Paying "too much" is a sure path toward underperformance
Nobody goes to stores hoping to pay more than everybody else for the same merchandise. That can usually be avoided because MSRPs (manufacturers’ suggested retail prices) are normally clearly marked on retail items’ price tags. Bargain hunters only like to purchase at discounts to list price.
Stocks, unlike vehicles, home goods or apparel, don’t provide such obvious signs of what they are worth. Their selling prices can vary greatly over time. Data mining of past trading can help detemine what fair value actually looks like.
Analysts’ projections of what shares “should sell for” often conflict with those same companies’ actual trading histories. When discrepencies arise, it is prudent to use real historical evidence to base your expectations upon.
Momentum traders jump on bandwagons only after substantial price run-ups. They stay away from cheaply-priced, but out-of-favor shares. That often leads to years of portfolio underperformance.
Here are three examples of high-quality firms that now appear to be too expensively valued to provide attractive returns from current quotes.
Accenture (ACN, Financial) closed last week at about 21.5x its 2016 consensus estimate. That represents an almost 37% premium to its typical post-recession P/E. The stock’s current yield stands more than 27% below its average level since the end of 2009. The dividend looks even worse when you realize that management had to bump up the payout ratio (all dividends / net profit) substantially since 2007, to achieve even that.
Accenture hasn’t been this expensive since near its 2007 peak (red-starred above). Traders who bought back then needed to wait three full years to see any headway despite the company’s substantial EPS growth and a tripling of the dividend.
Note the many chances (green-starred) that investors had to own ACN at very attractive entry points.
Research firm Morningstar’s quantitative evaluation, based on ACN’s April 13 price of $114.38, led to a well-justified sell-rating accompanied with a fair value estimate of just $101.
Morningstar was not alone in sensing investors’ over-enthusiasm. On April 9, Standard & Poors researchers came to a similar conclusion. They labelled Accenture a 2-star (out of 5) sell while calling for a 12-month target price well below where it was already changing hands.
What good is high quality if a share price is poised to decline, rather than appreciate?
DJIA component 3M (MMM, Financial) set a new all-time high of $169 last week. That makes many people excited about the prospects for further gains. Those who researched the firm’s past trading history, though, should be more prone to take profits than to buy more or even hold tight to current positions.
During the past decade, 3M was only this pricey once before in the waning days of 2014. Momentum chasers near that top have seen almost no appreciation over the last 15 and a half months. That came in spite of the record profits expected this year and after 28.9% in cumulative dividend increases since the end of 2014.
3M had previously experienced long periods of share price stagnation. Buyers near 2007’s peak paid around $97 per share. That was 17.3x that year’s earnings along with a 1.98% yield. Six years later, near the start of 2013, 3M was still available as low as $94 with a forward multiple of 14x and a 2.70% dividend.
Why should anyone be willing to pay almost a 29% premium to 3M’s own normalized valuation now, when it’s been buyable year after year at much better (green-starred) entry points?
Morningstar rates 3M as neutral, but feels it is already trading some dollars above their own fair value estimate.
Standard & Poors also carries a middle of the road rating on 3M. It’s not clear why, though. 3M was quoted way above S&P’s 12-month goal price, while garnering near S&P’s worst price/fair value relationship.
Once again, good quality at a bad price appears to offer more risk than reward.
Shares of fast food giant McDonald’s (MCD, Financial) ran up significantly from summer of 2015 levels. At last Friday’s close of $127.90, the stock now fetches 23.6x projected earnings for this year. Traders haven’t paid that kind of valuation for McDonald's in more than a decade.
McDonald’s current yield at 2.78% is the lowest in years. It would look even worse if management hadn’t pandered to the dividend growth crowd by raising payouts at a much faster rate than EPS have increased.
McDonald’s bloated payout ratio bodes poorly for the rate of any future dividend boosts. Why should anyone be willing to pay north of 23x forward earnings when McDonald’s has been available for 13.3x to 17.6x earnings on numerous occasions (green-starred below)?
It is not as if McDonald’s has been tearing the cover off the ball on fundamentals.
The most recent three times when McDonald's rose to P/Es of about 19x (red-starred) each preceded significant pullbacks, not further upside breakouts. McDonald’s has averaged a P/E of only 17.7x since the end of 2009. A simple regression to that normalized valuation suggests risk down to below $96, even if things play out reasonably well this year.
Applying that same multiple to McDonald’s 2017 estimate would only support a 21-month target price of around $108.
Morningstar takes a more aggressive view of what McDonald's might be worth. Even so, they see fair value as pretty much where the stock already trades. Why hold shares with well-defined downside when potential profits are virtually nonexistent?
Standard & Poors’ 4-star (out of 5) buy rating defies explanation. They place McDonald's in their lowest 20% in terms of current price compared with their own fair value estimate (now $103.40).
McDonald’s trading history and quantitative evaluation both indicate the stock is more likely to decline than advance.
The best time to buy good companies is when they trade for lower than their own documented historical average valuations.
Avoid getting involved or staying long when P/E multiples are greater than that same stock’s normalized level. Unsustainable prices are usually accompanied with lower than average, for that same share’s, current yields.
These facts on ACN, MMM and MCD are symbolic of the overall market conditions generated as stocks surged higher from the February lows. Most big-cap stocks are looking pretty expensive right now.
You can see my reasoning on that topic in another of my GuruFocus articles.
Disclosure: No positions in any stocks mentioned.
