Sherwin-Williams Inc. (SHW): the shares have rarely been this overvalued
Summary and Synopsys
Compared to the average historical valuations at the annual highs, SHW shares are currently overvalued relative to what investors have historically been willing to pay for SHW at its annual highs in each calendar year since 1982 by 46%. The Value Model calculates that 2013 highs should occur at approximately $115.39 when applying the average ratios from 1982 to now to the most current projected business results. The shares currently trade at $168.00. Be sure to examine Table 2 that summarizes the ratios at the actual highs and lows from 1982 to 2013.
Holders of the shares should sell at current levels. Speculators should consider following the lead of insiders, who have been consistent sellers of the stock from $100 to current levels of about $168.00 since late 2011, and consider shorting SHW by buying put options. The shares of SHW are significantly overvalued compared to the prices that the market has been willing to pay historically for the company,
Make no mistake about it; SHW is a fine company. The return on equity has averaged over 19% from 1982 to the present, displaying significantly above average long-term performance and management. It has delivered consistent growth over the long term with a temporary disruption of earnings and cash flow growth during the "market meltdown" in 2008 and 2009 that was followed by a resumption of better results from 2010 to now. The "meltdown" coincided with one of the biggest collapses in the US real estate market in decades and a near total collapse in global leveraged financial institutions. For SHW, through the end of 2011 and this far into 2012, estimates for this year's Sales, Cash Flow, Earnings and Book Value have been reduced from somewhat higher numbers. The recovery has been recognized in the SHW share price, however the current price level is 46% above where the average valuation highs have occurred over the last 31 years.
How have SHW share price levels compared to the long term valuations assessed by my Value Model from 1996 to 2013? (See chart 1, below)
A look at the monthly chart below shows the actual SHW trading prices overlaid by the lines representing the Value Model Projected highs and lows in each calendar year. This chart illustrates how the actual share prices compared historically to projections determined by the Value Model. The purpose of the model is to provide an indication where share prices historically actually peaked or troughed when compared to the actual business generated in that period. The Value Model allows one to assess when shares are trading outside valuations that investors have been willing to pay as far back as 1982 (that is as far back as I have data for about 2/3 of the 1300 companies that I have under continuous scrutiny in my Value Model).
The highs and lows in each calendar year are used to calculate Price/Sales, Price/Cash Flow, Price/Earnings, Dividend Yield and Price/Book Value. Since the shares notionally represent the business, knowing where these ratios were at the annual peak and trough and then averaging them over this 31 year time frame provides a pretty good idea whether the shares are under-, over- or fairly-valued based on what investors were willing to pay in many business and economic environments and different levels of market psychology. Consequently, we have access to the actual valuations that occurred in each calendar year. The clear purpose of this is to be able to calculate whether a company's shares are historically expensive, cheap, or fairly valued. In the case of SHW, the Value Model Estimated Highs and Lows for 2013 are $115 and $77. With the current price of $168, the shares are about 46% overvalued.
I screen daily to compare about 1300 companies' Value Model projections to their current market price, observe the quantitative valuation, then do a qualitative assessment to see if I am willing to commit either long or short. The market prices anticipate the actual results that are announced after the calendar year end. This provides me with a range of data that shows the highs and lows that were paid relative to the different business measures and ultimately, I easily calculate what the average prices were paid for a company's shares over a long period and many different economic, market and psychological conditions. I then use the estimates for the current calendar year and apply them to the average long term ratios at the highs and lows of Price/Sales, Price/Cash Flow, Price/ Earnings, Dividend Yield and Price/Book Value. The clear purpose of this is to be able to calculate whether a company's shares are historically expensive, cheap, or fairly valued. In the case of SHW, the Value Model Estimated Highs and Lows for 2013 are $115 and $77. With the current price of $168, the shares are about 46% overvalued.
NOTE: Chart was run as of the last week of July 2013
The share price has rocketed from $69.47 in August 2011 to a high of $194.55 in April 2013. For some important perspective, let's examine some of the factors that contributed to how this evolved.
The Real Estate Recovery From the "Meltdown"
The recovery of the US real estate market from 2008 to the present time coincides with the recent valuation resurgence for SHW. Analysts postulate that SHW's fortunes improve as real estate activity improves. The theory goes that people remodel and/or repaint when they buy or move into a different house. The share price movement over the years is a typical example of how investor psychology swings from one extreme to another over a long period. SHW is currently a typical "bandwagon" stock. It has received raves from momentum players, notably Jim Cramer, for some time. An observation: momentum players often recommend situations that they feel will go up simply because they have gone up in the past, and sometimes they can do so a frustratingly long period of time, but shares almost always return to reasonable valuation levels. Having worked with the Value Model now for 14 years, I have observed that there is often not any specific reason as to why an individual company's stock becomes overvalued. Often momentum begets momentum.
