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Summary

  • Investing in equities only when they are fairly valued or undervalued is an important method for achieving both an adequate total return and an adequate level of income.
  • Valuation and earnings growth are the two primary drivers of long-term return.
  • Investing in stocks at fair valuation is about soundness and predictability of long-term return.
  • Valuation is also about soundness and controlling risk.

Introduction

This series of articles is focused on the successful management of the equity portion of the individual investor's retirement portfolio. Conventional wisdom states that investors in retirement should be more conservative with their investment portfolios. In a general sense, I agree with that position. However, I also believe that retired investors need to be careful that they don't take conservative investing to the extreme. With interest rates as low as they are today, I believe that the risk profile of bonds (fixed income) is aberrantly higher than normal. Consequently, I temporarily at least, favor equities over fixed income.

Moreover, I contend that there is no such thing as a riskless investment. I hold this view because I recognize that there are many facets to the concept of risk, and therefore, I believe that all investors should evaluate risk in all its many disguises. The big risk of total loss associated with equities is quite rare, and I believe, more fear-based than fact-based. Furthermore, the risk associated with a falling stock price, especially when the underlying business remains strong, is more related to investor action than pure loss. In other words, the greatest risk of a falling stock price is how the investor reacts to it.

For example, conventional wisdom primarily predicated on Modern Portfolio Theory (MPT) would like us to believe that volatility is risk. Consequently, they like to utilize mathematical measurements, such as standard deviation, beta and others, in their attempt to define risk. I have written extensively about risk in previous articles found here and here, therefore, I direct the reader's attention to these articles for a more comprehensive explanation of my views on the subject of risk.

However, for the purposes of this article, I will be focusing on risk in a more practical way. For me, one of the greatest risks that retired investors face is not having enough money to maintain an adequate lifestyle throughout their retirement years. Consequently, this article is offered to address those retired, or close-to-retirement investors that have accumulated enough retirement assets to theoretically fund a healthy lifestyle, assuming of course, their portfolio generates adequate enough returns to accomplish that objective. The important questions, such as how to accumulate enough assets, how much to save, when to start, what asset classes should be utilized, etc., although important, are beyond the scope of this article.

The main reason that I am introducing this article with a discussion on risk is because of its importance and relevance to the concept of valuation in regard to managing an equity portfolio. In my experience, most investors are prone to think of valuation as merely a market timing tool. I believe it is true that valuation is an important metric for determining long-term buy, sell or hold decisions. Conversely, I don't think it is necessarily an effective concept for timing the market short-term. The reason is simple. The stock market can incorrectly price or value a stock for a long period of time. I will address this more fully when I cover valuation, as it relates to the six primary categories of stocks discussed in Part 1.

To summarize this introduction, valuation is an important consideration for controlling risk, as much as it is a consideration for making sound buy, sell or hold decisions. To my way of thinking, at least, controlling risk is a conservative strategy that can be implemented without relegating a retiree's portfolio to becoming so extremely conservative that it becomes incapable of generating appropriate long-term total returns. This means achieving investment results that consider both components of total return - income and capital appreciation.

Investing in equities only when they are fairly valued or undervalued is an important method for achieving both an adequate total return and an adequate level of income, if the company pays a dividend. But perhaps most importantly, investing in equities at sound valuations can simultaneously accomplish these objectives at controlled and reasonable levels of risk.

The Benefits of Sound Valuation: Part 2

In Part 1 of this two-part series I introduced six primary categories of equities according to Peter Lynch. In this, Part 2, I will address how valuation applies to each category. However, there are points of clarification that I feel should be made. First of all, based on several comments made on Part 1, I feel that certain readers may be disappointed that I will not be offering a list of fairly valued stocks in this article. Instead, this article is designed to address the many nuances of valuation and its usefulness as a metric when applied to the six primary categories of equities. Offering a list of fairly valued research candidates in each of the six categories might be the subject of follow-up articles after this series is complete.

Second, I offer this article to illustrate that valuation is not a one-size-fits-all concept. Also, I intend to demonstrate that valuation alone will not generate high or even appropriate total returns. Investing in stocks at fair valuation is about soundness and predictability of long-term return. Because once fair valuation is ascertained, total return (income and capital appreciation) will be a function of each respective company's earnings growth rate achievements.

Stated more clearly, sound valuation is not a concept that can be effectively utilized in a vacuum. Sound valuation is a relative concept. In order to determine return potential, it must be implemented simultaneously with the consideration of future earnings growth potential. I discussed this more extensively in a prior series of articles found here and here.

