A quick word on Wal-Mart stock. Did you see the recent news that Wal-Mart plans to close down 269 stores? It is a mostly a non-event that affects about 0.5% of Wal-Mart’s revenues, as 256 of the 269 underperforming stores being closed are those that are located within 10.5 miles of another Wal-Mart. Given that earnings at Wal-Mart in 2016 and possibly 2017 are expected to be lower than Wal-Mart’s 2014 reported earnings estimates, you may fairly wonder: Why do I consider Wal-Mart a good purchase in the low $60s, rather than advocate waiting until the earnings show signs of a turnaround?
Isn’t there an opportunity cost associated with holding a company whose earnings aren’t growing? Yes, there is an opportunity cost of waiting for ideas to come to fruition, but what must be remembered is this: The opportunity cost of waiting for earnings to improve, however, is not the same thing as waiting for the stock price to improve. Since the price of a stock is a function of future expected business performance, it is typical for a stock to improve in stock price before the fundamentals fully justify it.
Take something like McDonald’s. This past May, I wrote an article titled “McDonald’s Stock: Your Best Bet For A Real Estate Investment” in which I calculated that a sum of the parts analysis would put the value of McDonald’s stock somewhere around $129 per share. At the time, the stock was trading at $97 per share. I figured the stock was trading at a 25% or so discount to what it was worth, and though it was above the recent lows of $88, the terms still offered a good deal.
Since then, the earnings have only gone up a nickel per share–we are talking about 1% earnings growth since my May article, yet the price of the stock has appreciated almost 20%. The earnings are bit understated due to the strength of the dollar, but even on a constant-currency basis, profits are still up only 4.5%. The disparity between the price appreciation and the actual business performance is the result of two things: (1) the constant-currency projections for McDonald’s changed from low single digits to 7% over the medium term, and (2) this change in sentiment prompted other investors to realize that they were valuing McDonald’s stock too lightly.
If someone insisted on waiting for the measurable earnings per share growth to arrive before considering McDonald’s stock, then they would have missed a good chunk of the P/E expansion that precedes the growth.
Peter Lynch often talked about how much fun he had borrowing stodgy old blue chips at undervalued valuations, saying most people missed out on how much money could be made just betting on the reversion to the mean P/E principle with large non-cyclical companies.
The difficulty of this strategy is that it can require patience, and of course, there is no guarantee that the price appreciation will precede the earnings growth–it’s not hard to imagine an alternative universe where McDonald’s had to actually deliver the earnings growth before the price caught on (that’s what happened with Johnson & Johnson back when it was enduring recalls in the $60 per share price range. It delivered some earnings growth, and then suddenly people regained their senses, and the price of the stock shot up $40 per share in a twenty-month period).
This is why I spend my time focusing on the “what” rather than the “when.” The question I ask myself is this: Does a substantial amount of P/E expansion lay ahead for this stock? If the answer is yes, then it is a good candidate. But predicting the “when” part is a fool’s errand because you are compounding your tasks in a speculative way–not only do you have to make rational estimates about what the business will do, but you have to tie it to the speculative prediction of when and how investors will react to that information at a precise time. I prefer strategies that can find success with the fewest moving parts.
I’m spending most of my day going through the drafts folder of half-finished articles to see which ones are worth finishing/publishing and which ones are worth discarding because the premises are weak, and I do wish I had finished this article when I started it because Wal-Mart stock was trading at $60 then so it was a bit easier to draw out the point (with Wal-Mart approaching $67, it’s more like analogizing to McDonald’s at $105).
But the central premise is timeless and not covered frequently enough. There are mistaken impressions that seem to persist in the field of investing. The first is that a dividend cut, particularly in a cyclical industry, is a time to sell a stock. That’s folly–the dividend cut is probably a signal that the stock is cheap as the previous income investor class shuffle out of the stock–selling it a damn near any price to the value investors that are moving in (you’re seeing that with Conoco right now).
The other mistaken impression that persists is the notion that you should wait for the earnings growth to arrive before considering the purchase of a stock. This mindset fails to realize that the absence of such growth at the present moment is the reason why a given stock has become temporarily undervalued. When you notice that a stock is unusually cheap, and still expect the earnings recovery to take a few years, it should not be a foregone conclusion that you should wait for the earnings growth to materialize before buying the stock. Just as McDonald’s shareholders of late have been reaping substantial capital gains before the earnings growth has really returned, I anticipate that the Wal-Mart shareholders that buy in the low $60s will see the stock price return to the mid-$70s (and beyond) before the stock delivers earnings per share growth that matches the stock price rise.