Over the past couple of weeks, I have spent most of my time focusing on the interplay between valuation and excellent companies, often leaning in the direction of selling companies that are currently overvalued by a moderate to substantial degree. In particular, I have been using Brown-Forman (NYSE:BF.B) and Hershey (NYSE:HSY) as my two examples of companies that are overvalued (both trade between 25-30x earnings) that may be ripe for selling. While I stand by my point, there is another element of the decision-making process that I would like to highlight: if you do decide to hold onto your overvalued blue-chip stock, you should still do quite well if you have a 10+ year time horizon.
After all, even though Warren Buffett decided to have Berkshire Hathaway (NYSE:BRK.B) hold on to Coca-Cola (NYSE:KO) stock through periods of severe overvaluation in the late 1990s, he still managed to turn his $1.3 billion investment in the soda giant (shares he accumulated from the late 1980s through early 1990s) into just shy of $15 billion today (and that is without reinvesting the dividends along the way). In hindsight, Coca-Cola traded at 30x earnings in 2002, and the company has still managed to deliver total returns of 7.39% since that time. I'd also like to note that, on a valuation basis, those Coca-Cola shares were 50% more expensive in 2002 on a P/E basis compared to today.
And by the way, Coca-Cola is not unique in this regard. This is true for many blue-chip stocks:
In 2002, Procter & Gamble (NYSE:PG) traded at 22x earnings, and the company has delivered 8.23% total annual returns since then if you bought at that price.
In 2001, McDonald's (NYSE:MCD) traded at 21x earnings, and the company has delivered 15% annual total returns since then if you bought at that price.
In 1997, Wal-Mart (NYSE:WMT) traded at 21x earnings, and the company has delivered 12% annual total returns since then if you bought at that price.
In 2002, Pepsi (NYSE:PEP) traded at 24x earnings, and the company has delivered 7% annual returns since then if you bought at that price.
There is a reason why I spend most of my time on Seeking Alpha writing about the most excellent companies, the bluest of blue chips if you will. That is because they are the most predictable sources of 8-12% earnings growth that can be found without taking on inordinate risk, and the harm that investors experience from P/E compression (namely, the transition from overvaluation to undervaluation) can be softened by the fact that the earnings of the corporation are growing.
I'll use famed toothpaste and soap company Colgate-Palmolive (NYSE:CL) as an example. For the past 10 years, the company has managed to grow earnings by 10.5% annually. Its historical P/E ratio is 20. Right now, the company trades at 22.26x earnings. Assuming that 20x earnings represents fair value, some people may assume that Colgate-Palmolive shareholders ought to experience a decline in share price from $114 to $103 to mark a return to the upper bounds of fair value. But fortunately for investors of excellent yet overvalued companies, P/E compression can often be softened by earnings growth.
If Colgate grows at the same rate, 10.5%, for the next two years, then earnings should rise from $5.15 to $6.29. If the P/E ratio shifts from 22.26x earnings to 20x earnings over the next two years, the stock should trade at $126. In short, even though the company may experience P/E compression over the next two years, the earnings growth of the firm may be strong enough that the share price actually continues to rise despite being currently overvalued. This is the joy of focusing on making investments in excellent, non-cyclical businesses that tend to grow earnings in a linear fashion, year after year.
At some point, the nagging fact that the S&P 500 returned 7.81% from 1991-2011 while investors actually achieved 3.49% starts to kick in, perhaps indicating that some investors would be better off not playing musical chairs with their portfolio just because some of the stocks have become overvalued. The thing is, most of us reading this site have the ability to guess which companies will achieve 8-12% earnings growth over the next decade, but we may not realize those returns because of inopportune trades. As I tried to point out in the Colgate example above, it is entirely possible that earnings growth can actually enable investors to enjoy stock price increases as their stock transitions from a period of overvaluation to fair valuation. Even if you hold or buy excellent blue-chip stocks during periods of mild overvaluation, you can still achieve satisfactory (or better) returns, as the examples above indicate. That is why worrying about slight overvaluation with your blue-chip stocks could very well turn out to be much ado about nothing.