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Walmart - A Tale of Two Investors

January 07, 2014 | About:

Imagine it is the year 1975, and you, working for one of the largest lenders in the nation, are in a little town called Bentonville in the state of Arkansas. You are meeting a gentleman called Sam Walton. Walton picks you up with his sons and their dog “Dan” on his pick-up truck. He shows you around a store called Walmart and he tells you he wants to expand to Iowa and Ohio and so on. The stores are a little dingy and dilapidated, but Sam seems like to be a really nice guy. He asks you for a $10 million loan. You, only noting the sketchy stores and yokel-like but seemingly reputable character, tell him, “Thanks, pal, but no thanks.”

If the above story were made into a movie, the protagonist's name would be Bill Gross, one of the legendary investors from PIMCO. Gross nicely summed up his experience in this entertaining yet highly inspiring video.

Now fast forward 24 years and imagine you received these two Morgan Stanley analyst reports in your mail box, one dated Nov. 17, 1998, and the other one dated Feb. 17, 1999. The first report reads something like this:

The second report reads like this:

“Any elephant can dance, but to our knowledge, there is no record of a flying elephant.  So the next time you hear about a UFO with a trunk and a tail flapping in the air, it won’t be the X Files, it will most likely be your favorite discounter- Walmart.” 

“A flying elephant who can also dance effortlessly? That’s pretty cool. I better jump on the bandwagon now before it’s too late.” So you purchase the stock of Walmart throughout 1999 and end the year being a pride owner of a flying dancing elephant.

I admit the second story is fictional. However, based on the trading volume of Wal-Mart’s common stock during 1999, I’d be happy to bet that the year of 1999 created many many flying dancing elephant owners.

Now, let’s take some time and ask ourselves what the common theme is in those two stories. In order to answer this question, let’s first take a look at the stock returns of Wal-Mart in each of the 10 years following our stories.

Year

  Beginning Price

  Ending Price

  Percent Gain or Loss

1976

13.125

15.5

18.10%

1977

15.5

20.25

30.65%

1978

20.25

22.75

12.35%

1979

22.75

34.75

52.75%

1980

34.75

60.50*

74.10%

1981

30.25

42.5

40.50%

1982

42.5

99.75*

134.71%

1983

49.875

78.00*

56.4%

1984

39

37.875

-2.9%

1985

37.875

63.75*

68.3%

  • - Adjusted for splits

Annual Compounded Rate of Return During the 10-Year Period from 1976 to 1985: 47%

Year

  Beginning Price

  Ending Price

  Percent Gain or Loss

2000

69.125

53.125

-23.2%

2001

53.125

57.55

8.3%

2002

57.55

50.51

-12.2%

2003

50.51

53.05

5.0%

2004

53.05

52.82

-0.4%

2005

52.82

46.8

-11.4%

2006

46.8

46.18

-1.3%

2007

46.18

47.53

2.9%

2008

47.53

56.06

18.0%

2009

56.06

53.45

-4.7%

Annual Compounded Rate of Return in the 10-Year Period from 2000 to 2009: ~0.15%

The tables show that the investor who did not invest in Wal-Mart in 1974 has seemingly made a huge mistake of omission, and the 1999 elephant owner who paid an exorbitant price tag for his flying elephant has made the mistake of commission. The mistake of omission seems to be more severe because of the opportunity costs forgone.

The two mistakes are vastly different, and I consider the first mistake to be much more forgivable than the second one. In fact, I may not even consider the first mistake to be a mistake at all. The reason is very simple. In 1974, Wal-Mart had just started a few years ago, and almost everything was still unknowable. You have to be extremely bold or lucky to predict that your neighborhood grocery store is going to become a $400 billion supermarket in 40 years. In 1999, for the reasons to be discussed in later sections, many more things are knowable than compared to 1974, and any intelligent investor should be able to observe divergence between the intrinsic value of the business and the price tag offered by Mr. Market.

With the benefit of hindsight, we know that in the late 1970s and 1980s, Wal-Mart continued its growth miracle with revenues and earnings grew by more than 30% compounded annually as it expanded. As a result of this consistent growth, the annualized return of Wal-Mart's stock from 1970 to 1990 was about 35%, and the return is in line with the growth in revenue and earnings.

