Treating Stocks As Businesses Still Works

Last month, I made fun of the fact that Fred’s stock had skyrocketed over 85% on the news that it was set to acquire 865 Rite Aid locations.

My reaction to the news included the following:

“Investors are speaking as if Fred’s got a ‘steal’ by getting each location for a cost of $1.1 million. I do not share in that sentiment. My view is that Fred’s purchase of 865 Rite-Aid locations will, in hindsight, prove to be a classic case study of the kind of market folly that pops up whenever you have a rising market mixed with cheap credit for corporate borrowers.

Despite having 4,600 locations, Rite Aid only brings in $125 million in profits per year. This means that each Rite Aid location, on average, makes $27,173 in net profit per year. I view this as folly because Fred’s is paying an average price of $1.1 million for each location. That is a payment of 40x earnings for a business with a five-year rate of NEGATIVE sales growth of 1.5% per year.”

Since the spike in Fred’s stock price, the stock has already come down 23% and now trades in the $15 range.

I offer this reminder because there are a lot of stocks trading at valuations which are 10% to 40% more than they are worth. When you have cheap credit, improving labor markets, and other capitalized assets trading at historically high multiples, the spread of overvaluation is practically inevitable.

What does this mean? Two things: (1) Perhaps it is always important, but the need to view stocks in light of the underlying business is as important as ever. In 2009, you could buy anything and make a killing so long as the enterprise remained solvent. Nowadays, you have to be more discerning and make some sober-eyed assessments of any given stock’s future growth possibilities. And (2) I have modified my objectives to re-align with the opportunities. I don’t think you can find highly intelligent bargains or cheap stocks these days. Instead, I look for opportunities that “aren’t stupid” and offer the possibility of 8-11% annual returns rather than deals that are fantastic and offer a colorable possibility of delivering returns north of 12%.

In my case, that means I keep doubling back to Johnson & Johnson which is trading at $114 per share. I don’t think the investor community has fully appreciated the $40+ billion JNJ cash hoard which offers merger possibilities and the record of mid single digit earnings growth which gets augmented further by stock repurchases and a growing dividend payout. The opportunity to purchase one of the ten best businesses in the entire world at a fair price is nothing to lament, and you only need to find one intelligent course of action at any given point in time.

And personally, I love it when there is an overlap between “most intelligent thing to do right now” and the old-timey conservative investing maxims. I have no calls for you to invest in closed-end funds, privately traded REITs, or MLPs that secured attractive funding. Johnson & Johnson is about as plain vanilla as it gets. There is nothing novel about JNJ stock. It is selling the same types of healthcare products it has been for the past century, and it is a strategy that has passively built a ton of wealth. For those that value simplicity and quality, it is one of the more attractive ways to build wealth through investing right now.

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