Wal-Mart: Don't Sell Early

| About: Wal-Mart Stores, (WMT)

For a long-term holder of Wal-Mart (NYSE:WMT), the 21st century has been a miserable experience. At the end of 1999, Wal-Mart stock was at $68.50 and at current prices near $74, that works out to a 0.6% annual return - approximately adding in dividends of 0.5-1.5% in those years, and you get a ~1.5% return. Well below inflation, even for a low-prices-everyday retailer.

But even that meager return has been delivered mostly in the past 2 years - in September 2011 WMT was near $50 and has appreciated since then by 50%.

So for those who have been watching or experiencing this exciting rise from a stodgy, relatively boring, retailer, it is tempting to say the ride is over and to move money to more exciting places. Our message is to hold on for more over the next few years - don't sell too early.

The reason we can say it is early with reasonable confidence is that Wal-Mart's results are highly predictable year by year, much more so than most US companies.

The graph below shows a 20-year history of Wal-Mart's net margins - a stable line like this, even though the margins are low, is a work of art from an investor's perspective.

The next graphs show Wal-Mart's return on assets (ROA, before interest) and return on equity (ROE, after interest), both of which again have very, very low variability over the years.

(click to enlarge)

The graph below shows Wal-Mart's turnover (I measure this as revenues divided by the non-cash, tangible assets that Wal-Mart has - removing the cash and goodwill makes for a more accurate view of turnover based on invested assets).

When you have a business that is as steady as the graphs above imply, it becomes less risky to project out that this level of performance will continue over the next few years. There will always be risk to the future, including the economy, natural disasters, wars, etc, but nobody knows how to predict those. Wal-Mart executives may do something illegal or lose a court case, but again nobody knows how to predict or time those risks. But fundamental business risk is pretty easy to handicap with results like this.

What can we predict? Well, if you look at this history you can say that the average ROE has been 20% and the last equity figure in the 2012 10-K report was $81.7 billion. So I can expect Wal-Mart's earnings power to be $16.3 billion (2012 earnings were $17 billion), which is $4.95 per share.

How does Wal-Mart distribute those earnings? It will give you $1.88 per share in dividends. Over the past 6 years, it has averaged a share buyback of close to $8 billion, or $2.42 per share. So $4.30 per share is being given back to you every year.

The remaining $0.65 per share is re-invested into a business that consistently earns 20% return on equity. If that $0.65 is invested at a 20% return, it means you can expect your $4.95 total earnings to increase by 2.6% per year by earnings growth (this doesn't include the effect of share buybacks, so you can't think of it as EPS growth).

The last part of a valuation is to look at the current price. Wal-Mart is selling for approximately $74. If my total profit is $4.95 per share, I am getting 6.7% in earnings, and 5.8% of that is being paid back to me in cash (2.5% dividends plus 3.3% share buyback).

When interest rates are near 2%, an investment that gives you 5.8% and also will grow at 2.6% per year (canceling out likely inflation, say) is a clear winner over long bonds. Never mind that earnings are actually slightly higher ($17 billion vs $16.3 above), and that the improving US economy is likely to act as a tailwind - all of that is extra upside.

The graph below shows you how Wal-Mart's valuations have plunged over the past 13 years - this can't continue forever, and we are arguing that the numbers imply share prices can only go up unless Wal-Mart hits some big disaster going forward.

Is Wal-Mart the best equity to buy out there? We are not claiming that. But for somebody who wants a defensive, stable return to anchor their portfolio (which is why they may have invested in it in the first place), our message is to not sell yet.

When would we consider selling? Only if today's price was above $100 per share would we even think about it, and only above $120 would we be in a hurry.

Disclosure: I am long WMT. 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.