When I usually think of a value investment, I conjure up images of Ben Graham and his well known net-nets. While this strategy has certainly proven successful in the past, it is far from flawless; some of the companies deserve trading below NCAV, generally for one of two reasons: they are running large operating losses and are pumping money back into the business model in an attempt to revive/jump start it, or have managers who are more than happy with their position of power, extravagant compensation packages, and majority stake, regardless of the plea to drive long term value from minority shareholders. Usually, when the ticker does move, the result is bankruptcy or big profits, which adds an uncomfortable component for investors who donât look at themselves as liquidators. Warren Buffett summed up these points succinctly in the 1989 annual report:
âUnless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.â
On the other end of the spectrum, we can find value in the earnings power of a corporation, along with a sustainable competitive advantage which eliminates a substantial amount of risk (defined as permanent loss of capital, not the stock moving around more than some arbitrarily picked benchmark; sorry CAPM/beta fans). Unfortunately, the markets are frequently efficient, and have a tendency to sniff out these types of opportunities and cancel out any inefficiency rather quickly. Thankfully for us as investors, the difference between âfrequently efficientâ and âalways efficientâ is like the difference between night and day (to use Warrenâs words); every once in a while, the market overlooks a great company with solid operations that have consistently outperformed over a long period of time, and yet are priced as though they are set to struggle in the future; in my opinion, Wal-Mart (WMT) fits this description quite well.
Letâs start with the background history. Sam Walton, the quintessential businessman, founded Wal-Mart in 1962. On Halloween, 1969, the company was incorporated in Delaware; the next year the company completed their IPO, offering 300,000 shares at a price of $16.50/share. Since then, the stock has split eleven times, the most recent of which was in March of 1999. Amazingly, the stock has returned 24.7% per annum over the 40 year period, meaning every dollar invested would be worth an astounding $6,833.74 (this explains why four people inside the top 20 on the Forbes Billionaire list are Waltonâs).
The business history for Wal-Mart is one of swift growth, a strategy which has led to a retail empire being been built in less than half a century. A lot has happened on the way to eclipsing $400 billion in sales. In 1979, Wal-Mart announced that they had hit the $1 billion annual sales mark for the first time. In 1983, Wal-Mart opened the first Samâs Club wholesale location (accounted for $36.3 billion or 12% of total revenues through the first nine months of the year). In 1988, the first Wal-Mart Supercenter opened, offering 24-hour shopping. Three years later, the company made their first international expansion, a strategy which has driven sales to new heights (accounted for $77.9 billion or 25.7% of total revenues through the first nine months of the year).
These business strategies have led to widespread success for Wal-Mart. For yearend January 31, 2010, the company had $405 billion in sales, compared to âŹ101 billion for Carrefour, the second largest retailer in the world (roughly $136 billion in sales at todayâs exchange rate); Wal-Martâs revenue outpaces their nearest competitor nearly 3 to 1 in sales.
The most recent development that will drive future growth is the launching of an online marketplace. The ultimate low cost competitor has entered into an arena where consumers can compare prices in an instant, and base the majority of their decisions on cost alone; for Wal-Mart, this has the making of another multi-billion dollar division over the coming years (online sales are not broken out).
Of course, revenue growth is only worth so much; the bottom line is where investors are looking. With a couple of weeks left in FY2011, last yearâs income data doesnât do us much good; Iâm trusting in Wall Street analysts (not something you will hear me say too often) for an estimated EPS of $4.06 in 2011, suggesting a current PE of 13.8x 2011 earnings.
For sake of historical comparison, Wal-Mart has traded at an average PE of 16.4x earnings over the past 5 years, and 23.2x earnings over the past 10 years; while I think 23.2x earnings for a company with this size in retail in absolutely ridiculous, this is what the market has been willing to pay in the past. After ten years of zero return (due to absurd valuations), along with a global recession, investors have decided that they wonât even pay 14x earnings for the time being; in my mind, this is a short term condition, and one that will change as WMT continues to strive.
