Value Investing

Beware The Financial Destruction Of Overvaluation

Beware The Financial Destruction Of Overvaluation by Chuck Carnevale – F.A.S.T. Graphs

Introduction

After such an extended bull run it’s only logical to assume that many stocks are trading at frothy valuations.  On the other hand, it’s also important to keep in mind that it is a market of stocks and not a stock market.  Nevertheless, the truth is that many stocks are now significantly overvalued based on both historic norms and fundamental values.  This is not true of all stocks, because it is also true that there are high quality stocks available today that are fairly valued.  However, they are admittedly getting more difficult to find.

But perhaps more pertinent to the purpose of this article, is the fact that there are many high quality blue-chip stocks that have become overvalued starting 2 or 3 years ago, and remain overvalued today.  This is one of the most insidious and dangerous aspects of overvalued stocks.  A great company can become overvalued and continue to generate strong returns for years to come.  This is typically a result of popularity because a steadily rising stock price attracts investors just as a bright light attracts moths.

Therefore, investing in an overvalued stock does not necessarily mean that you will immediately lose money.  However, I contend that it does mean that when you are investing in an overvalued stock you are taking on more risk than you should be for the long-term return potential you are likely to receive.  This is especially true for the prudent long-term oriented investor.

Although you can make attractive returns investing in an overvalued stock in the short run, in the long run I suggest you are doomed to earn returns that are too low relative to the risk you are assuming.  Academics would refer to this as stocks inevitably reverting to the mean.  To me, this is simply a fancy way of saying that a company’s stock price will inevitably move towards fair value.  Sometimes it happens very quickly, and other times it is delayed for an extended period of time.  But, in the long run, Ben Graham’s weighing machine principle will inescapably apply.  You don’t want to be holding a stock no matter how high quality it is when this inevitability occurs.

But the most important message that I am endeavoring to convey with this article is that overvaluation risk is a mistake that is easily avoidable.  Investing in stocks by its very nature exposes you to the potential to make mistakes.  Many mistakes are unavoidable and only practices such as proper diversification can protect you from these.  On the other hand, there are mistakes that are easily avoidable; therefore, it is imperative that investors do not expose themselves to making obvious errors.

Investing Is Most Intelligent When It Is Most Businesslike

The venerable Warren Buffett once said that “investing is most intelligent when it is most businesslike.”  These wise words speak to the truth that overvaluation is a risk that is easily avoidable if you think like a business owner.  This simply means embracing investing strategies that are predicated upon simple principles of business.  To illustrate this important concept, I often use a simple business oriented analogy and apply it to common stock valuation metrics.  When these metrics are thought out from the context of a business owner, clarity and understanding often follows.

One of the most commonly utilized valuation metrics on common stocks is the P/E ratio.  Unfortunately, to many investors it is simply a number or a statistic.  However, in order to truly understand the relevance and importance of the P/E ratio, it is quite useful to think of it from the perspective of a business owner.  To accomplish this, let’s create a hypothetical scenario where you are the owner of a business that is generating you a net profit or income of $100,000 annually.

Next, let’s pose the question: What would you be willing to sell that business for to a willing buyer?  And then convert that value conceptually to a P/E ratio.  With the following, I will examine a couple of offers from low to high and apply rational reasons why I might, as a businessman, accept or reject these various offers.  My goal is to provide insights into what various P/E ratios actually mean from a business perspective.

For example, if someone offered me $100,000 for my business, that would translate to a P/E ratio of 1.  No businessman in his right mind would accept such an offer because the business is earning that much annually.  A rational businessman would only sell their business if they believe the proceeds were high enough to generate a comparable annual income at a prudent rate of return expectation.

Historically, a common and acceptable P/E ratio for common stocks has averaged around 15.  If I apply a 15 multiple (P/E ratio 15) to my business generating $100,000 annually my sell price would be $1,500,000.  My rational business mind might assume that a rate of return of 6% per annum could be achievable.  Therefore, if I invested the $1,500,000 at 6%, I would earn $90,000 per annum.  Although that is slightly less than my business is currently generating, I might be willing to entertain that valuation considering that I would no longer have to work.  My money would be working for me instead.