Sound Valuation As It Applies to the Six Primary Categories of Equities

In order to be consistent with Part 1 of this series, what follows will be a discussion of valuation and how it uniquely pertains to each of the six primary categories of equities as presented by Peter Lynch in his best-selling book "One up on Wall Street." However, before I address each specific category, a few general remarks about valuation are in order. As I alluded to earlier, valuation is not just about achieving an optimum or even maximum total return. Valuation is also about soundness and controlling risk.

When it comes to valuing equities, I believe there are some generalities that are useful, but not necessarily absolutes. For example, the P/E ratio is an important valuation measurement metric. To me, the importance of the P/E ratio is best understood by considering its inverse, or the E/P ratio (earnings divided by price). When looked at with this perspective, the P/E ratio represents a calculation of the earnings yield that a given equity offers its owners. As a prospective owner of a business, I want to be sure that the earnings power of the company provides me an adequate return on my investment.

Consequently, I suggest that a P/E ratio of 15, calculating an earnings yield of 6% to 7%, represents a minimum threshold (maximum P/E ratio), or fair valuation indicator. Therefore, I do not consider it a coincidence that a P/E ratio of approximately 15 (14-16) is the historical 200-year average P/E ratio of the S&P 500. Moreover, I do not think it's a coincidence that the average long-term total return on common stocks is approximately 6%-8%. Nevertheless, for most companies, I believe a P/E ratio of 15 or lower indicate a sound proxy for a common stock trading at fair valuation. Again, a P/E of 15 is not an absolute number, but instead, a reasonable valuation barometer.

Therefore, as a general rule, I tend to avoid investing in most any stock when its P/E ratio is above 15. However, like all rules, there are exceptions. For very fast-growing businesses, I will consider paying a higher P/E ratio, as long as I believe that future earnings growth supports the higher valuation. This is predicated on the power of compounding. When investing in a high-growth stock, if the earnings growth manifests, the investor will be buying future earnings at a much lower future valuation than they would achieve from a slower-growing entity. I will discuss this more fully when I cover fast growers later. Nevertheless, for the vast majority of stocks, I tend to avoid paying a P/E ratio above 15. I like lower P/E ratios, but I don't like the extra risk, coupled with a lower potential return that a P/E ratio above 15 implies.

Fair Valuation - It's Enhanced Importance for Slow Growers

Personally, I define a slow grower as any company with both a history of and the future prospects of earnings growth of 5% or less. However, I would never consider investing in a slow grower, unless it paid an above-average dividend (high yield) and unless I considered it predictable and safe. Going in, I believe it would be irrational to expect a high total return from investing in a slow grower. Therefore, I would only consider investing in slow growers, such as utility stocks, when interest rates on fixed income investments are low, as they are today. Otherwise, I would avoid investing in them, with the exception of when safety is my primary objective.

Regarding valuation, and my general rule of a P/E ratio of 15 or less, it has enhanced importance when earnings growth potential is low. Since capital appreciation potential is meager, and even tenuous, overpaying for a slow grower exaggerates the risk. Frankly, I believe that when, not if, the typical utility stock's valuation reverts to the mean, any chance of achieving even an anemic level of capital appreciation is lost. To me, utility stock investing makes most sense when interest rates are low (like they are today) and when valuations are low (which is difficult, if not impossible, to find today).

Consolidated Edison Inc. (NYSE:ED)

Consolidated Edison Inc., through its subsidiaries, provides energy services to residential, commercial, industrial, and government customers in the United States. The company's subsidiaries include Consolidated Edison Company of New York, Inc. (CECONY) and Orange and Rockland Utilities, Inc. (O&R). It also owns the competitive energy businesses.

In Part 1, I drew earnings only graphs based on the formula P/E = EPS growth rate. On the graph below, I will, for the most part, present complete earnings and price correlated F.A.S.T. Graphs™ with dividends utilizing Ben Graham's formula for valuing a business. Furthermore, the graph now includes monthly closing stock prices (the black line) and the historical normal P/E ratio (the dark blue line).

