Fundamentals & Valuations
As I look out the window on this chilly, Tuesday morning I cannot help but reflect on the beauty of nature. The snow is glistening under the early sunlight and the silence is profound, broken only by the distant chirping of a lone bird. The tree branches are dusted with snow, creating a pristine white appearance. Gardening season is another day closer, but nature is never in a hurry, yet everything is accomplished in due time.
Most young tree saplings spend their early decades under the shade of their mother’s canopy. Having limited sunlight early results in slow growth leading to the development of dense, hard wood. Interestingly, if you plant a tree in an open field, the sapling gorges on sunlight and grows quickly. Fast growth leads to soft, airy wood that doesn’t have time to densify. This soft, airy wood is more susceptible to fungus, disease, and ultimately a shorter life. A tree that grows quickly, rots quickly, resulting in a slimmer chance to grow old.
I presume by now some are wondering why Monarch is talking about nature and trees. If you ponder upon the progression of a tree’s life, it is comparable to how it works in business and investing. History is littered with companies and investors who tried to grow too fast, attempting to reap a decade’s worth of rewards in a year or less. Individuals often learn the hard way that capitalism doesn’t like it when you try to take short-cuts or use a cheat code.
We have routinely addressed the importance of long-term thinking in investing. We have also spoken at length about our philosophy of investing in what we define as quality companies. A core belief of ours is to buy good companies and hold them for the long-term, but another facet to our investing philosophy is that the valuation must make sense. Even if an individual buys the best business, he or she may not make a satisfactory return if too high of a price is paid. Today, investors appear to be so concerned with anticipating the future that they are already paying handsomely for it in advance. Stated another way, even if a company grows by double-digits over several years, it may not result in much profit to the investor if the price paid was too high.
Below are a couple of companies that meet several of the criteria we look for in stocks / businesses to own, but the valuations of these companies are just too steep for our liking. We would love to own them, but it is much more difficult at today’s valuation levels. Buying great companies at 15-20x earnings has worked out well historically but buying them at 50x+ earnings is probably a different story. It reminds us of the proverb, “What the wise man does in the beginning, the fool does in the end.”
The graphs on the following page show two companies’ price to earnings ratios over the last 20 years. (A price to earnings ratio measures a company’s stock price relative to its earnings, essentially indicating how much investors are willing to pay for each dollar of a company’s earnings. For example, if a stock trades at a 20x P/E ratio, investors are paying $20 for $1 of current earnings.)
Cintas is America’s largest uniform rental company. Cintas collects, cleans, and replaces uniforms for organizations in industries such as lodging, hospitality, entertainment, manufacturing, and retail. It provides products and services to over one million businesses of all types and sizes.
Costco is a membership-only big box retailer of groceries and general merchandise. It is the nation’s largest wholesale club operator, serving approximately 128 million cardholders. The company’s business model is driven by its membership fee revenue, which allows it to offer bulk products at low prices to its customer base.
Both Cintas and Costco are impressive businesses with qualities that are easy to see and appreciated by many. Costco’s moat lies in its ability to continually pass cost savings down to its customers. The company maintains a limited selection of SKUs. This limited selection combined with bulk packaging contributes to high sales volumes and sales per square foot.
High sales per square foot is a network effect advantage: the customer base allows for high throughput, low gross margins, and better value for the customer. This better value for the customer helps grow the customer base (slowly over time). The habitually trained customers, therefore, are the moat. Another grocer with lower customer counts cannot replicate Costco’s value proposition, as they would do so with low throughput and significant operating losses for years before attracting enough customers. Simply put, Costco’s high sales volumes allow it to have significant buying power and discounted prices. These cost savings are then passed down to its loyal fan base creating a virtuous cycle.
