Costco Wholesale (COST) is an excellent corporation. It has an extraordinary Board of Directors that includes Berkshire Hathaway Vice Chairman Charlie Munger, has grown profits by 11% annually for a decade, has 195,000 workers that generally experience better working conditions than many of their similarly situated peers, and has an excellent balance sheet that features $200 million more cash on hand than total debt obligations required (which is extraordinary for a large retail corporation). As best I can tell, it meets every characteristic of Benjamin Graham’s “Defensive Investor” checklist.
Except one. Valuation.
It is no secret how well run Costco is, and the current $151 per share price tag reflects this information. It makes about $5.35 per share in profits. That’s a valuation of 28.2x earnings. Looking out over the medium term, this current valuation mixed with expected future returns is exactly the kind of thing that will give you net positive returns but not do much to turn a small pile of capital into a large pile of capital.
In 2021, Costco is expected to grow profits from the current pace of $5.35 to $8.00 per share. That’s 8.34% annual growth. Nothing wrong with that. That would probably make it the best big box store performer over the next five years if that prediction holds.
But there is an important factor that also needs to be considered. The expected effect of P/E compression. Over long periods of time, large retailers tend to see their valuation compress towards the 14x to 18x earnings range (with interest rates, balance sheet strength, size, and growth being the causal factors for the range). But because there are only 700 Costco stores around the globe, and it is at the medium stage of market penetration compared to other firms like Target and Wal-Mart, let’s give it the benefit of the doubt and assume an ending valuation of 20x earnings five years from now.
That still implies P/E compression. With the valuation now at 28.2x earnings, and an ending valuation of 20x earnings, we can approximately if not precisely estimate that Costco shareholders will be sacrificing 6.51% annually in total returns if the valuation shifts from 28.2x earnings down towards 20x earnings in the next five years. That is a substantial amount of future returns to forfeit to get your hands on a box store with high single growth.
This means that, if the growth projections of 8.34% hold true, you will only be generating returns of 1.83% after sacrificing 6.51% to P/E compression. Combine that with the 1.05% dividend, and you are looking at 2.88% over the medium. If you are predicting that Costco shareholders will do better than that over the next five years, which may very well prove to be true, you have to make some conclusion that I am unwilling to draw: Either the earnings per share will grow faster than 8.34%, and/or the valuation of the stock will stand above 20x earnings.
There are ways that you could sort-of make the numbers work. If you assume continued 11% annual growth, then the ending earnings are at $9.25 (also, Costco’s historically due for a hike in its membership costs, suggesting an initial bump in earnings near the start of this comparison period). And if the P/E ratio is at 25x earnings in response to this continued high growth, then you would get a share price of $231. That would give you 8.87% annual returns, plus a bit over a percentage point from the dividend, and you’d be right there at 9.92% annual returns.
But, if the valuation did come down to the 20x earnings, your ending price would be $185 even with 11% annual growth. You’d get 4.15% annual returns from capital appreciation, 1.05% from the dividend, and 5.20% annual returns.
When I study stocks, I am mostly focused on the range of reasonable outcomes. Sure, there are situations like BP or Bank of America in the 2008-2010 range that fall well below the range of possible outcomes, but they can be offset by the occasional thing that greatly exceeds the range of probable outcomes like Visa these past ten years.
The ideal investment is one where, if future performance comes in at the low end of that range of reasonable outcomes, you still do well and earn 9% to 10% returns. If it is the midpoint of reasonable business performance that is necessary for you to achieve good returns, then it should depend on the quality of the business (this would be fine with Colgate-Palmolive or Johnson & Johnson, but not Staples. i.e. “It is better to buy a wonderful company at a fair price…”). The definition of “hold”, therefore, is when you own something that will do well at the high end of the range of reasonable outcomes but won’t give great returns if the subsequent business performance falls below that.
That’s where Costco is right now. If you get 11% annual earnings growth, and an ending valuation of 25x earnings, you can pace the historical returns of the S&P 500 for the next five years. That’s the high end of reasonable, and if I owned Costco stock, I wouldn’t sell at this price. But if you’re studying Costco from the perspective of a prospective investor, the hurdle is higher. Because we are talking retail, a sector whose history reads like the rise and fall of empires, you are not setting the bar at the “midpoint.” You should be setting the bar where, even with the low range of reasonable playing out, you will still do well. That’s not where Costco’s valuation is right now.
The quality of the business, which includes the historical success of businesses in that sector, should affect your determinations of fair value. If it is a historically prosperous sector, and you are considering a leading company, you can pay fair value and “settle” for returns that match subsequent business performance because you’re not really settling at all–you’re getting sound growth and great safety.
But when the sector is not historically strong, and you are considering a strong company, additional discipline is justified. You don’t just want a fair price–you want a good price. With Costco right now, you have to pay a premium to get into a sector that doesn’t lend itself well to generational investing. For that reason, it is wise to be picky and choosy with this sector and demand a much more attractive price before considering a well-run corporation like Costco.