It is interesting that many investors continue to desire "reasons" why the stock has gone up or should go down. My experience is that trying to cite specific reasons for overvaluation is simply guesswork. That works adequately well for a journalist writing an interesting story, but is often futile when trying to fathom why certain shares are over- or under-valued. That the shares are overvalued (as you will see) is not in dispute. They are trading at a 46% premium to where they would trade in an average year. A true value investor (and I had Sir John Templeton and Bob Krembil, a founder of the Canadian Trimark mutual funds as mentors in the 1980s) knows that one can tell that shares are over- or under-valued , but the timing of a move to fair valuation is completely unpredictable. As the old saying goes…"Wall Street is littered with the corpses of those who were right before their time".
I truly believe that value investing is the best method and will provide the best returns over the long term with the least risk. It involves buying companies that trade for much less than they are worth as an economic entity and selling (or shorting) companies that trade for more than they are worth. Share prices can remain over- or under-valued for a long time, but in my 35 years as an investment professional, I have observed that the share prices move to reasonable valuations eventually. I have also observed that it is generally impossible to know the exact reasons why shares run to levels that are too high or too low. Eventually, reason sets in and the shares revert to reasonable valuations.
The monthly chart above only goes back to 1993 because the monthly charts I am using from Thomson/Reuters defaults at 20 years as the longest period for a monthly chart. There is no other special reason for picking that time horizon.
Take a few minutes to study chart 1 to get a feel for the projections that my value model made in comparison to the actual monthly candlestick chart. One will observe that SHW has exceeded the Value Model projected high valuations (only occasionally, and certainly not in every year) before the current massive overvaluations. It happened for parts of 1997 and 1998 and in part of 2010. The shares have also had periods where they were near, or below the projected lows. As market psychology varies, the actual valuations that investors are willing to pay varies quite significantly as a matter of course. Chart 1 clearly illustrates how a company's shares fluctuate from low to high valuations over a long period of time. As you can see, SHW shares have been significantly overvalued since late 2011 and remain overvalued now.
Massive swings in market psychology are now more the norm than they have ever been. SHW shares now represent a true valuation bubble and are vulnerable to significant price adjustments to more historical valuation norms. In 2008, when the "meltdown" was foremost in investors' minds (in calendar 2008), Shw shares traded as far as 20% below my model's projected lows, or about $40 (note again that they are now about 46% above the projected highs).
The shares hit $195 in April and are vulnerable to a significant decline if anything causes investors to sell. With the 2013 Value Model projected high at $115, there is significant downside to that level.
SHW's actual trading range has averaged 52% from low to high per year over the last 31 years, with volatility as high as 175% in 1982 and as low as 20% in 1994 and 2005. Although its business's nature is that of a cyclical company, SHW has shown long term growth in the basic business.
The price vulnerability was shown on July 18, when the shares dropped from the July 17 close of $183 to open at about $164 after a minor disappointment in the earnings announcement. Analysts had projected $2.585 for the June 2013 quarter, but the $2.54 reported disappointed by only 1.75% and resulted in an 11% decline overnight.
The shares peaked at $194.55 on May 14, 2013; based on estimates for this and next year's business, my VALUE MODEL calculates that SHW should see highs of $115 and $122 respectively in 2013 and 2014, both levels that are significantly below current levels.
The price has been above the Value Model 2013 projection of $115 since roughly April 2011. The current price is about 46% above that level.
|Average Valuation Ratios 1982 to The Present Compared to Current Levels|
|CURRENT||RELATIVE TO RATIOS|
|0.67||PRICE/SALES @ LOW||0.98||PRICE/SALES @ HIGH||1.70||174.45%|
|10.97||P/CF @ LOW||16.32||P/CF @ HIGH||21.49||131.68%|
|9.45||P/E @ LOW||13.91||P/E @ HIGH||21.35||153.46%|
|2.69||P/BV @ LOW||3.96||P/BV @ HIGH||7.30||184.56%|
In Table 2, I have displayed the average ratios for SHW at the lows and highs for 1982 to 2013 and also calculated the ratios based on the current price and the current Value Line estimates for the business in 2013. Many factors might be attributed to the share price rise, including the recognition that a recovering real estate market has benefited SHW and also a landslide of money seeking dividend yields. At times, momentum investors can lose sight of the disconnect between the excellence of the company and the valuation of the company's shares. It is at times like this that blinders are donned and higher than warranted valuation creates risks that exceed potential investment results. That is where SHW is at now. Good company, decent results, overpriced stock.
Insider Selling is Significant
Management has shown that it is perhaps aware of the valuation excesses since late 2011. Insider selling (Source:Yahoo Finance) has been consistent and single-minded with significant insider sales from $100 to current levels and no purchases other than option and compensation-related ones during that period (those transactions can generally be considered to be primarily part of the compensation package for the executives involves). Insiders sell for many reasons, including estate planning, paying children's tuition fees, and many other reasons too numerous to mention, but essentially insider purchases are made for only one reason; they believe and expect that the share price will go up. Since late 2011, there have been significant insider sales and no outright purchases.
