One of the things that makes investing so interesting is the fact that market prices are not always rational. The exploitation of this irrationality is the bedrock of Professor Benjamin Graham's life work. To apply that lesson to today's market, we should remember that even excellent businesses can become bad stock investments once they reach a certain price.
For our starting example, let's take a look at the five year projections for Hershey Chocolate (NYSE:HSY). First of all, let me say this: in terms of earnings quality, Hershey is about as excellent of a business as you can find. The company sells Hershey's chocolate, Reese's, Milk Duds, Ice Breakers, Twizzlers, and Kit Kats. This is a company that generates profits through all market cycles, and for investors with the "I don't want to own businesses that will ever go bankrupt" perspective, this company is on the short list of stocks that you could probably get away with buying and forgetting.
But just because a company happens to be an excellent business does not mean that it is a good stock. Last week, Hershey hit a high of over $91 per share. Let's try to make some projections to see how this might play out in real life. The most optimistic analyst projection for Hershey that I can find predicts 11.0% annual earnings growth over the medium term, with the specific estimate being earnings of $5.40 per share in 2017 or 2018. Keep in mind this is the most optimistic figure I can find. Value Line estimates that Hershey will trade at 19x earnings over the long-term. If Hershey meets those optimistic growth projections and trades at 19x earnings, we're looking at a future stock price of$102.60.
I love Hershey the business, but I do not like Hershey the stock. I like to make investments when I can stack the deck in my favor, and when the most optimistic scenario I can find involves waiting five years to turn a $91 stock into a $102 stock while collecting a 2% dividend, I'm not interested in starting a position. Just imagine what happens if the optimistic forecasts do not come true and the earnings only grow at 4-5% (this is not entirely out of the range of possibilities, considering that Hershey grew by 7.5% over the past decade). It is quite possible that investors could lose money over the next five years if Hershey posts weak earnings growth and experiences "reversion to the mean" P/E compression.
Realty Income (NYSE:O), my favorite real estate investment trust that owns commercial properties, is another one of those companies that is a "dividend investor's dream holding." The company has paid 514 straight monthly dividends. The firm's acquisition of American Capital Realty Trust will likely mean that a third of Realty Income's revenues will come from investment grade tenants (it had been at the 20% threshold previously). Additionally, the fact that the company gives investors a reliable dividend each month makes this a nice company to tuck into a diversified portfolio.
But when you look out five years ahead, the projections for Realty Income seem hard to justify. The most optimistic projection for Realty Income's future funds from operations per share is $2.85 in 2017 or 2018. Value Line estimates that Realty Income will trade at a long-term P/FFO ratio of 17.0. Right now, Realty Income is trading at $49.67. If the company manages to increase its funds from operations to $2.85 in 2017 and the company trades at a P/FFO ratio of 17.0, we're looking at a stock price of $48.45. Yikes, the most optimistic projection that I can find involves the price going down five years from now (although the 4-5% dividend means that investors should realize a positive return if this actually happened). And if interest rates increase in the next five years or if Realty Incomes fails to generate $2.85 per share in FFO, Realty Income investors could be looking at a sharp price decline five years from now.
Most of the companies that I typically discuss are not overvalued to this extent, but they have reached a point where they have what I'd call "a reverse margin of safety", meaning that the total returns should lag earnings growth over the medium term because there should be modest P/E compression. Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), and Colgate-Palmolive (NYSE:CL) are about 5-18% above their forecasted P/E ratios, which I would guess means this: if those companies grow earnings by 9-10% for the next five years, investors might experience total returns of 7-8% if those companies experience slight P/E compression. The margin of safety in terms of price appears to be gone: it's hard to see how paying 21-22x earnings for Coca-Cola shares give investors a margin of safety in terms of valuation.
I would be especially hesitant about initiating positions in companies like Hershey or Realty Income at the present valuation. I encourage you to calculate the expected five year growth of these companies and determine what kind of valuation those companies will trade at then. Normally, you establish a margin of safety with your stock purchases by setting yourself up to benefit from P/E expansion to enhance your total returns at a rate higher than the earnings growth. With a lot of the defensive names, it seems that there will be some P/E compression over the coming years. For that reason, I would be cautious about initiating a new position in many of the non-cyclical defensive names that happen to be excellent businesses. The price protection just isn't there.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.