We are going to start the new year off by looking at Wal-Mart Stores, Inc. (NYSE:WMT), which we believe is a blue-chip growth and dividend income selection that can be purchased at a sound and attractive valuation. Additionally, we offer Wal-Mart with its historical business results and price performance as an excellent example extolling the principles of sound investing versus speculation. We believe the lessons that this analysis offers are both important and invaluable to investors.
Most rational thinking common stock investors intuitively understand, and we believe would agree, that shareholder value is ultimately created through the operating success of the business behind the stock. The more successful the business is, and the faster it grows as an operating enterprise, the more intrinsic value it generates on its shareholder’s behalf. Of course, the gold standard for measuring business success is profit growth. The more profits a company generates, the more successful it is considered to be.
Wal-Mart Stores, Inc. is inarguably the world’s greatest retailer as evidenced by the fact it is also the world’s largest retailer. Although Wal-Mart has many detractors who believe that it is a retailing juggernaut that ruthlessly crushes its competition, it is hard to argue with its exceptional execution as the low-cost retailer spanning many decades. Wal-Mart’s low prices and wide array of goods has certainly benefited many consumers that needed to stretch their dollars, and this is especially evident during periods of economic weakness like we’ve just gone through.
The following 17-year plotting of Wal-Mart’s earnings per share record depicts a paragon of consistent above-average earnings growth. Wal-Mart’s earnings have increased at a steady and consistent compound annual earnings growth rate of 13.5%, which is more than double the 6.3% earnings growth rate for the average company as measured by the S&P 500 over the same time period. It’s also important to note that this time frame includes the recessions, 2001 and the great recession of 2008. This consistent earnings achievement by Wal-Mart is rare and hard to find among the broad universe of common stocks.
Although Wal-Mart has achieved a consistent record of earnings growth spanning many decades, we chose the time frame 1996 to current time for specific reasons which will be made clear as this article continues. First of all, we chose this time frame because Wal-Mart’s performance results over these years correlate very closely with their operating results (earnings growth). Wal-Mart grew earnings at a compounded rate of 13.5% and generated shareholder returns of 12.6%, which represents a strong correlation between earnings growth and shareholder returns. Therefore, the following performance results table offers evidence that validates the thesis that shareholder returns and the company’s business results are functionally related. However, as we will soon see, there is a second overriding and critically important factor that also comes into play -- valuation.
Valuation Can Make or Break Shareholder Results
The primary reason that Wal-Mart’s earnings growth and shareholder returns so closely correlated between 1996 to current time is because valuation was in alignment with earnings at the beginning of this period and earnings and price are also in alignment today (Wal-Mart appears modestly undervalued currently). Therefore, shareholder returns, to include dividends and the growth of dividends, were mostly a function of earnings growth. However, as the following earnings and price correlated graph clearly reveals, valuation was out of alignment for most of the time periods in between.
Since smart investors are always looking to invest in the best businesses, they will attract the most investor attention. However, there is an often overlooked danger associated with focusing on business results alone. Great business results can attract undue and excessive capital which can inflate valuations beyond what business and economic realities would justify. When this happens, investment returns of even the best businesses can become distorted and devalued. Investors need to be aware of, and acknowledge, that the current market price is not necessarily the correct price. Knowing that the market can behave irrationally, and recognizing when it does, either over or under, is a great investor benefit and advantage.
From 1996 through 1999, the period infamously dubbed “irrationally exuberant,” Wal-Mart’s stock price clearly became excessively overvalued. Consequently, even though operating results (earnings growth) continued on its superb and consistent trajectory, stock price had nowhere to go but sideways or down. It appears that investors infatuated with Wal-Mart’s continued success were blinded to the poor economics created by such lofty valuation. Apparently, because the news continued to be so positive each quarter, investors continued to hold their overvalued positions. However, it would also appear that prospective new investors were thwarted by the huge premium they had to pay to buy Wal-Mart shares. Of course, these last statements are based on the assumptions presented, and they seem to be the only logical conclusions that can be drawn from reviewing the facts.