Reported Numbers vs. Projections in the near future
Comparing the growth of the business to the growth in the share price shows how the share price movement has outstripped the growth in the business. SHW sales per share in 2000 was $31.66 per share and are projected to be at $99.05 in 2013 and $104.85 in 2014, a 303% change. The share price is currently (using the August 16 closing price of $168.69) 641% of the 2000 high ($27.60) that occurred. With sales at 311% of the 2000 level, should the shares be ahead 609%? Although the relationship never moves in lockstep, the shares have risen more robustly than the basic business.
Given that the current share price is at $168 and the 2013 Value Model Projection is $115, it would not be unreasonable to conclude that there has been an excessive move in the stock from the 2011 lows of about $70 (about 240% in appreciation to current levels), which has risen more than double the rate of sales. Examination of the growth of Cash Flow, Earnings, and Book Value ratios noted in the table above supports my contention that the shares are overvalued by all the peak ratios illustrated in the table below as determined in the Value Model.
The shares are valued as though the company is generating significantly more business than it is. On average, for instance, the shares have traded at their annual high at 98% of sales, but are currently 182% of 2013 projected sales. If the growth rate was much higher, it might justify higher ratios, but the whole purpose of calculating the ratios at the highs and the lows each year shows the actual history of the share price related to the actual business (which notionally should be what the share price should be based on in any case). Consider that there has been a real, but not particularly robust recovery in the US and global economy. Much focus is given to the Chinese economy, which has been an important provider of economic recovery since the meltdown. Chinese efforts to moderate growth so it will be sustainable have been continuing and include such measures as adjusting bank reserve ratios and making it known that steps will be taken to prevent runaway growth and possible asset pricing bubbles that could be ultimately disastrous. Given the uncertainties these actions portend, it seems less than prudent to hold shares in cyclical global businesses that have premium pricing, like SHW.
For perspective consider that in 2000 the shares were projected to see a value model projection high of $34.53 based on the average of High Price/Sales, High Price/ Cash Flow, High Price/ Earnings and High Price/Book Value applied to SHW's business in that year. In 2000, which represented the highs just prior to the "tech wreck", the shares actually reached a high of $27.60. Value model projections are intended to illustrate long term relative valuation, and are not intended to be a prediction of actual prices in any given year.
I find opportunities when share prices vary significantly from where they would be valued "on average according to the value model". My value model's "projections", are intended to reflect how the company would be valued based on what was paid for the shares historically, based on the actual business the company is estimated to generate in the current year. The projections are not a forecast, but they do give an indication when shares are significantly over or undervalued.
Examination of table 2, above illustrates that the market has driven the price of SHW to levels that are significantly beyond what investors have historically been willing to pay for SHW by any measure since 1982. The Price to Sales Ratio has averaged 0.98x since 1982 and is currently at 1.86x. From 1982 to the present, at its highs, SHW's Average High Price to Cash Flow is 16.3x and the current level of that ratio is over 22.6x; likewise the P/E averaged 13.9x at the average high and is currently 22.4x and the Price/Book Value averaged 3.96x at the peak versus the current level of 7.66x. It has been my experience that overvaluations like this share some common characteristics.
- The timing of when shares will return to historical valuation levels is unpredictable.
- Disappointments in the company's results or general market corrections can be catalysts for such price adjustments.
- Insider selling activity tends to accurately foreshadow price adjustments.
- Ultimately, and almost invariably, shares return to reasonable valuation levels.
- The existence of such price overvaluations is more common in times like now when the general market conditions have been robust; the S&P 500 has recently ticked to new all-time highs.
With the shares currently at $168.00 (a 609% increase rise above the actual 2000 high of $27.63 which was a time of market giddiness and overvaluation that preceded the "Tech Wreck"), they exceed the Value Model's valuations at the projected 2013 valuation highs by about 46%.
The charts below show the current valuation of SHW relative to its historical valuations.
Charts 2 to 5 clearly show that the shares have been significantly overvalued from 2011 to the present. By every measure, the price of SHW shares are overvalued based on the average Value Model High Ratio levels by about 46% from the highs the shares have actually experienced going back as far as 1982.
The most important attributes for value investors are patience and discipline, because for share prices to reflect a reasonable valuation, a change in market psychology must occur. In any long term investment program the timing is unpredictable. Based on where "the market" has been willing to value them back as far as 1982, ultimately, SHW shares will come down to a reasonable valuation, therefore it is recommended that investors follow the lead of insiders since early 2011 and sell any SHW owned.
Those that have financial capacity and emotional temperament to assume speculative positions should consider taking short positions using long term put options.
Additional disclosure: I own SHW Put Options. This is a story about overvaluation; since I first submitted it, the shares have fallen from about $183 to $168. This is my own opinion and reflects my views, not those of any other person or company.