We are going to start the new year off by looking at Wal-Mart Stores, Inc. (WMT) which we believe is a blue-chip growth and dividend income selection that can be purchased at a sound and attractive valuation. Additionally, we offer Wal-Mart with its historical business results and price performance as an excellent example extolling the principles of sound investing versus speculation. We believe the lessons that this analysis offers are both important and invaluable to investors.
Most rational thinking common stock investors intuitively understand, and we believe would agree, that shareholder value is ultimately created through the operating success of the business behind the stock. The more successful the business is, and the faster it grows as an operating enterprise, the more intrinsic value it generates on its shareholder’s behalf. Of course, the gold standard for measuring business success is profit growth. The more profits a company generates, the more successful it is considered to be.
Wal-Mart Stores, Inc. (WMT) is inarguably the world’s greatest retailer as evidenced by the fact it is also the world’s largest retailer. Although Wal-Mart has many detractors who believe that it is a retailing juggernaut that ruthlessly crushes its competition, it is hard to argue with its exceptional execution as the low-cost retailer spanning many decades. Wal-Mart’s low prices and wide array of goods has certainly benefited many consumers that needed to stretch their dollars, and this is especially evident during periods of economic weakness like we’ve just gone through.
The following 17-year plotting of Wal-Mart’s earnings per share record depicts a paragon of consistent above-average earnings growth. Wal-Mart’s earnings have increased at a steady and consistent compound annual earnings growth rate of 13.5%, which is more than double the 6.3% earnings growth rate for the average company as measured by the S&P 500 over the same time period. It’s also important to note that this time frame includes the recessions, 2001 and the great recession of 2008. This consistent earnings achievement by Wal-Mart is rare and hard to find among the broad universe of common stocks.
Although Wal-Mart (WMT) has achieved a consistent record of earnings growth spanning many decades, we chose the time frame 1996 to current time for specific reasons which will be made clear as this article continues. First of all, we chose this time frame because Wal-Mart’s performance results over these years correlate very closely with their operating results (earnings growth). Wal-Mart grew earnings at a compounded rate of 13.5% and generated shareholder returns of 12.6%, which represents a strong correlation between earnings growth and shareholder returns. Therefore, the following performance results table offers evidence that validates the thesis that shareholder returns and the company’s business results are functionally related. However, as we will soon see, there is a second overriding and critically important factor that also comes into play ---valuation.
Valuation Can Make or Break Shareholder Results
The primary reason that Wal-Mart’s earnings growth and shareholder returns so closely correlated between 1996 to current time is because valuation was in alignment with earnings at the beginning of this period and earnings and price are also in alignment today (Wal-Mart appears modestly undervalued currently). Therefore, shareholder returns, to include dividends and the growth of dividends, were mostly a function of earnings growth. However, as the following earnings and price correlated F.A.S.T. Graphs™ clearly reveals, valuation was out of alignment for most of the time periods in between.
Since smart investors are always looking to invest in the best businesses, they will attract the most investor attention. However, there is an often overlooked danger associated with focusing on business results alone. Great business results can attract undue and excessive capital which can inflate valuations beyond what business and economic realities would justify. When this happens, investment returns of even the best businesses can become distorted and devalued. Investors need to be aware of, and acknowledge, that the current market price is not necessarily the correct price. Knowing that the market can behave irrationally, and recognizing when it does, either over or under, is a great investor benefit and advantage.
From 1996 through 1999, the period infamously dubbed “irrationally exuberant,” Wal-Mart’s stock price clearly became excessively overvalued. Consequently, even though operating results (earnings growth) continued on its superb and consistent trajectory, stock price had nowhere to go but sideways or down. It appears that investors infatuated with Wal-Mart’s continued success were blinded to the poor economics created by such lofty valuation. Apparently, because the news continued to be so positive each quarter, investors continued to hold their overvalued positions. However, it would also appear that prospective new investors were thwarted by the huge premium they had to pay to buy Wal-Mart shares. Of course, these last statements are based on the assumptions presented, and they seem to be the only logical conclusions that can be drawn from reviewing the facts.
Overvaluation’s Terrible Toll On Shareholder Returns
Regardless of whether our assumptions stated above are correct or not, the mathematics underneath Wal-Mart’s share price based on its earnings justified valuations