The primary point I am expressing with the following graph on Consolidated Edison Inc. is the relationship or correlation between price and earnings. The orange line represents a P/E ratio of 15, and the graph clearly depicts how price follows and relates to this valuation. More importantly, we see that during times when the price is above fair value (red arrows) and below fair value (yellow arrows), it quickly reverts to the mean. Therefore, I believe this shows clear evidence that investing in this utility, and I will add most other utilities, should only be done when the P/E ratio is 15 or less. With capital appreciation so razor-thin because of such low earnings growth, even slight overvaluation can eliminate any chance for capital appreciation.

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When we evaluate performance of this low-growth utility, there are several stark realities revealed. This particular company has raised its dividend each year, but the growth rate of that dividend increase is meager and highly correlated to the company's earnings growth. However, because of its above-market yield, total dividends declared have been more than double what could have been earned by investing in the S&P 500 index. However, the annual rate of capital appreciation is also approximately half what the index provided.

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The bottom line is that when investing in low-growth stocks, such as utilities, valuation is critical. With faster-growing enterprises, earnings growth can overcome some moderate overvaluation. However, with growth so slow, there is very little margin for error. Consequently, I contend that being strict with valuation when investing in slow growth stocks is of heightened importance. Never overpay for slow growth.

Are Stalwarts Worth a Premium Valuation?

Throughout the history of investing, it is a commonly accepted principle that investors are willing to accept a lower return for quality. When dealing with equities, I refer to this as a quality premium which often applies to blue-chip dividend-paying stalwarts. Consequently, it can be argued that the standard concept of fair valuation can be deservedly altered or adjusted for blue-chip dividend-paying stalwarts. However, I believe it's up to the individual judgment of each investor to decide whether they are willing to accept a quality premium adjustment - or not.

The Coca-Cola Company (NYSE:KO)

The Coca-Cola Company operates as a beverage company worldwide. The company owns or licenses, and markets approximately 500 nonalcoholic beverage brands, primarily sparkling beverages, and also various still beverages, such as waters, enhanced waters, juices and juice drinks, ready-to-drink teas and coffees, and energy and sports drinks.

The following earnings and price-correlated graph on the stalwart Coca-Cola vividly reveals the quality premium valuation principle. Once again, the orange line on the graph represents the theoretical fair value P/E ratio of 15.

However, the blue line on the graph illustrates the historical normal P/E ratio that this high-quality stalwart has typically commanded. A careful review of the graph shows that Coca-Cola's stock price only touched the orange fair valuation line twice since 2005, and only briefly each time. For the rest of this time frame, Coca-Cola's stock price correlated more closely to a P/E ratio of approximately 20 (19.5). Moreover, the reader should note that I chose a time frame where the price was at or near the blue normal P/E ratio line at the beginning and at the end. The importance of this will become clearer when we examine performance below.

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When we review the performance associated with the above graph, we discover that long-term shareholders of Coca-Cola since 2005 would have earned an above-average rate of capital appreciation consistent with the company's earnings growth achievement, even buying the stock at its quality premium valuation on 12/31/2004. Moreover, they were also able to harvest the above-average dividend income (the income component) as well.

Therefore, it can be argued that Coca-Cola warrants a quality premium and that investors might be rational in paying it. However, for those investors that believe in strictly adhering to the principle of fair valuation, like yours truly, there were only two brief time periods since the beginning of 2005 where Coca-Cola could have been bought. This is a valuation decision that each investor must make according to their individual policy. Nevertheless, the bottom line is that investors can pay a premium valuation when investing in a stalwart, and still do fine long-term. But I will continue to contend that much of the lower risk of investing in quality is lost by paying the premium.

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Wal-Mart Stores Inc. (NYSE:WMT)

Wal-Mart Stores Inc. operates retail stores in various formats worldwide. The company's operations comprise three segments: Wal-Mart U.S., Wal-Mart International, and Sam's Club.

Wal-Mart possesses all the most important attributes of a stalwart, especially from the perspective of what I consider an impeccable operating history. The following earnings and dividends-only graph reveals a company that has consistently grown its earnings every year at an above-average rate. Additionally, Wal-Mart is a David Fish CCC List Dividend Champion that has raised its dividend every year for 41 consecutive years (the pink line on the graph).

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However, from the perspective of valuation, Wal-Mart tells an entirely different story than what we saw with Coca-Cola above. Moreover, I believe this company provides a quintessential example of the importance and the influence of valuation on risk and on market timing. By adding monthly closing stock prices to the above graph, we can learn a great deal about how overvaluation increases risk, while simultaneously impacting returns in a negative way.

