility of 10% annual returns. And if Wal-Mart exceeds expectations and delivers 8% earnings per share growth, you could get annual returns in the 13% range due to the dividend and P/E expansion over the medium term.
If you intend to hold Wal-Mart as part of a generational portfolio, I would not reinvest the dividends generated by Wal-Mart stock back into the company (if you reinvest back into Wal-Mart stock in the early years because you deliberately want to build up your Wal-Mart position, that is fine). Escalating your commitment to a company through reinvestment for years and years is fine if you’re dealing with a company like Coca-Cola, Hershey, Colgate, or Johnson & Johnson because there the brands are strong enough to think they will be timeless. But retail history does not lend itself to such an assumption.
My conservatively reasonable expectation for Wal-Mart’s dividend over the next ten years is 6.5% dividend growth. That means you’d collect $2.09 in 2016, and then: $2.23 (2017), $2.38 (2018), $2.54 (2019), $2.71 (2020), $2.89 (2021), $3.09 (2022), $3.29 (2023), $3.51 (2024), and $3.75 (2025). By my estimates, each share of Wal-Mart stands to return $28.48 in cold, hard cash to shareholders over the coming ten years. If you place a buy order for Wal-Mart stock at $63, you stand to receive an estimated 45% of your purchase price returned to you as a share of the retail giant’s profits.
What I really like about taking dividends and investing them elsewhere (“The Altria Principle”) is that it hedges uncertainty–the cash machine is strong now, and you think it will be strong ten years from now, but you want to mitigate the risk of the unknown once you get out more than ten years or so. Every dividend payment received and deployed elsewhere acts as a growing insurance policy against a worst case scenario. At a minimum, you’ll have at least $4,500 to show for each $10,000 you put into the stock. And, of course, the money isn’t a lump sum invested at the end, so the year one invest will have nine years to grow for this case study, and so on.
This strikes me as a strategy that mixes the best of Graham with the best of Munger with the best of Fisher. By intending to hold the initial investment indefinitely, you are modeling the long-termism that Fisher talked about when he had a 60+ year position in Motorola stock on his books at the time of his death. By putting a limitation on the investment with the dividends, you are recognizing that it doesn’t pass Munger’s test of the type of company that will be around forever. And by purchasing the stock while earnings are strong and the valuation is low, you are incorporating Graham’s margin of safety principle.