Mired In Stock Market Froth

Unless I think a business is trading at a discount, I don’t cheer stock price movement forward. I cheer on earnings growth. If a business grows by 5% in a year, I expect the stock to go up by 5%, all else equal. When the stock price goes up much faster than earnings growth, or lags it by a noticeable amount, then I evaluate the business to see how much current sentiment is shaping future returns.

The consequence is that I don’t really cheer the post-election rally that we’ve seen since November 9th. Most stocks are up about 5% since then, though sectors such as financials and industrials have received outsized gains. This creates a problem for those seeking out investment opportunities because the P/E ratio of stocks continues to climb.

I have previously lamented that the S&P 500 doesn’t have great prospects going forward because the P/E ratio was 24. Well, now the P/E ratio of the S&P 500 is pushing 26. That is a near guaranteed formula for mid single digit returns. Maybe business-friendly politics bumps you up a half point or so, but it does not affect my view that purchasers of an S&P 500 index fund at this point are going to inherit returns of 6% annually over the next decade.

It’s not going to cause late 1990s dotcom disappointment, but it will mean that putting money into America, Inc. won’t come attached with a self-propeller to riches. A valuation return towards the 20x earnings range is inevitable, and it will take a few points off of returns.

I just read through the annual report of Panera, Inc. (PNRA). It has had a fantastic twenty-five year run, compounding at a rate of 15% annually since its 1991 initial public offering. Earnings have grown at a rate of 18% annualized over the past decade. It is very fashionable.

But I can’t help but notice some of the creaks. Profits of $160 million are lower than the profits of $190 million that were generated back in 2013. The reason why shareholders may not have noticed is because Panera has been repurchasing a lot of stock, bringing the total count down to 24 million from 31 million.

Just three years ago, it had no debt outstanding. Now, it has $431 million in debt. It is financed at an attractive borrowing rate of 3%, but it still represents a shift from no leverage to triple the cash flow.

Analysts are calling for earnings growth of 13% annually, which sounds reasonable in light of Panera’s 18% annual growth since 2006. But I’m a little more skeptical. For the past two years, Panera has only improved same store foot traffic at a rate of 3%. That’s why buybacks have fueled the earnings per share growth. From 2000 through 2012, it was posting Starbucks-type numbers of 7.5% foot traffic growth each year.

These concerns aren’t enough to make me think that Panera is a bad business. Far from it! Unless a headline is thrust in my face, I usually seek out annual reports because I have a pre-existing intuition that a business is excellent.

But my concerns about Panera are enough to make me insist upon a valuation of 20x earnings or cheaper to fall within the category of “intelligent behavior.” But what do I find? A price of $213 compared to $6.72 in earnings. That is a P/E ratio of over 31.

Imagine that two things happen over the next five years. First, Panera grows at a rate of 10% annually. And second, that the P/E ratio comes down to 20x earnings. This would mean that Panera’s earnings grow from $6.72 to $11.06, and the 20x earnings valuation would imply a price of $221. Well, we are practically there right now at a price of $213.

To make money with Panera, you are going to need some combination of growth greater than 10% and a terminal valuation greater than 20x earnings. Is that possible? Of course.

But the odds aren’t titled in your favor. It’s like turning on the TV during the summer to see your favorite baseball team down 2-0 in the 5th inning, and then seeking out a friend willing to take you up on a bet when you’re predicting a comeback. Of course it can happen–but at a minimum, you want to place your wager when the game is tied. At a maximum, you want to find a situation when you get to bet on the team with the 2-0 lead to win.

If that metaphor was a stretch, I’ll be blunt: I want to avoid investment situations where I need 10% growth for five years just to break even after taxes.

Even in the best of times, bargains are hard to find. But recently, even fair deals are hard to find. That’s why I talk up corporations like Johnson & Johnson trading at $112. That’s a fair deal for a wonderful business, and you only need to find one place that is fair at a given moment. But the good deals are increasingly becoming few and far between.

From a selfish perspective, the current environment is better for individual investors because it is fertile soil for proving that active investing is worth it. Someone buying Nike at $51 is going to do a lot better over the next ten years than someone buying the S&P 500, and this comment will be a useful reference point in 2026. But from a broader perspective, I do have concerns for those good people with expectations that the S&P 500 will perform in accord with 10% expectations because you won’t get that from a base of 26x earnings.