In the social sciences, the concept of "limerence" usually refers to the notion of unrequited love. An alternative definition of limerence refers to loving the idea of someone, rather than the reality of what they actually are. The financial equivalent of this is when you categorize a particular company as a high-quality blue chip investment, but it simultaneously possesses a deficient character trait that would make it a false candidate for a spot on the pedestal of ideal sleep-well-at-night investments to initiate today.
The common causes of what I call "stock market limerence" usually show up when a company possesses one of three character traits:
- (1) An unusually high debt burden that threatens future growth
- (2) A much lower long-term earnings growth rate than you'd expect
- (3) An absurdly high valuation (this one is not the fault of the company).
The most common examples of the high debt burden blocking growth would be Anheuser-Busch (BUD) and Clorox (CLX). In the case of Anheuser Busch, the company is sitting on $44 billion in debt. There's not a lot of history to draw on because of the Anheuser Busch/Inbev merger of 2008, and plus the company immediately started functioning as one during The Great Recession, but the debt ought to be substantial enough to prevent the company from enjoying profit growth in excess of 8% over the medium term.
In the case of Clorox, the company is probably much smaller than you realize. Even though it is a household name, it is only a $11 billion company. For comparison, Exxon (XOM) is a $395 billion company. I had a habit of mentally categorizing both companies on the same plane, but it took me a while to realize that Exxon is 35x bigger than Clorox.
Clorox has $2.2 billion in debt, and that is partially why the company has only grown earnings by 7% annually over the past ten years, and earnings by 2.5% annually over the past five. The dividend has not yet reflected this change in business performance. The dividend has gone up by 11% annually over the past decade, and 12% annually over the past five years, and this has masked the fact that debt is dragging down profits.
Here's the clearest example: in 2004, Clorox posted normalized earnings of $546 million. In 2013, the company is making $574 million in profit. The company is very strong, and I do believe over the super long-term it will make shareholders rich, but if you are looking at a 9-15 year time horizon, the company's debt situation will likely prevent the company from enjoying the kind of profit growth that you might initially associate with its brand-name quality.
The second cause of stock-market limerence refers to companies' with blue-chip names that simply do not grow profits at rates you'd expect. Some examples of this category might include Campbell Soup (CPB) and Kimberly-Clark (KMB). Both of those companies are profitable, storied franchises that will likely be here generating profits 20-30 years from now, but the high profit growth just isn't there.
Campbell has only grown earnings by 5.5% over the past decade, and 5.5% over the past five years (it does, however, get points for consistency). The soup and snack market isn't growing that fast, and plus, Campbell Soup also has a $4 billion debt load that complicates matters further. The profits are reliable, but the growth is not.
Now Kimberly-Clark is one of the most interesting case studies of a poor-growing company that has managed to be a great investment over the past decade. I'll explain-the company has actually given investors 11% annual total returns over the past decade. But that has been due to P/E expansion and an increase in the payout ratio, which have served to hide Kimberly-Clark's unexpectedly low profit growth.
Profits have only grown 2.5% annually over the past ten years. The reason investors did well is because the company went from spending $0.39 on the dollar to pay for dividends to using $0.67 on each dollar of profits to pay for dividends. Also, the P/E ratio went from below 14x earnings to 17-18x earnings. But profits have only gone up 1.5% annually over the past five years-now that the payout ratio and P/E expansion are likely tapped out, investors are going to need actual honest-to-god growth going forward to get "blue-chip returns."
And the last category just refers to marketplace conditions that prevent businesses from becoming good investments, despite the success of the underlying business. Coca-Cola (KO) traded at 60x earnings in the late '90s, and General Electric (GE) and Microsoft (MSFT) each traded well above 40x earnings at some point between 1999-2001, and that is why none of those companies gave investors returns north of 4% annually between then and today. That's not the fault of the company-it's our job to spot poor valuation and react accordingly.
Hershey crossed the $100 threshold in the closing days of October, and Brown Forman is now trading well into the $70s. That means each company is trading between 25-30x normalized earnings. That is where those companies traded in the bubble days of the 1990s. I'm not necessarily interested in drawing the line between "overvaluation" and "bubble", but I am interested in saying this: "Hey, these are companies that usually trade around 20x earnings. They are both well above that. Unless you think this new valuation level represents a permanent new normal, you are going to be disappointed when the valuation returns to 20x earnings, and your total returns lag the growth rates of each company."
There is a reason why many income investors cluster around the same thirty or so companies. It is because brand-name quality is not enough. Not only do companies need to be a household name to merit investment consideration for conservative investors, but they also need to avoid high debt loads, have respectable growth rates, and be trading at non-harmful valuations. Otherwise, you enter the realm of stock-market limerence where the stocks you think you love won't have the fundamentals to love you back.