Those Rarely Mentioned Excellent Blue-Chip Companies

Some of you have written in to me asking why certain blue-chip stocks don’t get mentioned, or only get mentioned in passing, here on the site. I can’t speak for everything, but often it has to do with valuation or my own estimates of future growth.

For instance, I would love to talk about Nike, Brown Forman, Hershey, and Colgate-Palmolive all the time. They are absolutely extraordinary businesses, as they possess both durable earnings quality that can make profits in all conditions AND they also have very strong earnings growth supported by sales figures that increase year in and year out.

My problem? Valuation. It is highly likely that anyone making a lump-sum investment in any of these companies right now will achieve long-term returns that trail the growth of the businesses themselves by an amount that you will find frustrating.

Take Nike, for example. This is a company that almost always trades between 17x earnings and 21x earnings. The only exception prior to the dotcom era has been the years 2012, 2013, and 2014. The price of the stock has been advancing very significantly compared to the growth of the business lately, such that the price of the stock is now sitting in the $97-$98 range even though the business only generated $2.97 per share.

If you care at all about the margin of safety principle before making a large investment, and you are contemplating Nike as your choice, this should bother you a lot: The current valuation of the company is just a shade under 33x earnings. Even though the business is performing excellently, and even though there is a reasonably good chance that the company can grow profits 10-12% annually in the coming ten years, that valuation should still be alarming.

Let’s run two scenarios about the next decade: One in which Nike does well and grows profits at 12% annually, and one in which Nike disappoints investor expectations and only grows at 5% annually.

Under a 12% growth assumption, Nike will be making $9.80 per share in profits in 2024. Under a 5% growth assumption, Nike would be making $4.89 per share in profits in 2024 (by the way, you should note that I find these low assumptions highly unlikely, but I’m modeling it anyway to show you what might happen if you receive positive growth that significantly lags expectations). When the P/E ratio comes down to 20, the stock would trade at $196 under the 12% assumption and at $97.80 under a 5% assumption.

Think about that for a moment—if the stock grows at 5% annually for the next ten years, but the P/E ratio comes down to 20, you will receive no capital appreciation. You will only collect the dividend. The current price offers you no leeway for a couple of years of mediocre performance. If, on the other hand, you receive 12% annual growth and the company trades at 20x earnings a decade from now, you would get a share price of $196 plus whatever dividends are paid out in return. That’s a compound annual growth rate of 7.29% (though the dividends would make this higher).

That’s why I don’t recommend that people holding this stock sell—you can still get the same return with Nike from here that you might get with a slow-growing utility or telecommunications company, and the dividend growth that you will receive should also be significant (although you’re starting out with a very low yield). But still, from the perspective of initiating a significant long-term investment in Nike, I wouldn’t do it here—there will be a spread of about five percentage points between what the business will do and the returns you will receive.

In short, valuation is the reason why some excellent businesses don’t get much coverage here right now. There’s nothing wrong with the business, but the price at which you buy the business is setting you up for somewhat disappointing returns going forward because the premium to initiate a business has gotten quite high (though the overvaluation of Colgate-Palmolive is not as bad as Hershey, Nike, and Brown Forman).

Other businesses don’t get much coverage here because I believe they will have a low earnings growth rate going forward. One of those companies is Campbell Soup. My personal predictions are that earnings per share will increase around 3-4% per year and you get a dividend of 2.8%. For someone buying the stock over the next ten years, I would anticipate that you get total returns around 5.8% and 6.8%. The earnings quality is great—soup will be around for a long time, and it’s a nice stock to have around for the reliability of the current profits and income (e.g. profits grew from $2.09 in 2008 to $2.15 in 2009, and inch upwards year after year for decades).

But why would Campbell Soup ever be the best option at a given point in time? Heck, ExxonMobil pays out a 2.9% dividends, and repurchases 4-5% of its stock per year, and plus it benefits from growing production and commodity prices that tend to rise over time. 2.9% dividend+4-5% repurchases+4% organic growth= 10.9%-11.9% long-term total returns. Given that Exxon has a higher credit rating and more financial strength than Campbell Soup, and given that it should deliver higher rates of compounding by four or five percentage points over time, why not spent an inordinate amount of time focusing on the blue-chip stocks that have the best combination of growth profiles and earnings quality, rather than pretending that the first element doesn’t exist?


Originally posted 2014-11-26 15:16:59.

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