We Like Walgreen but Market Prices Cannot Be Trusted

Even after almost 40 years in this business, I still don’t get the peculiar illogic of Wall Street. Last week, the market trounced Research in Motion (RIMM), a stock we hold in client portfolios, on what we felt was a very strong quarter. Even weirder, this is a very healthy company in a fast growing industry with huge potential for growth.

We lamented that the market value of an established business like Research In Motion could not have changed in intrinsic value by as much as it did in a single day. On that day, the market was against us, so our comments could have been viewed as sour grapes.

Tuesday, Walgreen (WAG), another stock we hold in client portfolios, was bid up at one point by 11% on what we felt was only an okay quarter. Once again, we lament that it’s simply not possible that Walgreen's true worth could have changed by 10-11% in a single day. We rationally state that the market was either wrong Monday or it was wrong Tuesday. In either event it proves that market prices cannot be trusted to reflect true value.

Utilizing our earnings driven fundamentals-at-a-glance research tool the following three figures are offered to provide insight into Walgreen's true worth. In figure 1, we plot Walgreen's compound earnings growth from 1991 to current (green line with white triangles). Walgreen has grown earnings at a compounded annualized rate of 13.5%. The black line plots monthly closing stock prices. Note how price correlated to earnings for the first 5 years and then became overvalued (above the line) until falling into value in 2007 and 2008.

Also note how price started in value and ended in value, therefore generating capital appreciation of 13.4% virtually identical to Walgreen's earnings growth rate.

Fig. 1. WAG 20yr EPS & Price Performance

In figure 2, we cut the first 7 years off. Even though the compounded annualized growth rate was still above 13%, note what the overvalued starting stock price did to performance. Walgreen generated good operating results (over 13% earnings growth) but capital appreciation was weak at a mere 1.5%, albeit better than the S&P 500. Figure 2 represents another compelling example of how the market can misprice stocks for short periods. However, eventually intrinsic value will manifest.

Fig. 2. WAG 12yr EPS & Price Performance

In figure 3, we show consensus earnings forecast of 15% growth for Walgreen over the next 5 years. If accurate, then Walgreen is reasonably priced at the closing price on Monday 09/28/09. We believe that Tuesday’s rise is irrationally exuberant, but we sill see Walgreen as an attractive long-term investment; however, not as attractive as it was Monday.

Fig. 3. WAG 5yr EPS Forecast

Conclusion

At close to PEG ratio and with a reasonably attractive 1.3% dividend yield, that has grown by about 13% a year, we believe Walgreen is a solid long-term holding.

Obviously we liked Tuesday’s reaction to Walgreen's announcement better than we did the reaction to Research In Motion’s last week. However, irrational behavior is irrational, whether in your favor or not. We believe in valuing a business based on its fundamentals and that it is always a function of earnings and cash flows and can be calculated reasonably accurately. On the other hand, stock price volatility is, in our opinion, an unreliable indicator of value as Tuesday’s example proves.

Full Disclosure: Long WAG, RIMM at the time of writing.

Comments

[Buckoux:]

The ubiquity of Walgreen's stores may be drag on its stock price. There's a lot of overhead in all those stores.

Sep 30 10:39 AM

[debtacid:]

After 40 years, it’s hard to believe you can be so naive to think wall street operates logically based on sound economic principles. After the past 2 years, you just now discover that market prices can’t be trusted? Get rid of the useless charts and find an insider at GS or the Fed

Sep 30 10:48 AM

[Windsun33:]

I believe part of the problem is that trading on many days for the past many months has been very thin compared to historical levels. I have seen $100M small cap stocks move as much as 4% on a single trade of a few hundred shares.

Another part of it seems to be that news (whether "real" news or not) seems to have exagerated effects over the past year, as do analyst up and downgrades (even from analysts nobody ever heard of before, or analysts with a 30% accuracy rate).

I do some daytrading, and I have made as much as 10% in one day on a couple of stocks just from the dead cat bounce.

Sep 30 10:51 AM

[Windsun33:]

Unfortunately, too much truth in that statement. I don't think it is anything new, just faster and more noticible now. With any news at all concerning a stock being instantly available all over the world, even to the local Yak breeders in Tibet, sentiment (rather than value) seems to cause a lot of volatility, at least in the short term.

For long term, I still think that value wins out, but for short term it seems more like a rerun of "Ice Age", where all the animals are running in panic in all different directions over rumors.

On Sep 30 10:48 AM debtacid wrote:

> After 40 years, it’s hard to believe you can be so naive to think
> wall street operates logically based on sound economic principles.

Sep 30 11:01 AM

[debtacid:]

Are there still people using the word "value" to describe stocks? Reminds me of all the sheeple stampeding toward hybrids, windmills and solar panels.

Sep 30 11:33 AM

[Larry House:]

You are sure to be disappointed if you look for sense in the market. I prefer CVS.

Sep 30 11:48 AM

[tripleblack:]

Review the RiteAid saga too.

I have 2 CVS stores within 4 blocks of my house, and they have just about finished one of their largest, new stores 2 blocks from my home (giving me 3 to choose from, now equaling the 3 StarBuck stores within the same walking distance).

CVS owns two of the stores, while the 2nd (which is less than 8 months old) is part of a strip center.

If this reminds anyone of a real-estate play of some kind (not sure if CVS also owns that strip center), I have to agree. Resembles the games that gas retailers and banks play.

With commercial real estate tottering, I would consider these ramifications before investing.

Sep 30 12:41 PM

[Windsun33:]

A "Value Stock" is one that keeps at least 50% of it's price after a market meltdown.


On Sep 30 11:33 AM debtacid wrote:

> Are there still people using the word "value" to describe stocks?
> Reminds me of all the sheeple stampeding toward hybrids, windmills
> and solar panels.

Sep 30 12:59 PM

[debtacid:]

“A "Value Stock" is one that keeps at least 50% of it's price after a market meltdown.”

There can’t be “value investing” with a fiat currency. Fiat currencies are no more than Ponzi schemes so any economic activity based on it is also a Ponzi scheme. Besides, I would think that earnings are at least as important as price and earnings reports can no longer be trusted because GAAP have been rescinded.

Oct 02 12:25 AM