Obviously, from a seller’s point of view I would rather sell my business at a higher multiple such as 20 times annual earnings (P/E ratio of 20).  If I was able to get that higher multiple for my business, I would sell it for $2 million (20×$100,000) which would generate $120,000/year of income at 6%, or 20% more than my business is currently making.  This would give me a 20% raise and I wouldn’t have to work to earn it.  On the other hand, from the seller’s point of view, I would rather purchase the business at a lower multiple.  The same principle is in effect here.  The $100,000 that the business is generating would represent a higher return for me if I purchased it at a lower valuation.

Now, obviously the above examples are conceptual and presented in order to relate the principles at work.  Obviously, the analogy does not take into consideration taxes and other important issues.  For example, if the business was growing very fast, I would expect a higher multiple (P/E ratio) in order to compensate for the opportunity cost of giving up higher future earnings potential.  In contrast, I might be more motivated to sell at a lower multiple (P/E ratio) if I expected the business to weaken over time, etc.  Nevertheless, the point is that assessing the fair value of my business is predicated on revenues past, present and future.

This is how a businessman makes buy, sell or hold decisions.  Therefore, I am suggesting that common stock investors are acting most prudently when they are basing their decisions on these same business principles.  The only real difference is that investing in publicly traded stocks in an auction market presents a constant stream of bids and asks that prospective investors must evaluate in order to make a decision to invest or not.

To add further clarity to these principles I would like to illustrate some other aspects of what various P/E ratios are implying.  For example, a P/E ratio of 25 means that you are willing to pay a price that equates to 25 years of current earnings in advance.  A P/E ratio of 15 means that you are willing to pay a price that equates to 15 years of current earnings in advance and so on.  The secret to ascertaining whether either of those valuations is prudent or not, rests upon your expectations of the future growth potential of the stock (business) in question.

More simply stated, the only logical reason to pay a high multiple of current annual earnings for a business is because you believe it is going to grow rapidly going forward.  Otherwise you are overpaying, and thereby taking on more risk by purchasing future cash flows at a level where they cannot possibly generate an acceptable long-term return.  A smart businessman is not willing to overpay for a future stream of cash flows because they think as a smart businessman should think.

However, common stock investors who are only seeing a stock as a lotto ticket or a poker hand often lose their presence of mind.  They forget all about the business principles discussed above and become attracted to stocks that are rising regardless of what the valuations truly mean.  Unfortunately, they can get away with this behavior over short periods of time.  However, in the long run, the reality of the business principles discussed above, are certain to come into play.  When that happens, overvalued stocks will begin to fall – and sometimes swiftly.

Beware the Financial Destruction of Overvaluation

Frankly, I have waited a long time to write this article.  Our current raging bull market has gone on a long time, and with it the valuations of many blue-chip stocks have become extended.  However, since this has continued on for so long, attempting to warn investors of the dangers of overvaluation would be speaking to deaf ears.  As long as the stock price is rising, valuation is irrelevant in the minds of many.  I understand that, because who doesn’t like to see the price of their stock increasing every month or year.

On the other hand, I have personally coined the phrase that measuring performance without simultaneously measuring valuation is a job half done.  Admittedly, just like everyone else, I take pleasure when I see a stock I bought trading significantly higher than my purchase price.  However, I am always measuring the stock price against calculations of fair value.  As a result, when I see one of my stocks that has gone up and is significantly beyond a reasonable valuation, my pleasure quickly turns to worry.  However, unfortunately for many people a rising stock price typically breeds complacency.

Nevertheless, now that the bull market is aging, I am already seeing the beginnings of the devastating results that can come from overvaluation.  For me, there is good news/bad news associated with this last statement.  The bad news is that many of my favorite companies (businesses) on the planet have risen to unacceptable levels of overvaluation since the beginning of 2013.  This is bad news, because these are the companies I admire the most, and therefore, the ones I am most motivated to invest in.  However, current high valuation levels are dissuading me.

