In 2016, I have a special affection for Tiffany stock and Wal-Mart stock in the $60s, Hershey in the $80s, Diageo drifting towards $100, Coca-Cola at $41, Johnson & Johnson at $95, and Berkshire Hathaway at $125. The first ones I mentioned have been bumped towards undervaluation, which is something to get excited about given the high earnings quality of the company. The latter ones are at the low end of fair value, which is something to get excited about because we are talking about three of the top fifteen businesses in the world.
Now, sometimes people might think: Why should these types of stocks be considered now, rather than waiting for a more attractive opportunity in the event of a deep market slide? Isn’t the opportunity cost of waiting for a better market opportunity worth it if the magnitude of the expected market decline multiplied by the time expected waiting for it to happen reveals greater long-term results than buying now?
The problem with identifying opportunity costs in this manner is that it assumes that large-cap American stocks will offer the best risk-adjusted opportunities during moments of recessionary prices. That assumption often proves unwarranted as stocks with lower quality earnings tend to endure more irrational pricing during times of distress. And if you have a fixed amount of capital to invest–everyone does–then it stands to reason that more attractive opportunities would exist concurrently at a time when/if Hershey traded down somewhere at like $65 per share.
Today, I was reviewing the history of Popeyes Louisiana Chicken (PLKI). This is not the kind of asset you would want to own for a lifetime. It is something that should be part of an international estate planning strategy. The brand is mostly unremarkable, the balance sheet average, and the growth is likely to trail the collection of businesses that make up the S&P 500 over the long run.
The strongest counterargument against my suggestion of Popeyes’ general inferiority is this: The stock has returned 12% annually since Goldman Sachs teamed with Credit Suisse to create a primary offering of stock during the IPO in March 2001, and the brand strength is strong enough to sell chicken at triple profit margins than you see at something like McDonald’s–and Popeyes executes a franchise operating model in which 1,857 chicken joints have a franchisee and 68 are run by Popeyes itself.
My response to that argument would be: (1) Those 12% annual returns since 2001 are illusory because Popeyes is almost always wildly mispriced. During bad times, it gets unfairly beaten down. And during good times, the stock gets unduly elevated. If you measured the returns from the 2001 IPO through 2010, you would have compounded at almost -3% annually and turned $10,000 into $8,000. Profits have doubled since 2010, but the price of the stock has increased by a rate of 680%. (2) The advantages of the business are not significant, as fast-food chicken is a competitive industry subject to rapid changes in foot traffic during changing fads or downturns in the business cycle.
Depending on interest rates, balance sheet debt, and a few other factors, this is the type of asset that I would value somewhere between 13x earnings and 17x earnings as my definition of the fair value range. It has only traded within that range during four of the fifteen years in its trading history.
It is subject to wild swings in sentiment that subject the stock to either wild undervaluation or wild overvaluation. After hitting a high of $21 per share in 2007, it fell to $3 per share in 2008. It also traded in the single digits in 2009 and 2010. That was beyond insane, as the earnings power of Popeyes even during the worst of the recession provided it didn’t merit such a decline.
Popeyes earned $0.76 per share in 2008 (and the profits only fell to $0.74 in 2009, with the then all-time earnings high being the $0.80 per share in 2007). This is a company that made about $20 million in profits before, during, and immediately after the financial crisis. When the valuation got down to $3, you were being offered a business making $20 million for a total price tag of $75 million. It was a P/E ratio of 3.75.
It was one of those rare, real-life opportunities to buy a company selling at a discounted price that was comparable to what investors were doing during The Great Depression. If you were a deep value investor, you had to love it. It’s also one of the reasons why deep value investors reject the academic arguments behind using beta as a measurement tool of risk–an analysis based on beta, or the price volatility of a specific stock compared to an index like the S&P 500, would have been extreme as the price plummeted from $21 to $3. The S&P 500 lost around 35% at this time. Yet, while beta analysis would be claiming that Popeyes was becoming riskier, it was actually becoming safer as the probability of high future returns from the $3 price point compared to $0.76 in profits was the safest time you could ever invested in the stock.
Now, those cheap valuation days for Popeyes are gone, and the valuation of the stock is moving in the other direction. Those $20 million profits have grown to $44 million in profits, as profits have climbed from $0.76 in 2008 to $1.90 in 2015. But the valuation has soared ever higher, taking the stock to $60 per share. That is a valuation of 31.5. Yikes. The stock is due for a long-term P/E compression of around 45% that will act as a strong headwind chomping off a significant percentage of future returns.
Although Popeyes is the specific company that has been on my mind, it is a real-life example that makes specific the general principle that inferior quality companies tend to get unfairly punished in the bad times and unfairly lifted higher during the good times.
What does this mean if you are someone that invests as money becomes available? It means that, in generally prosperous times, you should really load up on the highest quality companies during the good times as they don’t get incorporate a lot of nonsense into their price (though some, like Nike right now, do get taken quite higher if they are blue chip and delivering 15% earnings per share growth.) But during the recessions, or at least severe market declines, it is the companies of a slightly lower quality that may offer the best risk-adjusted returns as their prices tend to incorporate more nonsense both on the way down and up.
It is almost axiomatic to suggest that companies like Coca-Cola or Johnson & Johnson will trade at better valuations in markets like 2009 or 2007. But when you deploy cash, you are also comparing available opportunities to the other opportunities that exist at that time. In 2007, the relative valuation of Johnson & Johnson compared to other stocks was more favorable compared to the opportunities that were competing with Johnson & Johnson for your investment dollars in 2009.
The Wall Street jargon for this phenomenon is “flight to safety” as stodgy blue chips become more attractive investment centers when the magnitude of economic uncertainty increases. If true, and if you are someone that invests on a regular schedule, how should that information affect your roadmap? I would say: Among common stock investments, you might want to invest in 75% high-quality firms in good/ordinary times and 25% in firms with better price appreciation potential.
But when bad times arrive, you may want to consider an equal allocation between quality and moderate quality. If you are immune to volatility–and I don’t mean that glibly, you really have to be immune otherwise this strategy would be a disaster–and can value cash flows, there are many companies that continue to earn impressive profits during bad times and don’t even require forecasts of “bounceback profitability” in order to determine that they are good investments under these circumstances.
It seems to me that profitable but unexceptional businesses should be increasingly discarded as economies improve, but should be increasingly pursued with aggressiveness proportional to a decline in the industry. A business like Colgate-Palmolive is a great long-term investment because of the quality of its earnings and growth characteristics–the time spent in the enterprise is what makes it truly lucrative. With something like Popeyes, it is not the time spent in the enterprise–far from it!–but the timing of the purchase as you measure fair value against the depressed price that may arrive again. There is something to the notion of running towards what I call “profitable distress”–there is a timeliness element that makes this strategy hard, but the prospect of far superior gains over the medium term are why it is worthy of consideration.
Originally posted 2016-01-21 13:29:15.