The red circle on the graph highlights a time period when Wal-Mart became excessively overvalued. From its highest peak, or most overvalued price, it took Wal-Mart approximately 8 years before price once again became aligned with fair valuation. More importantly, over the same time frame, Wal-Mart grew earnings and dividends consistently in each and every year. Therefore, I contend that the low-risk aspect of investing in this quality business was destroyed by overvaluation. Put differently, Wal-Mart, the low-risk stalwart, had become Wal-Mart, the high-risk stock. Peter Lynch put this nicely in perspective in "One Up On Wall Street" with the following:

"It's a real tragedy when you buy a stock that's overpriced, the company is a big success, and you still don't make any money."

In contrast, once price came into alignment with fair valuation by the summer of 2007, Wal-Mart, the quality business, simultaneously became Wal-Mart, the quality stock (the green circle on the graph). Perhaps what's most interesting about this example is that the reputation of Wal-Mart as a bad stock persisted for many years, even after it became a quality company at a sound valuation.

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The following earnings and price-correlated graph shows Wal-Mart since the beginning of 2008 with valuation aligned with earnings, making the good company also a good stock. The reader should note that this occurred even though earnings growth had slowed from a 20-year average of 12% per annum to a more recent earnings growth rate of 7.7% per annum.

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From the perspective of performance, Wal-Mart, the good company and good stock, generated capital appreciation that was double the stock market. Moreover, Wal-Mart the fairly valued dividend-paying stalwart generated dividend income that was over 2 ½ times what the stock market produced in dividends.

When evaluating stalwarts, valuation remains important, but perhaps not as critical as it did with slow growers. Additionally, some stalwarts might deserve and receive a quality premium valuation, while others might not. Recognizing this difference can both reduce risk and enhance long-term total returns.

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Fast Growers Command a Higher Valuation

Fast growers are the category of companies that Peter Lynch liked best. However, fast growers present an entirely different aspect or nuance of valuation. Fast growers generally deviate from the P/E ratio of 15 valuation metaphor discussed above. Due to their rapid rate of earnings growth, fast growers routinely command P/E ratios that are equal to their earnings growth rates. The justification behind this is that fast growers generate significantly more future earnings than slower or average growers do. Therefore, it makes sense to invest in them at higher valuations because, in effect, the investor is buying future earnings at a much lower multiple.

Chipotle Mexican Grill Inc. (NYSE:CMG)

Chipotle Mexican Grill Inc., together with its subsidiaries, operates Chipotle Mexican Grill restaurants, which serve a focused menu of burritos, tacos, burrito bowls (a burrito without the tortilla), and salads, made using fresh ingredients.

Chipotle Mexican Grill represents a perfect example of a fast grower commanding a P/E ratio equal to its earnings growth rate. The reader might note that the P/E ratios of the orange earnings line and the blue normal P/E ratio line are almost identical. Moreover, we see a clear example of price tracking earnings, and how price quickly adjusts back to earnings when it deviates over or under. From a longer-term historical perspective, a 38-40 P/E ratio for this example is clearly justified, based on historical precedent.

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The performance, comprised solely of capital appreciation (no dividends) for Chipotle Mexican Grill shareholders, closely correlates to the company's earnings growth record, lavishly rewarding shareholders. But, as I will illustrate next, high rates of historical earnings growth are hard to achieve and virtually destined to slow.

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Since 2011, Chipotle Mexican Grill's earnings growth rate has been approximately half its longer-term historical average. Therefore, this company that looked only moderately overvalued on the long-term perspective, now looks dangerously overvalued, based on more recent earnings growth. The moral of the valuation story for fast-growth stocks is that prudent investors must always be on the lookout for slowing earnings growth. History can be a guide, but as investors, we can only buy the present and future.

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Cyclicals: When Does Valuation Makes Sense?

Although the principles of valuation still apply to cyclical stocks, it is not as tidy, because variations of earnings growth become very erratic. With a cyclical stock, the company can be fairly valued based on current earnings, while simultaneously extremely overvalued based on future earnings due to entering a down cycle. Consequently, cyclical stocks present a very different valuation challenge, and may not be appropriate for the prudent investor in retirement. If you can navigate the cycles correctly, which is easier said than done, you can make a lot of money. However, the problem is predicting and timing the cycles correctly.

Interface Inc. (NASDAQ:TILE)

Interface Inc. engages in the design, production, and sale of modular carpet, also known as carpet tile. The company markets modular carpet in approximately 110 countries under the established brand names Interface and FLOR. Its principal geographic markets are the Americas, Europe and the Asia-Pacific.

