I don’t think people realize how difficult it is to deliver annual returns in the 10% range once you reach a certain size. In the case of Wal-Mart, it is almost incomprehensible how huge this company is. In terms of revenue, it generates about $487 billion per year. They sell about $1.3 billion worth of goods every single day. It wouldn’t surprise me if, within the next fifteen years, Wal-Mart comes closing to moving $1 trillion worth of merchandise in a given year. In terms of profits, Wal-Mart makes about $16 billion in a year. That’s a little bit less than in 2012 when Wal-Mart made just shy of $17 billion per year.
It doesn’t get a lot of attention these days, because its yield is 2.31%, its natural earnings per share growth rate has been somewhat low in the past few years, and the P/E ratio in the 17-18x earnings range likely means that the stock is trading at a price towards the high end of what you’d consider fair.
Yet, I continue to admire Wal-Mart’s stewardship of shareholder capital. It has delivered 6% annual returns over the past ten years, which I find commendable under the circumstances: In 2004, Wal-Mart was trading at 23x profits, as investor expectations for the stock had gotten higher than justified (based on current known factors, I consider Wal-Mart’s fair value to be between 14 and 18x profits. If it gets cheaper than 14x earnings, you’re buying the stock on sale. Once you hit 19x earnings or so, you start to approach the territory where your total returns lag the earnings per share growth of the business.
In terms of business performance, Wal-Mart’s management team has turned in an excellent decade. They’ve grown profits per share by 10.5%. That’s all you have a right to expect with a company of that size. The management did their job. As investors, if we bought in 2004, we overpaid. No, it’s not some terrible hardship—you still increased your purchasing power at a rate that is double inflation, so it’s nothing to lament. However, if you are constantly seeking to improve your investing skills, then it is important to recognize that large, mega-cap retailers shouldn’t be bought when the starting earnings yield is below 5%.
If you want to approach a Wal-Mart with a value investing mindset, than you insist on a price below 14x earnings, or $67 per share. You could have gotten that kind of valuation at some point in the calendar years 2007, 2009, 2010, 2011, and 2012. If you want to be a growth-at-a-reasonable-price investor in which you just want total returns that mirror the growth of Wal-Mart the business but do not demand the accelerator of P/E expansion as well, then you should consider purchasing shares anytime the price of the stock is in the $67 to $84 range. As your price rises above that, it becomes increasingly likely that your long-term returns will lag the growth of the business (as was the experience of those Wal-Mart owners that established their position in 2004).
What I find commendable about Wal-Mart’s management team is that they have not “reached for” profits by raising prices to pad the bottom line during a period of slower store rollouts. It could be very tempting to try and raise the profit margins to something like 5% so that they could report higher short-term profits, but it would be at the expense of ceding market share to Amazon, Target, and a few others as Wal-Mart would be diminishing its competitive advantage which is low industry prices.
When I study Wal-Mart, I am reminded of Warren Buffett’s thoughts on GEICO from when he sent a letter to George Young at National Indemnity back in 1976. Buffett wrote at the time, “I have always been attracted to the low-cost operator in any business and, when you can find a combination of (1) an extremely large business, (2) a more or less homogenous product, and (3) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty-five years ago when I first became interested in the company, and it still prevails.”
Wal-Mart makes a profit of 3.5% on all its goods; ten years ago, the figure was 3.6%. Wal-Mart management has refused to reach for extra profit by raising its profit margins, and in the process, surrendering its low-cost advantage of its peers. I find this strategy praiseworthy, as it keeps long-term competitive advantages in mind when making short-term decisions.
The stock has been relatively cheap since 2006. Wal-Mart has been using its free cash flow (the dividend typically consumes only 25-33% of cash flow, compared to Target which is currently dedicating 60% of cash flow to the dividend) to repurchase very large amounts of stock. In 2006, Wal-Mart had 4.1 billion shares outstanding. That has been reduced to 3.2 billion in 2014, for a reduction in shares outstanding of 22%.
The reason why Wal-Mart trades at the high end of a fair price now (while a lot of other blue-chips are 15% or 25% overvalued) is because analysts had been concerned by Wal-Mart’s decision to slow down store rollouts as it determines whether it wants to expand primarily through new supercenters or the smaller, more focused neighborhood stores that have become more popular (just look at the explosion in the profits at the dollar stores to see what I mean). I find this concern more than more trivial but manageable: Wal-Mart is still going to expand its 11,000 store count by 600 in the next year, and it’s going to be retiring 90 million shares of stock in the next year as it has more cash flow available from slowed down store expansion.
Wal-Mart seems on pace to be making around $7.50 per share in profits five years from now. If you figure the stock will be valued around 16x profits at that time, we are looking at a fair price of around $120 per share. You also get a 2.3% dividend yield that should grow somewhere around 8% annually over that time frame. My conclusion is that the stock is at the high end of what you’d want to pay, and it’s probably worth being patient, but you probably will receive satisfactory high single-digit total returns if you buy at this current valuation.
Originally posted 2014-11-20 08:00:36.