Year

  Beg Price

  End Price

% Change

Revenue Growth

EPS Growth

Avg P/E

ROE

1975

9.5

26.25*

176.32%

44.10%

66.70%

    12.1

26.7%

1976

13.125

15.5

18.10%

40.70%

60.00%

    11.9

28.7%

1977

15.5

20.25

30.65%

41.70%

12.50%

    11.5

26.3%

1978

20.25

22.75

12.35%

32.70%

33.30%

    12.1

26.3%

1979

22.75

34.75

52.75%

38.60%

41.67%

    11.1

28.2%

1980

34.75

60.50*

74.10%

31.60%

29.41%

    14.1

27.0%

1981

30.25

42.5

40.50%

48.80%

40.91%

    14.2

28.9%

1982

42.5

99.75*

134.71%

38.10%

48.39%

    20.0

30.6%

1983

49.875

78.00*

56.4%

38.2%

52.2%

    24.5

32.0%

1984

39

37.875

-2.9%

37.2%

37.1%

    20.4

31.0%

1985

37.875

63.75*

68.3%

32.0%

20.8%

    24.2

28.8%

1986

31.875

46.5

45.9%

41.0%

37.0%

    20.8

30.3%

1987

46.5

52.00*

11.8%

34.0%

39.0%

    28.3

31.8%

1988

26

31.375

20.7%

29.0%

33.0%

    20.0

31.8%

1989

31.375

44.875

43.0%

25.0%

29.0%

    19.0

30.9%

1990

44.875

60.50*

34.8%

26.3%

20.0%

    31.8

27.7%

Entering the 1990s, growth began to slow as the expansion was starting to take a breath. Growth rated gradually dropped to less than 20%. As a result, Wal-Mart’s stocks were no longer the darlings of Wall Street from 1992 to 1996.

Year

  Beg Price

  End Price

% Change

Revenue Growth

EPS Growth

Avg P/E

ROE

1992

58.875

64

8.7%

26.4%

24.4%

    38.0

22.8%

1993

64

50.00*

-21.9%

21.4%

17.0%

    27.8

21.7%

1994

25

21.25

-15.0%

22.5%

14.9%

    20.9

21.1%

1995

21.25

22.25

4.7%

13.5%

2.3%

    20.4

18.6%

1996

22.25

22.75

2.3%

12.0%

11.5%

    18.4

17.8%

From 1997 through 1999, Wal-Mart rejuvenated itself by expanding into a new market again. However, this time, the growth rate is much less impressive that what it achieved from the early days. Wall Street started to chase after Wal-Mart again. Wal-Mart’s stock skyrocketed during this short three-year period.

Year

  Beg Price

  End Price

% Change

Revenue Growth

EPS Growth

Avg P/E

ROE

1997

22.75

39.4375

73.4%

12.5%

16.9%

    21.8

19.1%

1998

39.4375

81.4375

106.5%

16.7%

27.0%

    31.2

21.0%

1999

81.4375

138.25*

69.8%

19.9%

21.2%

    39.1

20.8%

Here we are in 1999. What’s knowable is that Wal-Mart has pretty much expanded to everywhere in the U.S and is expanding aggressively internationally. What’s also knowable is that Wal-Mart’s revenue has only grown 58% in the previous three years, and EPS has only grown 80%, yet the stock has more than sextupled.

What’s fascinating about Wal-Mart’s stock history up until 1999 is that when Wal-Mart was growing at more than 30% from 1970 to 1990, the average P/E ratio was just shy of 20. When the growth was anticipated to rekindle itself, market participants were willing to pay a much higher multiple for unrealized growth promises. At the high of 1999, investors were paying almost 70 times earnings for Wal-Mart, a hefty price that made them no money in the next 10 years excluding dividend.

If I have to name one reason why investors in the last 1990s paid so much for Wal-Mart, I would say it is the mindset of “fear of missing out.”  The last thing an investor wants to tell himself or herself is, “Oh, I missed that.”  I’ve seen so many articles by investors who are so regretful about the fact that they missed out on Apple, Google, Mastercard, Tesla, Yelp, etc. Their justification is that had they bought Apple at $300, Google at $500, Mastercard at $400, Tesla at $110, or Yelp at $30, they would have made tons of money by now. The margin of safety, with the benefit of hindsight, was unmistakably there at those prices.

Well, was the margin of safety really there when so many things were important yet unknowable when Google was trading at $500 or when Mastercard was trading at $400? I think not. Just because the price has appreciated significantly since the first time one looked at a stock doesn’t mean the margin of safety was there, especially if the margin of safety is calculated based on assumptions of future growth rates and discounts rate for businesses that are inherently not predictable. Even in the case of Wal-Mart, an inherently more predictable business, had the assumption of a 25% future growth rate in 1999 panned out as expected, an investor’s return would have been much better in the next 10 years. This alternative history is almost always ignored, just as the alternative histories of the Apples and Googles are.  

Knowing what has happened in the past and why it happened is an enormous advantage when it comes to investing. It informs you of the range of possibilities, allows you to conceptualize possible outcomes to various scenarios and provides a framework for thinking about cycles.

The lessons from the Walmart case study are really “secrets in plain sight.” A stock's price is determined by its fundamentals combined with how much the market is willing pay for the fundamentals and future growth. Therefore, a rising price can come from either growth in the underlying business or from multiple expansions, as the market becomes more optimistic about the company's future.

If the price appreciation comes from growth in the underlying business with no or slight multiple expansion, such as the case with Wal-Mart in its early 20 years, a satisfactory return is expected in most cases. However, when the price appreciation mainly comes from multiple expansions due to opportunistic future assumptions with fundamentals and prices showing a notable divergence, it is time to worry.

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Rating: 4.9/5 (27 votes)

Comments

itzarjuna
Itzarjuna premium member - 8 months ago

Ning, I've watched that video numerous times :-) .. Very insightful..

The Science of Hitting
The Science of Hitting premium member - 8 months ago

Great post Ning - thanks!

20punches
20punches - 8 months ago

Arjun: It was a video worth watching repeatedly. Lending is by character!

20punches
20punches - 8 months ago

Thanks for the nice words Science.

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