General Electric Stock vs. Market Excess

For the first time since the financial crisis, General Electric (GE) is no longer an undervalued stock. While 2008-2009 marked the worst period for General Electric since The Great Depression–and the end of the company’s seventy-two year streak without a dividend cut is a testament to this–the six years after the crash provided a great extended opportunity to buy one of the top thirty companies in the world at a discounted price.

GE spent almost five years trading in the teens, and even fell to $19.37 on August 24th, 2015 during a brief period of general market panic. It also provided a nice reminder of the value of having some extra cash laying around, as the August 24th opportunity let incoming investors secure a 4.7% dividend yield.

Now that GE is knocking on the door of $30 per share, the six-year chapter of undervaluation has finally come to a close. I would define General Electric’s fair value as the range of $28-$35 per share, meaning that people buying near $28 will likely receive total returns that equal the earnings per share growth at GE plus the dividend income with a fair chance of earning returns a point or so above this. People that buy GE near $35 also stand a good chance of capturing the earnings per share growth plus dividend payout of the firm, but the long-term chance of earning total returns in excess of this would be quite minimal.

If oil stays down for a few years and the sale of financial assets disappoints expectations a bit, investors are probably looking around 5% growth. If the sale of financial assets runs smoothly and the industrial division grows in line with the recent twenty-year average, then you might see 8% earnings per share under a good case scenario. Plus, you get a 3% dividend, putting the range of outcomes over the next ten years somewhere between 8% and 11%. If I had to guess which of these is most likely, I’d figure the 8-9% range because GE historically has trouble reducing the share count by the rate advertised during the buyback announcement.

All things considered, that’s still not a bad deal compared to other opportunities out there. If I were dollar-cost averaging into shares of General Electric each month, I would happily continue to do so. GE remains much more attractive than the S&P 500 at large which trades at 22x earnings–something we will look back upon in history as a period of moderate overvaluation.

This reaffirms my personal aversion to index funds, as the valuations of some companies have become truly unhinged. Have you looked at the valuation of WD-40 lately? WD-40 is a good company. It has a nice balance sheet. It is the leading performer in the spray lubricant market. The brand name has recognition with people, making it the first choice among people looking to ward off rust, add some grease, and displace moisture and dust buildup.

But still, this company is a slow grower. It has a ten-year growth rate of 4%, and a twenty-year growth rate a bit above 5%. This was okay in the 1990s, as the company yielded around 4% to 5%. Even with 5% growth, you still got market-average returns when you included the dividend. If you owned it for the long haul, you get richer at a jogging pace, and there is nothing wrong with that.

This is a company that usually trades between 16x earnings and 20x earnings. That makes intuitive sense, as the company provides in quality what it lacks in growth. But right now, the company trades at $95 per share. The P/E ratio is 31. The dividend yield, long in the 4% to 5% range, currently sits at 1.6%.

Other than this bull market, WD-40 has never been valued like this, at least since the data going back to 1987 that I’m looking at. I see a brief blip in 1993 when it traded at 24x earnings, and a short period in 2004 when it traded at 21x earnings. Other than this recent run, there were only four years total that the stock traded above 20x earnings between 1987 and 2011. At no point has it traded above 30x earnings like it is right now.

Look at what happened between 2007 and 2015 to shares of WD-40. Back in 2007, it traded at 19x earnings–right around the high end of what you might be willing to pay for the stock. It was making $31 million that year. This year, it is going to make $45 million. You got 45% profit growth over eight years. Yet the price of the stock climbed from $30 to $95. The share price has climbed 216% during the same time overall profits grew by 45%. And between 2014 and 2015, it has only grown profits by 2.97%.. This is textbook irrationality, playing out right before our eyes.

If someone told me they were buying Nike today, I would react by thinking they are getting a little carried away and paying too high of a price for the stock. But the investor buying Nike is still acting far more intelligently than someone buying WD-40 at these prices, as Nike has a realistic possibility of 12-16% annual growth going forward while WD-40’s growth hovers in the 3-6% range.

There are other companies going through the WD-40 experience right now–moderate growth with historically high valuations. I didn’t have any intention to pick on WD-40 specifically, other than the company being something I recently studied and figured it would be good to put a face to this trend I’ve been discussing.

Here is where things get perverse: The smallest company in the S&P 500 has a valuation around $2.5 billion. The rise of WD-40’s valuation has taken the company’s market cap from $750 million to $1.5 billion in the past three years. If the valuation becomes even more extended–say, near 40x earnings or so alongside moderate growth–the company could find itself entering the S&P 500 at precisely the moment it is most overvalued. That is a flaw in S&P 500 construction that gives weighting preference to market cap–when a company becomes more expensive and sees its P/E and market cap rise, it is going to take up a larger place in the index compared to a company that is getting cheap and finds its influence on the index shrink as the P/E ratio diminishes.

The bargain sale on General Electric has come to an end, but it’s not necessarily a cause for lamentation–adding to GE right now is still far more rational than many of the other opportunities available in the S&P 500 at current valuations. And that may soon include WD-40 as well, if the valuation of the stock becomes so extreme that the market cap exceeds $2.5 billion or so.

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