The good news is that the reversion to the mean (movements towards fair value) appears to have started on some, and some have even come into my fair valuation ranges.  Therefore, some of my favorite companies have become research worthy, and others are starting to look like they’re going to eventually get there.  I might add that this is occurring while the bull market rages on.  Personally, I could care less about the value of the market.  Instead, my interest rests in the specific valuations of the great companies I would like to own.

To illustrate what I’ve been writing about, I offer the following earnings and price correlated F.A.S.T. Graphs™ on several of my most favorite companies (stocks).  What I am seeing is the inevitable results of the dangers of investing in overvalued stocks.  Some of the following examples have already moved to fair value, others look like they’re on their way.  However, what I most hope to accomplish with the following examples is to illustrate my point that overvaluation is an obvious mistake that can, and should, be avoided.  I will provide brief commentary on each to illustrate what I believe I am seeing.

Walt Disney Company (DIS)

Disney is a favorite of mine as a high quality total return candidate.  The company’s historical earnings growth rate and record has been above-average and I believe exceptional.  The company pays a moderate dividend, but the dividend has historically grown at a rate consistent with its historical earnings growth.  However, the company did become overvalued in early 2014, but since July 2015 reversion to the mean has happened.

Although I would like to see the stock a little cheaper, I believe that the shares can currently be purchased within a reasonable range of fair value.  Additionally, the earnings and price correlated graph since 2003 clearly illustrates the relevance of valuation.  Periods of high valuation as occurred in 2003, 2004 and at the beginning of 2005 were clearly less-than-optimal times to purchase Disney.  The same occurred since the beginning of 2014.  Otherwise, Disney’s stock price closely tracked its earnings justified value and occasionally was available at very attractive valuations.

Financial Destruction Of Overvaluation

Hormel Foods Corporation (HRL)

Another favorite of mine for long-term total return is high quality Hormel Foods.  The company has low debt, a very consistent record of growing earnings and dividends, and its stock price has historically tracked earnings within a reasonable range of fair value (between the blue normal P/E ratio and orange earnings justified valuation line).  However, by the spring of 2013 the stock became overvalued separating from fair value and remained there for approximately three years.

I consider this an excellent example representing the risk of owning an overvalued stock.  Since the spring of 2016, Hormel’s stock price has been in a freefall of approximately 20%.  The overvaluation correction can occur very quickly at times, and take longer and other times.

Financial Destruction Of Overvaluation

AmerisourseBergen Corporation (ABC)

AmerisourseBergen is a classic example of how quickly overvaluation can be corrected by the market.  In this example, a couple of years of exceptional growth created a level of euphoria that drove valuations beyond reasonable levels.  Consequently, it didn’t take any significantly bad news to bring stock price down approximately 35% over the course of one year.

Additionally, AmerisourseBergen represents a clear example of what I mean by overvaluation being an obvious mistake.  The disconnect from fair value (the orange line on the graph) was crystal clear starting in early 2013.  The stock price continued to rise for a while until the inevitable reversion to the mean.

Financial Destruction Of Overvaluation

McKesson Corporation (MCK)

Since McKesson operates in the same industry as Amerisourse, it’s not surprising to see a similar pattern of stock price action relative to fundamental value.  These two examples illustrate a classic case of an industry that gets too hot and then quickly becomes too cold.

Financial Destruction Of Overvaluation

Nike, Inc. (NKE)

Nike is truly one of my favorite companies on the planet.  However, I’ve been quite frustrated in recent years with what started to look like perennial overvaluation.  This blue-chip became overvalued and stayed that way for approximately three years.  This type of relentless stock price advance will cause many people to doubt the principles of valuation.

On the other hand, price action for 2016 is hopefully bringing the importance of valuation back to the forefront of people’s minds where it belongs.  However, it is also possible that Nike’s stock price could turn around and begin advancing again from here.  Mr. Market can be a very fickle and unreliable partner.