Interface Inc. represents a quintessential example of a cyclical stock. Historically, the company enters moderately long periods of rapid earnings growth followed by moderately long periods of collapsing earnings. As the earnings and price-correlated graph below depicts, price tends to follow or correlate to the cycles. Consequently, if you can time the cycles correctly, you can make a great deal of money over the intermediate term. However, time them wrong, and the losses can become severe.

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The following shorter-term earnings and price-correlated graph on Interface Inc. illustrates the opportunity that investing in a cyclical offers as it enters a rapid earnings growth phase. But again, I caution the reader to recognize that executing a profitable cyclical investing strategy is both dangerous and difficult.

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On the other hand, when the cycle can be successfully navigated and the investment successfully executed when fair value is truly present, the rewards can be exceptional.

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In contrast, owning a cyclical during a down cycle can be devastating. During the down cycle 1998-2002, note how both earnings and price collapsed. There is great risk in investing in cyclicals, and simultaneously makes valuation decisions difficult and challenging.

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Long-term shareholders during the down cycle 1998-2002 lost almost 80% of their investment, and dividends provided little support.

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Proper valuation still applies as a risk reducer and a return enhancer when investing in a cyclical stock. However, calculating fair valuation becomes more complicated, because current earnings are less meaningful than when evaluating a stalwart or even a slow grower. The possibility that earnings can virtually disappear obscure fair valuation calculations.

Turnarounds

In my opinion, turnarounds leave the venue of investing and move into the venue of speculation. Consequently, this is a category that I believe should only be looked at and participated in with money that the investor is willing to gamble with and prepared to lose.

Rite Aid Corporation (NYSE:RAD)

Rite Aid Corporation operates a retail drugstore chain in the United States. However, unlike its more renowned counterparts, such as CVS Caremark Corporation (NYSE:CVS) or Walgreen Co. (WAG), where both possess strong operating earnings growth rates and histories, this company has failed to keep pace.

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However, the primary allure of a turnaround is the incredible profit opportunity it provides when and if operating results truly do turn around. Since 2012, Rite Aid Corporation has generated a strong earnings recovery, and stock price is responding.

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Consequently, speculators with the courage and foresight to invest in this stock at the beginning of 2011 were lavishly rewarded. There are truly times when risk has its rewards, as Rite Aid Corporation produced astounding results since 12/31/2011 that dwarfed even the exceptional returns of the S&P 500 over that same time frame.

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Clearly, turnarounds can be very profitable when successfully identified. However, investing in turnarounds is not for the faint of heart. Consequently, as previously stated, I see turnarounds as speculations - not true investments.

Asset Plays

I'm not going to provide an example of an asset play in this article, because identifying the value of assets cannot be done based on the traditional valuation metrics based on earnings. The attraction of investing in asset plays is the opportunity to invest in an asset-rich company, where the intrinsic value of those assets is not currently reflected in its price. However, I have personally not found any reliable method of evaluating assets. Moreover, the question of when and if the value of those assets can be harvested is unpredictable. Consequently, this is a stock category that I tend to shy away from, since I have little knowledge of how to calculate asset values.

Summary and Conclusions

Valuation and earnings growth are the two primary drivers of long-term return. However, valuation also serves as a mitigator or reducer of risk. The holy grail of investing would be to reduce risk, while simultaneously enhancing long-term returns. Therefore, only investing when fair value, or better yet, undervaluation is manifest goes a long way towards accomplishing both of those important tasks.

Additionally, fair valuation is not necessarily a universal principle that equally applies to all six categories of stocks. There are sound foundational principles of valuation, to be sure. However, there are also nuances to valuation that investors should be aware of. I have tried to highlight some of the most important nuances with this article. Moreover, investing at fair valuation will not always produce high rates of return, as illustrated by my review of slow growers. However, investing at fair valuation does bring a level of soundness to the process.

In Part 3 of this series, I will review various methods of portfolio construction, based on applying different levels of diversification. There is more than one way to construct a successful equity portfolio, and I will be discussing several variations that have been proven to work. However, some of these variations will not be acceptable to certain investors, while other variations may. As the old adage goes: there is more than one way to skin a cat.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: I am long ED, K, WAG, 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.

Source: Retired? How To Create A Strong Foundation Of Valuation Under Your Portfolio: Part 2