Looking at the past ten years, Wal-Martâs consistent success has proven that this is a stock you want to buy and hold for a long time. Reported EPS for 1999 was $1.30/share, compared with the predicted 2011 earnings of $4.06/share discussed above; based on these figures, earnings grew at 10.09% per annum over the twelve year period. Assuming earnings growth is cut in half over the next three years compared to the average over the past ten years (so 5.048% per annum), FY2014 EPS should come in around $4.71. Based on a multiple of 15x earnings, which is below both the 5 and 10 year trailing average, the stock will be trading for roughly $70/share, or 25% upside from todayâs close; this does not including dividends. When cash distributed to shareholders is added in (dividends have increased every year over the past 36 years), you are looking at 10-11%/annum, in line with the markets historical average. So based on the assumption that Wal-Martâs business strategy suddenly suffers and canât produce the growth rates they have consistently achieved over the past ten years (which there is no reason to believe for long term investors), you are stuck with historically average market returns.
What about if Wal-Mart continues to perform as they have in the past? Based on 10.09% growth in EPS per year, FY2014 would be $5.42/share. Along with this growth assumptions comes another kicker; if Wal-Mart can exit the global recession and deliver comparable results to the previous decade, there are no issues that would justify a low teens multiple. Wal-Martâs valuation in this situation should fit in the range of the 5 and 10 year averages of 16.4x and 23.2x earnings (hopefully investors learned their lesson about overpaying for large caps at the turn of the century when names like Coca-Cola (KO) and Microsoft (MSFT) were fetching 40, 50, and 60x earnings). For the sake of being conservative, I will simply use the lower of the two (16.4x). Based on that multiple, WMT stock would be trading at $88.90/share, an upside of nearly 60% from todayâs price, and good for an investment return of 16.7% per annum, not including dividends.
Based on the simple arithmetic calculated here, the stock has very limited risk. On the downside, you perform in line with historical index returns. On the upside, you return nearly 20% per annum, without running the risk of watching 40% of your capital disappear in an instant like with growth stocks. Analyst estimates call for $4.46/share in EPS for 2012, suggesting 9.85% growth compared to FY 2011 (and right in line with our upper estimate). For investors, Wal-Martâs current valuation is a case of simple mathematics and basic business with a great risk/reward tradeoff.
âUnless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.â
On the other end of the spectrum, we can find value in the earnings power of a corporation, along with a sustainable competitive advantage which eliminates a substantial amount of risk (defined as permanent loss of capital, not the stock moving around more than some arbitrarily picked benchmark; sorry CAPM/beta fans). Unfortunately, the markets are frequently efficient, and have a tendency to sniff out these types of opportunities and cancel out any inefficiency rather quickly. Thankfully for us as investors, the difference between âfrequently efficientâ and âalways efficientâ is like the difference between night and day (to use Warrenâs words); every once in a while, the market overlooks a great company with solid operations that have consistently outperformed over a long period of time, and yet are priced as though they are set to struggle in the future; in my opinion, Wal-Mart (WMT) fits this description quite well.
Letâs start with the background history. Sam Walton, the quintessential businessman, founded Wal-Mart in 1962. On Halloween, 1969, the company was incorporated in Delaware; the next year the company completed their IPO, offering 300,000 shares at a price of $16.50/share. Since then, the stock has split eleven times, the most recent of which was in March of 1999. Amazingly, the stock has returned 24.7% per annum over the 40 year period, meaning every dollar invested would be worth an astounding $6,833.74 (this explains why four people inside the top 20 on the Forbes Billionaire list are Waltonâs).
The business history for Wal-Mart is one of swift growth, a strategy which has led to a retail empire being been built in less than half a century. A lot has happened on the way to eclipsing $400 billion in sales. In 1979, Wal-Mart announced that they had hit the $1 billion annual sales mark for the first time. In 1983, Wal-Mart opened the first Samâs Club wholesale location (accounted for $36.3 billion or 12% of total revenues through the first nine months of the year). In 1988, the first Wal-Mart Supercenter opened, offering 24-hour shopping. Three years later, the company made their first international expansion, a strategy which has driven sales to new heights (accounted for $77.9 billion or 25.7% of total revenues through the first nine months of the year).
