Since June of 1998, Coca-Cola stock has returned 2.5% annually. I always keep that figure in the back of my mind, as it is a harsh reminder that getting the company right is never enough–you can’t mess up the overvaluation and drastically overpay. In a way, that 2.5% is actually an incredible testament to the enduring strength of Coca-Cola’s beverage portfolio, as the valuation shifted from 62x earnings to 19x earnings over the June 1998 through September 2015 measuring period. The fact that you were able to come close to keeping pace with inflation, despite paying almost triple what the asset is worth, is actually impressive in light of the overvaluation amount.
Although the 2015 market presents nothing quite so drastic, there are still companies trading at valuations far in excess of what is merited when you take a deep look at the growth projections, balance sheet, and historical valuation metrics. One of them is Clorox.
I do put Clorox on my list of Top 40 Companies to hold for life, but it has almost been the most attractively valued blue-chip stock available since I started writing finance articles in 2011.
The balance sheet never particularly impressed me–94% of the capital structure is allocated to debt, the pension is underfunded by $200 million, it has to allocate 6% of its earnings to just paying off the interest on its debt, and almost 30% of its sales occur at Wal-Mart (half its profits come from a combination of: Wal-Mart, Target, Costco, and Kroger.) None of these items individually are reason for deep concern, but in aggregate, are the kind of thing that would make me want to insist on a moderate discount before buying Clorox–after all, why not just buy Johnson & Johnson at $92 where you can get that type of high quality without these concerns?
The other aspect of my concern is valuation. During every year between 2003 and 2013, you had an opportunity to buy Clorox stock below 20x earnings (there were some heavy non-recurring impairments in 2011 so you would have to normalize the figure for that year as Clorox didn’t really trade at 36x profits then).
Five years from now, you’ll get a shot to buy Clorox at 20x earnings or better. Ten years from now, you’ll get a chance to buy Clorox at 20x earnings. Fifteen, twenty years–the opportunity will be there. You can get away with overpaying for a company like Nike that is selling athletic ware literally faster than it can make it–the earnings per share growth in the 12% range will drag you forward to great returns even if you pay a higher price than you might normally be comfortable paying.
But that is not what is going on at Clorox. The company has been able to deliver 5.5% earnings growth to shareholders, but it has done so by drastically reducing costs. The demand for its products is only currently increasing at 2%. It will work its way out of that rut eventually, especially as the company expands into lipsticks and will be advertising heavily in the bleach and cat litter segments in November through January.
The current status quo of the business, coupled with the expected growth rate over the next couple of years, does not warrant paying the premium of 25x earnings. Based on current operating conditions, I wouldn’t treat Clorox as a “must buy” until it reached around 17.5x earnings or a stock price around $80. So I’d recommend focusing elsewhere for now.
What will likely happen is that earnings will grow moderately, and as interest rates rise or some other global event leads to a decline in general valuations, the stock price will grow at a slower rate than the earnings growth. I would wait for that moment before making that initial purchase of stock.
My guess is that, if the valuation for Clorox is rational five to ten years down the line, the current purchasers of the stock will find themselves looking at total returns in the range of 6% and 8.5% annualized. Probably a bit below the S&P 500–the earnings of Clorox ought to outpace the S&P 500 slightly, but the valuation compression at Clorox will be greater than you’d see from the S&P 500 Index and the stock will probably trail the general market index by a little bit.
If someone had the imperative of dollar-cost-averaging into Clorox stock every month with a time horizon of 25 years or more, the current valuation is nowhere near being excessive enough to stop the monthly contributions. There, the objective is different: You are searching for the certainty that comes with quality, and moderate overvaluation becomes a rounding error once the measuring period becomes two and a half decades. But if you are looking out over the next five to ten years, I would recommend being patient and waiting at least until the stock trades at less than 20x earnings: History shows that opportunity shows up with quite a bit of regularity, even if the past two years don’t feel like it.
Originally posted 2015-09-26 17:37:50.
