In the past three months, stocks have had quite a run. After hitting a post-election 1350s low in mid-November, the S&P 500 Index has since jumped to over 1500, delivering many gains for those who stayed long. Many companies, especially those of higher quality in steadier sectors, have seen very substantial gains.
In this article, I will take a look at the fundamental valuations of three companies. Two of them are in consumer packaged goods and one is in municipal utilities. That's three in "risk-off" sectors. The uniting characteristic of these three is that they have more downside than upside, which makes them risky. Shareholders of these companies should consider how much of a downside move they may be willing to stomach.
Before buying shares in any company, one exercise I've found useful over the years is to estimate how high and how low the stock price could possibly go. In doing so, we can determine the upside risk vs. the downside. Though I do consider technical analysis, I tend to look at things from more of a fundamental perspective.
Therefore, in looking at potential upside to downside, my primary focus will be the PEG Ratio, price-to-earnings over growth, and Benjamin Graham's "Fair Value" metric:
Where V stands for the stock's value, EPS stands for Earnings Per Share and "g" stands for reasonable growth expectations for the next 7 to 10 years. I will use these above two metrics, as well as the historical stock price, to determine the potential downside and upside. The most useful tool I've yet seen for this kind of analysis is FAST Graphs, and I will use this to look at these three stocks.
- Upside of $15
- Downside of $28
Colgate-Palmolive, a consumer products company, operates in oral, personal and home care and also has a pet care business. It is best known for Colgate, the leading brand of toothpaste, mouthwash and dental floss. In addition to dental hygiene, it also provides well-known personal care products such as Palmolive, Irish Spring, Lady Speed Stick and Sanex deodorants.
The stock has seen a smooth ride up from $76.50 at one point in 2010 to nearly $115. Since this is a "moderate" growth company, FAST Graphs uses the Graham-Dodd number as well as the PEG ratio to determine fair value. The stock is well above its fair value line.
Until 2009, however, Colgate stock has correlated well with its "normal" Price/Earnings [PE] ratio of 22.8 times (this is the normal P/E ratio for the fifteen-year duration of this chart). That trend was broken by the 2008-2009 drop, with the stock bouncing along its "fair value" line until 2010 when it began its impressive move up.
One could argue that the price action of the last couple years is a sign that Colgate is moving back to its normal P/E. If so, Colgate still has room to run up to $130 before it hits fundamental resistance. That gives us an upside of $15, or just above 10 percent. But a drop back to Fair Value at $86 is not completely unfeasible as it has happened before. This implies a downside of $28, or 24%. Buying in here is not a winner's bet.
Make no mistake, Colgate is a great company for the long term and this is not a recommendation to sell. However, those who are long must have a price target where they feel the risk doesn't justify the reward and will raise cash. My personal target for Colgate is indeed at or near $130, and although I am long Colgate, I am not buying at these levels.
Procter & Gamble (PG)
- Upside of $5
- Downside of $13
Procter & Gamble is also a consumer products company. It sells numerous leading brands such as Bounty, Gillette, Tide, Crest, Luvs, Bounce, Downy, Head & Shoulders, Duracell and many more.
P&G's stock price narrative is similar to Colgate's. Beginning in 2008 and '09, the stock ceased correlating to the normal, fifteen-year P/E ratio and bounced along its Fair Value line determined by the PEG ratio and the Graham-Dodd number. It now seems to be making a beeline back to the normal P/E ratio of 19.5, which is where it has oscillated in years past.
At its normal P/E ratio, the stock price should be around $80 or slightly higher. This gives P&G upside of about $5 or 6%. Like Colgate, a drop back down to the Fair Value line would not be unfeasible: it was after all bouncing along that line until mid-2012. This would mean a stock price of $63. A downside of $13, or 17%.
Note also that P&G stock did drop below its Fair Value line from late 2008 to 2009. This scenario is not too likely to repeat anytime soon, but it is a possibility.
Personally speaking, I am not long P&G, but if I were, I would consider taking advantage of this price action by raising some cash, especially if it continues upward and nears its normal P/E ratio.
Before I move onto my third stock, I want to highlight that consumer packaged goods companies have benefited from a more benign commodity environment. This has boosted earnings across the board and has been a tailwind under stocks such as P&G and Colgate.
Waste Management (WM)
(Click to enlarge)
Waste Management is a provider of waste management services in North America. Its services include trash collection, recycling and disposal. In addition, Waste Management develops, operates and owns waste-to-energy and landfill gas-to-energy facilities in the U.S.
Although the pattern is not exactly the same for this municipal utility company, we can see some similarities in how the stock has been valued over the past ten years. During better days, it has traded around its normal P/E ratio of 19.1. During less friendly economic times, however, it has traded close to its Graham-Dodd number, but has rarely dropped below it.
By the same token, Waste Management has rarely traded far above its normal, fifteen-year P/E ratio. The last time it meaningfully did was during the much better macroeconomic backdrop of 2006.
With all this in mind, Waste Management stock would hit a lot of fundamental resistance at $42, about $4.70 or 12.5% from here. The fair value line of $32.70 is about $4.60, or 13.3% from here. This would make the risk only slightly greater than the reward. Waste Management is probably the least "risky" of these three stocks at the moment.
Careful, though. This formula factors in 8% EPS growth for 2013. Much of this is due to the company's fundamental turnaround and cost savings from switching to a natural gas powered fleet. As someone who has followed Waste Management for a few years and has been long the stock since 2010, I would be pretty surprised to see EPS grow by that much. Therefore, there will be additional downside if the Graham-Dodd valuation number must be adjusted for slower EPS growth.
These three stocks may very well be a part of a larger trend: one of steady, defensive stocks finally recovering from their financial crisis doldrums and reverting to their normal P/E ratio mean. And don't forget, reversions include exceeding the mean as well as falling below it.
If this is the case, then these stocks do still have significant room to run. Even in this scenario, however, it's a good idea to have an exit point in mind: Waste Management and Procter and Gamble are both near their normal P/E ratio, anyway. I would be a little more forgiving of Colgate, not only because it is still significantly below its normal P/E, but because it has a secular growth story of which the other two do not.
But for many investors, this view is missing the point. Many have gotten into these defensive sectors for their perceived safety. They bought for the long term, not to make a bet on reversions to and above a mean. Defensive names have led much of the recent rally, but a high enough price will add a downside risk that many are not willing to stomach.
These "safe" names are too much of a risk to buy into at these levels. Again, this is not a recommendation to sell for those who are already long, but merely to think of a point where you would trim these positions.
In my own case, I am no longer in P&G but hold both Colgate and Waste Management. I personally plan on reducing my holding in Waste Management at around $40.50, where the dividend would yield only 3.5%. My target price for Colgate would be around $130 because it has more long-term growth ahead of it.
My convictions on both stocks are fairly high, especially Colgate. I personally don't mind some downside movement from either Colgate or Waste Management and I want to be in both of them for the long term. Your target depends entirely on your own conviction, risk tolerance and how long you plan to be in stocks. But do have a target.