These business strategies have led to widespread success for Wal-Mart. For yearend January 31, 2010, the company had $405 billion in sales, compared to âŹ101 billion for Carrefour, the second largest retailer in the world (roughly $136 billion in sales at todayâs exchange rate); Wal-Martâs revenue outpaces their nearest competitor nearly 3 to 1 in sales.
The most recent development that will drive future growth is the launching of an online marketplace. The ultimate low cost competitor has entered into an arena where consumers can compare prices in an instant, and base the majority of their decisions on cost alone; for Wal-Mart, this has the making of another multi-billion dollar division over the coming years (online sales are not broken out).
Of course, revenue growth is only worth so much; the bottom line is where investors are looking. With a couple of weeks left in FY2011, last yearâs income data doesnât do us much good; Iâm trusting in Wall Street analysts (not something you will hear me say too often) for an estimated EPS of $4.06 in 2011, suggesting a current PE of 13.8x 2011 earnings.
For sake of historical comparison, Wal-Mart has traded at an average PE of 16.4x earnings over the past 5 years, and 23.2x earnings over the past 10 years; while I think 23.2x earnings for a company with this size in retail in absolutely ridiculous, this is what the market has been willing to pay in the past. After ten years of zero return (due to absurd valuations), along with a global recession, investors have decided that they wonât even pay 14x earnings for the time being; in my mind, this is a short term condition, and one that will change as WMT continues to strive.
Looking at the past ten years, Wal-Martâs consistent success has proven that this is a stock you want to buy and hold for a long time. Reported EPS for 1999 was $1.30/share, compared with the predicted 2011 earnings of $4.06/share discussed above; based on these figures, earnings grew at 10.09% per annum over the twelve year period. Assuming earnings growth is cut in half over the next three years compared to the average over the past ten years (so 5.048% per annum), FY2014 EPS should come in around $4.71. Based on a multiple of 15x earnings, which is below both the 5 and 10 year trailing average, the stock will be trading for roughly $70/share, or 25% upside from todayâs close; this does not including dividends. When cash distributed to shareholders is added in (dividends have increased every year over the past 36 years), you are looking at 10-11%/annum, in line with the markets historical average. So based on the assumption that Wal-Martâs business strategy suddenly suffers and canât produce the growth rates they have consistently achieved over the past ten years (which there is no reason to believe for long term investors), you are stuck with historically average market returns.
What about if Wal-Mart continues to perform as they have in the past? Based on 10.09% growth in EPS per year, FY2014 would be $5.42/share. Along with this growth assumptions comes another kicker; if Wal-Mart can exit the global recession and deliver comparable results to the previous decade, there are no issues that would justify a low teens multiple. Wal-Martâs valuation in this situation should fit in the range of the 5 and 10 year averages of 16.4x and 23.2x earnings (hopefully investors learned their lesson about overpaying for large caps at the turn of the century when names like Coca-Cola (KO) and Microsoft (MSFT) were fetching 40, 50, and 60x earnings). For the sake of being conservative, I will simply use the lower of the two (16.4x). Based on that multiple, WMT stock would be trading at $88.90/share, an upside of nearly 60% from todayâs price, and good for an investment return of 16.7% per annum, not including dividends.
Based on the simple arithmetic calculated here, the stock has very limited risk. On the downside, you perform in line with historical index returns. On the upside, you return nearly 20% per annum, without running the risk of watching 40% of your capital disappear in an instant like with growth stocks. Analyst estimates call for $4.46/share in EPS for 2012, suggesting 9.85% growth compared to FY 2011 (and right in line with our upper estimate). For investors, Wal-Martâs current valuation is a case of simple mathematics and basic business with a great risk/reward tradeoff.
