Investors don’t often make a distinction between a good company and a good stock, which is an understandable but potentially costly error. Indeed, it can be one of the biggest pitfalls on the road to success encountered by the everyday investor.
It isn’t an overly-daunting task to identify a great company on paper. Great companies have great brands, a bulletproof balance sheet, terrific profit margins, high return on capital, etc. It is on the basis of these tried and true fundamentals that so many regard these companies as “must-own” issues, regardless of cost. Cost, however, can never be a non-issue; the momentum that gathers from investors pouring more and more money into these stocks can produce astronomical valuation levels. The result? Good companies….but poor investment choices.
As evidence, I would invite you to pull up a ten-year chart for almost any “behemoth” large-capitalization issue. You are familiar with the names of most of these companies, as you encounter them regularly during the course of your day-to-day life; that is, in fact, precisely how they became household names. The list would include such giants as WalMart (WMT), Microsoft (MSFT), Coca-Cola (KO), McDonalds (MCD), Pfizer (PFE), and Colgate-Palmolive (CL). Everybody will recognize these companies as icons of corporate America. They all, however, share a dubious distinction: In addition to being the “superstars” they are, they are also a sampling of great companies whose stock has gone nowhere since the late 1990s, and which sits very close to their respective bear market lows. The reality is that the stocks of these companies, and many others like them, were significantly overpriced in the latter part of the previous decade, with most trading well over thirty times earnings. Coca-Cola alone was trading with a price-to-earnings ratio of 53 during that time. That number is ridiculous on its face, but becomes absolutely absurd when you throw in the razor-thin profit margins in the beverage business. A funny side note to the story: I can vividly remember analysts speaking highly of the stock during this period of gross overvaluation, and actually mentioning Warren Buffet’s position in Coca Cola as an apparent justification for their recommendation. However, what they weren’t telling you was that he had bought it years prior when the valuations were much, much lower. Truth be told, he was probably selling his stock to the sadly misinformed investors who were listening to those “genius” analysts.
You should know that most of these companies have grown earnings in the low to mid-teens, but their stocks have yet to budge. Earnings do typically drive stocks, but in this case, as earnings were growing, the result simply contracted the multiples back to reasonable levels. Thus, the stocks were not appreciating in price.
We screen the markets every day, using a variety of analytical methods, in our search for quality companies in which to invest. Often, I do find a company I’d like to own because of the quality of its business, but determine that its stock doesn’t meet our valuation benchmarks based on the metrics (P/E ratio, P/Cash multiple, etc.). I will put that company on the back burner, but continue to watch it. Once it arrives at more reasonable levels, we reconsider a purchase. Cintas (CTAS) is a great example of this process in action. I reviewed the company initially in the latter part of the 1990s and found a very attractive business. They are the dominant player in the corporate identity uniform market, a true niche and one over which Cintas has a dominant hold. However, what we also found was a great company with a true competitive advantage that was WAY too expensive. In the last couple of years, it’s become much more attractive…but is not quite yet where it needs to be in terms of valuation. It currently trades at about 1.4 times the multiple for the S&P 500, and that’s a bit rich for my blood. Assuming it gets cheaper, we will re-evaluate their market position and their fundamentals to see if it’s worth taking on.
In the end, as an investor, you must be capable of looking past the glare given off by the biggest names in business and peer into the darker corners, wherein lies the most important information. To that end, remember that long term success as an investor requires that you never divorce valuation from any other criteria. By holding true to that idea, you will be sure to always see yourself invested in both a good stock as well as a good company.
