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March 24th marked the 10-year anniversary of the peaking of ‘The Great Stock Bubble”. While technology was the biggest factor in creating the biggest bubble in U. S. stock market history, there were a number of other large cap stocks that sold at valuations way above their intrinsic value. Non-technology companies such as Wal-Mart (NYSE:WMT), Home Depot (NYSE:HD), General Electric (NYSE:GE), Pfizer (NYSE:PFE) and Coca-Cola (NYSE:KO) all sold at Price/Earnings valuations above 40 on March 24, 2000. I remember so many people near the top of the market saying, ‘I am a buy and hold investor’. Unfortunately a lot of these people learned a painful lesson that buy and hold does not always work.

As a value investor, I believe the most important factor in selecting stocks is valuation. As a rule of thumb, I do not believe any company is worth more than 25 times earnings. Being a follower of Benjamin Graham and Warren Buffett, I think you should be disciplined and only buy stocks at a discount to their intrinsic value. In the large cap universe of stocks, I do not think you should pay more than 17.5 times earnings. Assuming no company is worth more than 25 times earnings, this provides a margin of safety of 30%.

I pulled the 1999 annual report of Vanguard’s S&P 500 Index Fund and looked at the 25 largest stocks. Below is a listing of the 14 stocks that sold above 25 times earnings on March 24, 2000. These may have been great companies. However, given the high valuation assigned to the stocks they turned out to be poor investments. The returns are from 3/24/2000 to 3/24/2010.

Company

Total Return

Ann'l Return

3/24/2000 P/E Ratio

Cisco (NASDAQ:CSCO)

-66.68%

-10.41%

191.9

Oracle (NYSE:ORCL)

-40.22%

-5.01%

175.5

Dell Computer (NASDAQ:DELL)

-73.44%

-12.42%

92.5

Microsoft (NASDAQ:MSFT)

-34.73%

-4.18%

69.5

Intel (NASDAQ:INTC)

-62.95%

-9.45%

66.2

Home Depot

-40.74%

-5.10%

64.4

General Electric

-53.28%

-7.33%

49.6

Coca-Cola

46.16%

3.87%

48.0

Wal-mart

13.01%

1.23%

46.3

Pfizer

-31.26%

-3.68%

44.7

American Int'l Group (NYSE:AIG)

-97.54%

-30.95%

31.3

IBM (NYSE:IBM)

18.87%

1.74%

29.5

Bristol Myers (NYSE:BMY)

-51.47%

-6.98%

26.2

Merck (NYSE:MRK)

-7.52%

-0.78%

25.2

Average Stock

-34.41%

-6.39%

68.6

S&P 500 Index

-10.45%

-1.10%

30.0

From 3/24/2000 to 3/24/2010, including dividends, only three of the 14 stocks posted a gain. The average annualized rate of return for these 14 stocks was -6.39%. $1,000,000 invested in these stocks would be worth $655,900. The best performing stock was Coca-Cola, with an annualized return of 3.87%. This is hardly stellar performance. The worst performing stock was American International Group (AIG) that saw investors lose 97.54% of their money. (You can attribute this loss to their foolish decision of writing credit default swaps. Read Michael Lewis’ wonderful book, The Big Short, to learn more about this foolish decision and those who benefited from it.)

You will also notice that the S&P 500 Index lost 10.45%, including dividends over this time period. This is one of the few times over a decade the U.S. stock market has posted a loss. The fact that the index posted a loss can be attributed to the P/E ratio of the S&P 500 Index on March 24, 2000 being at 30.0. This was near an all-time high valuation level. Studies have shown there is an inverse correlation between valuation and subsequent returns. I think an investor should make valuation the cornerstone of their investment process. When analyzing a company, it’s the first thing I look at.

A Dozen Large Cap Stocks for the Next Decade

One positive from a decade of negative returns is that there are some attractive values in the large cap stock landscape. For the first time in the 10 years I have been following my intrinsic value philosophy, I am finding significant value in large cap stocks. Below are 12 large cap companies (market cap greater than $10 billion) that sell at least 30% below my intrinsic value estimate. These are companies that own outstanding business, offer good growth potential and are well managed. As a group, I think they offer an above average chance of posting market beating returns over the next decade.

Company

Ticker

Mkt Cap ($Bil)

P/E Ratio

3/26/2010 Price

Abbott Labs

ABT

83.1

14.3

52.90

Altria Group

MO

42.7

13.3

20.42

Automatic Data Processing

ADP

22.2

16.5

44.24

CA

CA

12.2

16.6

23.41

eBay

EBAY

36.0

15.0

27.45

General Dynamics

GD

29.3

12.4

76.92

Johnson & Johnson

JNJ

178.0

14.6

64.38

Kimberly Clark

KMB

26.2

13.9

62.81

Microsoft

MSFT

263.2

16.3

29.66

Procter & Gamble

PG

184.8

17.2

63.69

Sysco

SYY

17.2

15.3

29.17

Wal-mart

WMT

211.9

15.2

55.51


Disclosure: The author is long ADP, CA, EBAY, GD, JNJ, KMB, MSFT, PG, SYY and WMT in his personal accounts. Clients of Granite Value Capital are long ABT, MO, ADP, CA, EBAY, GD, JNJ, KMB, MSFT, PG, SYY and WMT.

Source: 12 Large Caps for the Next Decade