Cintas has also seen its moat strengthen over time. The key to Cintas’s business is building route-density to leverage the efficiency of its truck drivers. The company has built the densest route which provides a cost curve advantage. Cintas has also become a highly efficient route operator and cross-seller of goods, resulting in demonstrably higher margins as a result of this efficiency. This allows them to compete on price more efficiently and to take market share. To provide an example, let’s say Cintas has a five-year uniform rental contract with a customer. If Cintas introduces a new product or service to that company, the relationship becomes stickier because the more products or services you provide a customer, the less likely they are to leave. Having more products / services with a particular customer allows economies of scope, which in turn provides Cintas with more cost savings that can then by used to capture more customers.
The recognition from investors about the strength of these companies’ competitive advantages has translated into massive multiple expansion. 20x earnings became 30x earnings and now 30x earnings has become 50x earnings as investors further extrapolate out years of continued growth.
We could provide 10 more charts of stocks that are now being priced similar to the above, so we are not trying to pick on Costco or Cintas. We are just noting that it is certainly possible for both companies to continue to put up strong earnings per share growth, but potentially see their stocks go more sideways (lower stockholder returns) versus where their respective earnings growth goes over the next 10 or so years. Could these stocks continue to work from here? Yes, but both businesses will need to continue to delight and serve customers, which has a high probability of occurring. Even then though, at 50x earnings, you need a lot of years for the multiple to de-rate to a more reasonable level. As an example, a stock trading at 55x earnings could grow its EPS at 10% per year for the next decade and if the stock is flat over that 10-year period, 10 years from now it would still be trading at 21x earnings.
There are several examples from history where remarkable businesses have been “bid up” to such high valuation levels that it resulted in low / less than satisfactory returns for the next 10, 20, or even 30 years. We can take a handful of companies from the 1970s and look at their returns over the years. In late 1972, Avon Products traded at a 65.4x P/E ratio, Black and Decker at 50.5x, Eastman Kodak at 48.2x, among others. Each of these companies was a leader in its field with a strong balance sheet, high profit rates, and double-digit growth rates. So, how did each fare over the next 29 years? The table below provides some context:
Remarkably, each of them provided a positive total return over the next 29 years. However, when comparing their shareholder returns to that of the S&P 500, it is a very different story. Every one of them underperformed the S&P 500, and some in dramatic fashion. From their 1972-1973 highs, Avon fell 86% and Xerox fell 71%.
We can use another time period and find much of the same. From 2000 through 2014, several large, well-known technology stocks were just returning to levels that occurred in the early 2000s. Their returns were also hampered by high starting valuation levels.
As the chart above shows, these businesses were all able to continue growing their earnings at relatively solid clips. Despite Qualcomm and Cisco both growing EPS at a double-digit rate for 15 years, investors saw little return; 15 years of basically nonexistent returns for owning those businesses. To be fair, the companies in the tables above were hand chosen by us to provide evidence that paying a high price for exceptional businesses doesn’t normally work out the best. There are exceptions such as buying Walmart in 1972 and holding for 29 years or buying Amazon in 1999 and holding for 15 years.
We are not saying that paying a high price doesn’t work, but the bigger takeaway is that the odds of achieving an acceptable return on such an investment are not in your favor if you pay what appears to be an expensive price. In investing, short-term price movement always drives narrative: if the stock price is going up, it must be a great business with strong management. If the stock price is going down, it must be a poor business with weak management. Disconnecting stock price from the business and focusing on the latter is imperative.
Psychology plays an important role as human beings are often driven by the fear of missing out. Because a stock has performed well recently, more individuals buy into it with the expectation that the strong performance will continue. This is one reason why you sometimes see businesses that traded at 20x earnings two years ago suddenly trading at 60x earnings today. This works well for those “investors” until something causes the tide to change. Potential reasons for a tide change could be increased competition, lower growth rates, loss of customer focus, etc.
In the grand scheme of things, keeping a rational mind and minimizing the impact of behavioral biases is key. Trying to take short-cuts often results in disappointment over an extended period of time. Just like with gardening; in investing you will have good seasons and bad seasons – you cannot control the weather, you can only be prepared for it.
We here at Monarch wish you much happiness in the New Year. If there is anything we can do to assist, please do not hesitate to call!