Overvaluation’s Terrible Toll On Shareholder Returns
Regardless of whether our assumptions stated above are correct or not, the mathematics underneath Wal-Mart’s share price based on its earnings justified valuations made no economic sense from late 1997 on. The PE ratio on Wal-Mart shares by year-end 1999 was over 55 times earnings, which calculated out to an earnings yield of only 1.9%. From the time this began in 1997 to its peak in late 1999, was a time frame when Wal-Mart Stores could only be considered a speculative momentum play. In other words, owning shares in Wal-Mart Stores at these inflated valuation levels was not a sound investment, even though the business continued its strong and consistent rate of earnings growth averaging over 10.5% per annum from 1996 to 1999.
The following earnings and price correlated graph shows what happened after Wal-Mart became excessively overvalued by late 1999. When you examine Wal-Mart Stores’ subsequent price behavior in relation to its operating earnings, the dangers of overvaluation become visually crystallized. Since there was no true economic value supporting the stock price, it had nowhere to go but down in the long run until it eventually became aligned with its earnings justified value by late August to early September of calendar year 2007 (see first orange arrow).
It’s interesting to notice that once it touched its intrinsic value (the orange line), the stock appreciated approximately 35%, from approximately $44 per share to approximately $59 per share over the next 12 months (red arrow on graph below). However, this time it didn’t take almost 8 years for the overvaluation to correct itself. Instead, Wal-Mart’s stock price was back to its intrinsic value by the end of January 2009 (second orange arrow), and their stock price has tracked the orange earnings justified value line ever since.
When you evaluate the effects that this overvaluation had on Wal-Mart’s performance over the 13-year time frame, calendar year 2000 to current time, the results are rather astonishing. Shareholders did lose approximately 13% of their capital based on capital appreciation (depreciation), however, a steadily increasing dividend as a result of steady and consistent earnings growth, mitigated the loss of capital. And, even though shareholder returns were only modestly behind the S&P 500, they were nevertheless an inadequate reward considering the risk taken to achieve them.
Wal-Mart - A Sound Investment with an Attractive and Growing Dividend
The consensus estimates of 20 analysts reporting to Zacks, expect Wal-Mart will grow earnings at approximately 11% per annum over the next five years. We believe this estimate is reasonable considering it almost precisely mirrors their record of earnings growth since calendar year 2000, which includes our last two recessions. We believe this level of earnings growth, coupled with a dividend yield of 2.4%, that is expected to grow with earnings by 11%, easily justifies today’s valuation.
We believe that Wal-Mart Stores, Inc. is currently fairly valued. Therefore, we believe it represents a very attractive candidate for the long-term investor interested in above-average capital appreciation, with an attractive dividend yield that is greater than the 10-year Treasury bond yield and potentially growing at double-digit rates. In other words, with Wal-Mart’s stock price aligned with its earnings, the company represents an ideal long-term buy-and-hold investment for the prudent fundamental investor.
In addition to Wal-Mart representing, in our opinion, an attractive investment today, we believe the above analysis also offers an underlying and very important lesson on investing: If you’re an active trader, then fundamental valuations may not be as important to you as price action and momentum. If your holding period is short, and you are willing to diligently watch the price movement of your stock on a daily, hourly or even minute-by-minute basis, then fundamentals are only of secondary importance. If you’re this type of investor (Speculator) you can lay your money down regardless of valuation or even the quality of the company.
On the other hand, if you’re interested in investing in the long-term ownership of great and growing businesses, then both fundamentals and valuation are of paramount importance to you. You cannot buy and hold even the best of all businesses if you pay too much to buy it in the first place. We believe you make your money on the buy side. However, find a great business with the potential for future growth and with sound fundamentals that is trading at a reasonable price; then you can confidently lay your money down without a lot of worry or fuss. We believe that Wal-Mart Stores, Inc. is one of those great businesses that can be attractively invested in for the long term at today’s sound valuations.
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.