One of the weird quirks that is necessarily associated with being a successful value investor is that attractive entry points are nearly always caused by the aftermath of a stock reporting some business conditions or adverse event that render it unfashionable. In other words, the “value” you find is almost always a direct result of concluding that the rest of the investor community is over-weighing the effects some business impairment will have on the firm’s long-term earnings and valuation.
During the past few years, Wal-Mart ran into the gravitational pull of large numbers as it struggled to grow its revenues that hover near the half a trillion mark (the high water point was $485 trillion in 2014).
The prospect of low earnings growth pushed the price of Wal-Mart’s stock down low into the $50s in 2014 and 2015. Meanwhile, earnings were about $4.50. This meant that, for most of 2015, Wal-Mart was trading around the 12-13x earnings range. For a company that was paying out a nearly 3% starting dividend and repurchasing 3% of its outstanding stock each year, and due for 2% in P/E expansion, you didn’t need a whole lot of core earnings growth for the investment to pay off. The combination of undervaluation, a high dividend, and a strong repurchase program created one of the rare scenarios in which maintaining the status quo would lead to 8% annual returns for the investor that did nothing but sit on WMT stock and permit the dividend payments to reinvest into additional shares.
You didn’t really need core earnings growth for the investment to do well. Now, here we are less than a year later, and Wal-Mart stock has already recovered nicely from its $56 valuation last November. People who stuck with it from November through October have reaped 31% returns in the span of 11 months. Not bad for one of the five largest businesses in the world measured by total revenues.
Part of the reason why Wal-Mart’s valuation has shot up from the 12x earnings range to the 17x earnings range is because Wal-Mart is finally showing signs that it is interested in leveraging its e-commerce presence so it won’t be a brick-and-mortar retailer solely but will act a dual threat that sells in-store and online.
Given the clunkiness of the user experience at walmart.com, it makes sense for the corporation to seek an external solution. It has done that in recent months with the purchase of Amazon’s budding competitor jet.com, and recent reports from the Financial Times have indicated that Wal-Mart is in talks to make a passive minority investment in India’s Flipkart (Flipkart and Amazon are currently slugging it out for supremacy of the Indian online purchasing market. When you have $7 billion in cash and almost $1 billion per month rolling in as unrestricted cash flows, you can buy your way out of problems resulting from your own management team’s competitive shortcomings.
This is what the sequence of a successful value investment looks like. You find something with a P/E ratio that is lower than usual. You check out whether there is any permanent deterioration in demand (if there is, like you see with Blackberry’s products, you stay away. If the demand for the product remains consistent, you inquire further.) You buy during this moment of un-fashionableness. And then, as earnings improve and good news occurs at a moment when expectations are set at a low point, you reap the quick capital appreciation that comes.
The important thing to remember about these types of investments is that you have to get in before the earnings growth materializes. Sometimes, I see people say things like: “I’m going to wait for Wal-Mart to grow earnings by more than 5% before I get in.” Or: “I need to see more than 2% dividend growth before I consider Wal-Mart stock.” These are examples of ideas that sound reasonable but aren’t.The period of uncertainty that occurs before those conditions arrive are the moments that you will receive the big positive swings in stock price movement. Earnings at Wal-Mart are only up a few percent while the stock is up over 30% in the past year. It is a real life example of how the wealth-creation process of value investing unfolds.