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Summary

  • In a previous article I demonstrated that the Hershey Company was a solid company that always appeared “overvalued.”.
  • The conclusion to that commentary was that shares of Hershey often traded at a premium and thus “paying up for quality” might not be the worst investment thesis.
  • At first blush, the Sherwin-Williams Company seems to share a lot of similarities – with a current P/E ratio in the mid-20’s.
  • However, this article demonstrates why a bit more caution with Sherwin-Williams could be warranted.

In a recent article I detailed why there never seems to be a great time to buy the Hershey Company (NYSE:HSY). Specifically, I indicated that this Pennsylvania-based confectionery had a large economic moat around its brands, a solid history of earnings growth and the propensity to reward shareholders - having increased its dividend in 38 of the last 39 years. Yet by any common metric, shares of Hershey appear to be chronically "overvalued" - regularly trading at a price-to-earnings ratio in the low to mid 20's.

At first glance, it appears that the Sherwin-Williams Company (NYSE:SHW) shares similar characteristics to the story of Hershey. Over the past 20 years this Ohio-based paint company has grown earnings by about 11% annually. Moreover, Sherwin-Williams has demonstrated just as much consistency in the shareholder rewards department by not only paying but also increasing its dividend for 36 consecutive years. The dividend has grown by about 12% annually over the past decade while shares outstanding dropped by an average of about 3.5% each year. It's plain to see that the business has performed well. Further, just like the Hershey example, shares presently trade at a P/E multiple in the mid-20's.

The conclusion to the Hershey example was that the company never seemed to trade at a lower multiple - bouncing around in the 17 to 27 P/E range. As such, it followed that paying a "premium valuation" might not be the worst investment ideology - otherwise you may never get an opportunity to partner with the company. I even provided an example whereby an investor who purchased shares of Hershey at 27 times earnings at the end of 2000 would have still generated 9% annual returns today - despite the seemingly inevitable multiple compression to come.

This is where the story of Sherwin-Williams and Hershey appears to diverge a bit. It could be argued that Sherwin-Williams had a better history and has even better prospects moving forward - thus justifying the high multiple. Yet today - with SHW shares trading around 25 to 28 times earnings depending upon your calculation -this is unchartered territory for the company. With Hershey you have a high current P/E ratio, call it 24, with a history of "high" P/E ratios. That is, today's valuation for Hershey isn't altogether that different from the average of the last decade. On the other hand, Sherwin-Williams is trading well above its historical norm. You have a high current P/E without much history indicating that it's sustainable.

Here's what that looks like in graphical form:


You can see that Sherwin-Williams is presently trading at about 25 times anticipated earnings against a historical average closer to 16. In fact, prior to 2010 the company didn't trade at a P/E ratio above 18 this side of the millennium. Granted a good deal of this might be a derivative of improved expectations - housing is coming back, the economy is improving, the whole deal. Yet consider that the company has previously grown in the 11-13% annual range before while simultaneously commanding a lower premium. Now the company is much larger and analysts are predicting similar prospects.

I'm not suggesting that SHW still can't be a reasonable investment today. Perhaps the company has entered new territory and will consistently trade at a multiple higher than its history. However, in considering such investments I believe it's prudent to be cautious if not skeptical.

Here's the return performance for the company over the last 13 and a half years:


The business grew earnings per share by about 11% annually, yet the price increased at a rate over 16% per year. This was due in large part to the P/E ratio expanding from about 14 to today's mark closer to 25. As such, investors would have seen 17% total annualized compound gains.

Today the expectations for the business are roughly similar. If they formulate - which is a big execution unknown but nonetheless possible - consider what would have to happen for an investor of today to see the returns of the past. If the business grows at 11% annually, the P/E would have to expand from 25 to nearly 40 to replicate 16% price growth - not to mention requiring the market cap to be over 4 times as large as it is today. So it's probably not prudent to think about the returns of the past.

In order for an investment in Sherwin-Williams to replicate its business expectations - say 11% annually - the P/E multiple would have remain about where it is today. It could compress a bit due to the growing dividend, but it would still have to be above the 20 times earnings range or thereabouts. This is still well above the historical average - more practical, but not yet a cautious assumption.

Finally, if the company reverts back a historical "normal" P/E this would mean return expectations in the mid-single digits - even if the business does great during this time. This scenario is probably the most practical, assuming the company can meet its heightened growth expectations. Incidentally, it should be underscored that even if the P/E dropped from today's 25 to say 15 in the future, the return expectations are still positive. Perhaps not in a risk-return adjusted sort of way, but at the very least this might be encouraging to those who are already partnering with this company.

Here's the bottom line: neither Hershey nor Sherwin-Williams are particularly attractive from an initial screen due to their "high" current P/E ratios. It'd be easy to skip over both in lieu of say Wal-Mart (NYSE:WMT) trading at 15 times earnings or Chevron (NYSE:CVX) at 12. Yet I would contend this is ignoring an intermediate analysis step. Hershey is "hard to buy" in that it seems to consistently have a premium valuation; but an argument could be made that it's value proposition is in line with what has happened historically and there's evidence that it might work out fine.

With Sherwin-Williams that simply isn't the case. Sherwin-Williams is hard to buy today because it's in unchartered waters. In order for a SHW investment to achieve solid returns, you need to expect both above average earnings growth and a multiple of earnings that is roughly one and a half times greater than it's historical average. Perhaps the company will execute, the pricing bids will prove resilient and it'll all work out. Then again, perhaps there's a reason why Sherwin-Williams seems hard to buy today.

Source: Sherwin-Williams: A Company That's Truly Hard To Buy Today