Now, for the flip side of the argument. Just as it is a mistake to sell a corporation like Nike or Johnson & Johnson when the market quotation of the stock looks like it might have gotten a little overheated, there does exist a price at which holding onto a stock becomes foolish because the future returns will be so impaired by P/E compression that even a great company would lose its ability to create meaningful wealth from that price point.
The late 1990s provided a good illustration of when those mega-cap firms can get a little too pricey. Coca-Cola traded in the vicinity of 70x earnings. Since the summer of 1998, Coca-Cola has only returned 3.44% annually. That’s actually an extraordinary result under the circumstances, considering that Coca-Cola has spent the past eighteen years growing earnings to offset the brutal P/E compression from 70x earnings to the neighborhood of 20x earnings. The fact that such an investor has something positive to show for it is actually a vindication rather than repudiation of owning excellent company as positive returns eventually resulted from epically bad valuation decisionmaking.
Anytime you design a rule to apply, you have to incorporate the risk of either being overinclusive or underinclusive. The trade-off equation looks something like this: Are you more concerned about eliminating the risk of selling an excellent company too early, or are you more concerned about avoiding the lower compounding rates that would result from a refusal to seize the gift of cashing out shares for way more than the fundamentals of the stock would justify?
In my view, it is better to design a rule that errs on the side of overincluding some stocks that probably ought to be sold but get held on anyway rather than assume the risk of selling too soon and watching a superior go on to deliver excellent results after you sold it.
This seems to be the right side to err because: (1) successful investing should be about identifying the right businesses to passively own rather than respond to each change in the P/E ratio; (2) selling comes with frictional costs such as broker fees and taxes and should therefore be disfavored; (3) excellent businesses generally perform well even from initial measuring points that include a higher-than-comfortable P/E ratio so we don’t want to set ourselves up for significant errors of omission; (4) most overvaluation can be burned off from superior businesses as Coca-Cola still delivered returns that matched inflation from the insane P/E ratio level of 70. If a superior business can overcome 70x earnings and still give you 3.44% returns, surely a P/E ratio of 25-30x earnings ought to still give you objectively reasonable results.
And again, we are trying to craft a rule for the absolute first tier of businesses, not just publicly held corporations in general. Because we are focusing on the businesses that drown their owners in cash, the overwhelming preference is to build long-term wealth through the receipt of dividends and earnings growth (rather than by opportunistically exploiting favorable changes in the P/E ratio).
With this context in mind, this is the rule I would draw up: Only sell a stock like Johnson & Johnson if the current price signals that you are giving up five years of capital appreciation. You find the five-year earnings per share forecast, compare that to the ten-year average P/E ratio, and then compare that to the current price.
Johnson & Johnson is expected to earn $9 per share in profit in 2021. The ten-year average P/E ratio for Johnson & Johnson is 17.2x earnings. If the price of the stock hit $154 per share this year, that’s the turning point when I would say: “Yes, buy and hold is greatly preferred, and yes, this is a superior business, but the amount of overvaluation that currently exists is so extreme that it would be the equivalent of rejecting a gift to continue holding the stock. The price of the stock’s relationship to the underlying fundamentals has become too attenuated, and I’m going to sell Johnson & Johnson at $154 to buy something like Diageo at $108 because the latter will almost assuredly increase my compounding rate because the earnings growth at both firms is nearly identical over the long haul and Johnson & Johnson will have to face meaningful P/E compression while Diageo will enjoy a bit of P/E expansion over the long run.”
The caveats to keep in mind with this approach:
#1. The higher the tax rate on the account, the less viable this strategy is to execute. Someone in California that has held Johnson & Johnson for 25+ years in a taxable account and is sitting on a substantial capital gain might even be better off holding Johnson & Johnson stock after a run-up that greatly exceeds fundamentals.
#2. This only applies to superior businesses in non-cyclical industries. Large companies tend to experience P/E reversion and have business models that whose earnings can be predicted within a general range of accuracy. Mid-cap and small-cap corporations, as well as cyclical ones, were not on my mind in designing this approach.
#3. This strategy is designed to err on the side of overinclusivity. It could very well be wise to sell Johnson & Johnson at $145 if it hits that price this year. I’m willing to accept that risk of lower compounding because I am more concerned with avoiding the common error of discarding a great business simply because it got valued like a great business plus a little bit of additional something. If Coca-Cola’s earnings proved so resilient it could eventually pace inflation over eighteen years from a base of 70x earnings, I’m not going to discard something of exceptional quality even though the price gets a little frothy. Johnson & Johnson traded at 27x earnings in 2000, and someone that bought the stock at that unfavorable valuation still compounded at 8.42% annualized through the present day.
Johnson & Johnson is not a corporation that is meant to be sold. For that reason, the hurdle for selling it should be quite high. For me, I would draw a line when it appears you are giving away five years of capital gains due to expected P/E reversion. That’s a high enough hurdle that should prevent you from making the mistake of selling a high-quality business when the investor community recognizes it as such, but also recognizes that price is the measuring anchor from which all future returns are determined. It lets you give a nod to Jesse Livermore’s recognition right before death that “most of the money is made by sitting” while also acknowledging the Benjamin Graham wisdom that a price exists at which even a great business would cease to be a great investment.
Originally posted 2016-04-11 14:33:22.