Hershey And The Idea Of 'Cheap' Or 'Expensive'

| About: The Hershey (HSY)

Summary

Recently an analyst came out with an “underperform” rating for Hershey.

Often times this sort of “news” can be an opportune time to check in on a security.

This article takes a long-term view, looking at relative valuation.

On April 20th of 2016, an analyst downgraded Hershey (NYSE:HSY) from "buy" to "underperform." The reasoning was a result of slower than expected U.S. chocolate sales and concerns in China. The analyst changed his price target from $95 to $92 and incidentally, as I write this, the security's share price has fallen from about $94.50 to closer to $92.

I think this sort of thing provides a nice opportunity to look at a couple of important factors in the investing world, especially for those with a long-term mindset. This "news" sort of reminds me of what happened with Wells Fargo (NYSE:WFC) recently. An analyst thought that shares might be worth $45 instead of the current price around $49 or $50 and thus suggested that the security was now a "sell."

In math terms, this makes sense: you think something is worth X, it's currently trading at X+10%, so you yell out that the price is too high and recommend that others ought to dispose of their stakes. Yet here's the thing: finance and investing are not perfect math equations. Instead, it's a whole lot of making guesses about the future - guesses that are naturally either going to be off or way off in the future.

So it's not enough to suppose something is worth $45, compare that to $49 and make an instant judgment. You have to consider a bevy of factors ranging from differing return requirements and replacing quality holdings, to frictional expenses and the possibility of being wrong.

With Hershey this particular update is even more extreme than that of Wells Fargo. From the analyst's point of view, you suspect shares are worth $95, and conclude that you ought to own the company. Next time this is reduced to $92 and suddenly the security is the equivalent of a sell; no intermediate ground.

Assuredly it's possible that the short-term concerns come to fruition and the company earns less this year. Then again, it's also plausible that things turn out better than expected and all you did was create frictional expenses to get rid of a very high quality partnership. The more frequently you jump in and out, in this case as a result of a slight change in expectations, the better for your brokerage, but probably not for your pockets.

The second thing that comes to mind is the relative valuation of Hershey and how shares might be generally perceived. Let's look at the history of the business and security from the end of 2006 through 2015:

On the top line you had annualized growth coming in at 4.6% per year - growing sales from about $4.9 billion to $7.4 billion. The profit margin increased a bit, resulting in company-wide earnings growth that increased by about 5.6% per year. With the share repurchase program, this turned into 6.5% annual earnings-per-share growth. That's pretty solid and more or less what you might expect from a large and powerful, well-known brand.

The next part is the valuation. You could have looked at shares of Hershey at the end of 2006 and saw it sitting there with a P/E ratio around 21. In comparison to what we know about securities in general, this might appear a touch high. Of course for something like Hershey, this sort of valuation has long been the norm. It makes the purchasing decision a bit more difficult - you're not getting a "steal" on the valuation - but the quality is certainly there.

Shares actually traded a bit higher valuation-wise by 2015, resulting in share price growth that slightly outpaced EPS growth. Once you add in the dividend component you come to a total gain on the magnitude of 8.4% per annum. As a point of reference, that's the sort of thing that would turn a $10,000 starting investment into $20,000 or so in less than a decade.

In effect the higher valuation "worked." That's not always the case for a lot of companies, but over long time periods buying shares of Hershey around this valuation has turned out well many times.

So let's keep this in mind for thinking about the future:

The middle column shows the same history as above and the right-hand column gives a hypothetical set of assumptions for the future. It's a baseline for how you might think about an investment in Hershey. This gives a very precise number, but it should be underscored that it's merely a place to begin. You ought to adjust the assumptions to your expectations. Moreover, you ought to consider a wide range of possibilities instead of this single set of numbers. However, this does still illustrate the concept well.

Getting to earnings-per-share, the above table presumes annual growth of just under 5% annually for the next decade. I've seen estimates for the intermediate-term for Hershey of over 7%, so this doesn't appear to be an overly enthusiastic assumption.

Should shares trade at the same valuation multiple (as has been quite close to the historical average for the last couple of decades) and continue to pay a dividend in line with earnings growth, you might suspect that an investment today could generate 6.6% annualized gains. And when I see 6.6% I think, "6% to 7%" or "5% to 8%." You get a very exact number, but it's more helpful to think in ranges as to not cement yourself to a given number.

Those types of returns would be adequate in my view. At the very least it's not a reason to automatically throw away a long-term - and in this case very high quality - partnership stake. Those types of calculations imply that your investment could double in the next decade. Moreover, if the actual business performance turns out better, it's easy to see that greater investment returns could be had.

The thing that often trips up the potential Hershey investor is the valuation. If you use the same numbers, but instead suppose a future earnings multiple of 15 instead of 22, your expected gains drop down to 3.5% per year or thereabouts. It's noteworthy that this is still positive, but still that's much less compelling. So an investment in Hershey is predicated on the company continuing to trade with a "premium" valuation.

In short, I think there are a couple of lessons that can be gleaned from the recent "news" surrounding Hershey. First, the notion of jumping in and out of stocks based on a guess that shares might be worth $3 more or less probably doesn't make a lot of sense. Your errors are apt to be much greater than this difference, so that doesn't really lend itself to an actionable idea, in my view.

The second thing to think about is relative valuation. This one is a bit trickier, but it can still be useful. "Cheap" or "expensive" are not so much universal as the terms are often used, but more specific to a given security. As a point of reference, had you been waiting to buy shares of Hershey around 15 times earnings two decades ago - something many consider "reasonable" - you'd still be waiting today (and subsequently miss out on solid gains along the way).

When you first encounter the security trading at 20+ times earnings this may seem too high, but for quite some time that has been a regular occurrence. That doesn't mean it must hold for the future, but as illustrated above, that part would likely factor into your expectations as to whether or not you might be interested in owning a portion of the business.

Disclosure: I am/we are long WFC.

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.