Financial Destruction Of Overvaluation

The Sherwin-Williams Company (SHW)

I offer Sherwin-Williams as an example representing my point about how fickle Mr. Market can be.  In a similar fashion to Nike above, this company has remained significantly overvalued for several years.  However, there was a significant correction from May to September of 2015 of approximately 20%.  On the other hand, Sherwin-Williams never fell all the way down to full value, and has since gone on to new highs.  I love this company – but I hate its valuation.  Therefore, I consider the risk of investing in it at these levels too great.

Financial Destruction Of Overvaluation

Walgreens Boots Alliance, Inc. (WBA)

I offer the Walgreens’ example in honor of the late great Yogi Berra when he said “it’s déjà vu all over again.”  Walgreens became significantly overvalued in 2003 and its stock price languished until the Great Recession finally instigated it to revert to the mean.  Then starting in fiscal year-end 2013 the stock became overvalued again and stayed that way until the summer of 2015.  Since that time, the effects of overvaluation are apparently taking its toll.

However, there is a more insidious aspect of a stock that falls from being overvalued compared with one that falls from being fairly valued.  Walgreens provides an excellent example of this point.  On August 31, 2005, Walgreens was trading at a high P/E ratio of 30 and a price of $46.33, which was significantly above its earnings justified valuation.  Over the years, as the stock price move back into alignment it took until March 29 of 2013 (the red line on the graph) for the market price of Walgreens to recover to its overvalued level.  That covers an approximately 7 ½ year time span, which is too long a time for even the most patient long-term investor.

Financial Destruction Of Overvaluation

In contrast, on July 29, 2011, Walgreens was trading at a fair value price of approximately $39 per share.  By June 29 of 2012 (approximately one year later) the price had fallen approximately 24% to $29.58, and at that point it was significantly undervalued with a P/E ratio of only 10.  However, in this case Walgreens’ stock price returned to the $39 per share level in just over a year’s time (the red line on the graph), and since then has moved significantly higher.

The point is that there is a significant difference between a stock price dropping from overvaluation territory compared to a stock price falling from fairly-valued territory.  In the former it can take an unacceptably long time to recover, but in the latter, recovery can and usually does happen very quickly.

Financial Destruction Of Overvaluation

V.F. Corporation (VFC)

VF Corporation is another favorite of mine that became significantly overvalued in 2013.  What I find most interesting about this example are two things. First of all, this company’s stock price has closely correlated to its earnings justified value until it suddenly became overvalued.

But secondly, what I found most interesting about this was the fact that earnings growth accelerated in 2010 and 2011 while the stock stayed fairly valued, and then it became significantly overvalued after earnings growth slowed down in 2013 and 2014.  Doesn’t make sense to me, but that is the fickle stock market for you.

Financial Destruction Of Overvaluation

Polaris Industries Inc. (PII)

I find the example of Polaris Industries fascinating on several fronts.  The company’s earnings growth did accelerate starting in 2010 through 2014 and the market lavishly rewarded that growth.  However, as is often the case, the valuation went too high.  This really puts a spotlight on the risk of owning an overvalued stock.  When a company becomes as overvalued as Polaris was, it is priced for perfection.  However, earnings flattened in fiscal 2015 and the perfection was gone.  From peak-to-trough, this company fell more than 50% before staging a modest recovery in the spring of this year.

Financial Destruction Of Overvaluation

Summary and Conclusions

With this article I have presented what I consider to be the rational dangers of investing in overvalued stocks.  When a stock, especially extremely high-quality stocks like those covered in this article, get overvalued and stay that way, they become very enticing.  Since the companies are highly regarded, it is very easy to overlook extreme levels of valuation.  Nevertheless, the principles of valuation are immutable, and the reality of an eventual reversion to the mean inevitable.

As stated in the article, investing in stocks contains risks, and as a result, mistakes are sure to be made.  There are some mistakes that are simply unavoidable and investors need to apply proper strategies such as diversification to mitigate those risks.  On the other hand, certain mistakes are clearly avoidable if you are investing based on reason rather than emotion.  Overvaluation is an avoidable mistake if you apply sound principles of business to your analysis.

Disclosure:  Long ABC

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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