I have been right about Starbucks (SBUX) and, more recently, I have been wrong.
I was right in November of 2006 when I recommended investors sell/short the highly overvalued stock at nearly $40/share. The stock dropped steadily over the next two years to under $8/share as SBUX went from being everyone's favorite to everyone's dog.
The stock should not have gone as low as $8/share any more than it should have been at $40/share in 2006 or $50/share in 2012. But that is how the market works these days.
Stocks routinely get pushed well beyond reasonable highs and lows. Research in Motion (RIMM) is another examples of a stock that went way too high only to fall back too far. These are volatile markets to say the least.
Momentum investors have capitalized on the volatility and enjoyed great returns over many of the last several years as they have mastered the art of speculation. However, keep in mind that speculation is different from investing.
Speculation is a dangerous game, because once the momentum turns, it usually turns viscously in the opposite direction of where it started. It is also dangerous for folks like me who attempt to warn investors about stocks whose valuation are getting out of hand. The same forces that cause the stock's valuation to get too high can continue to push the stock higher and higher. Remember the tech bubble? Momentum investing is not for the faint of heart.
My latest short call on SBUX was last fall, when the stock was at $40. Now, it is over $50. When I made the last short call, I put myself in the crosshairs of speculators who had plenty of momentum ammunition to push the stock higher. And my short call has, so far, been wrong. But I do not expect it to stay wrong.
I am not changing my investing opinion on SBUX. The stock is even more overpriced now than it was last October.
Don't get me wrong. I like Starbucks. CEO Howard Schulz has led an incredible turnaround of the business. The shift in focus from building lots of stores to leveraging the brand across multiple (non-store) delivery platforms is excellent. He has built a much more profitable business model this time.
From 1998 through 2011, Starbucks has delivered very impressive NOPAT growth - 25% compounded annually. That is performing at a high level for a very long time. At some point, the law of large numbers catches up, and the company's growth will slow. I am not saying Starbucks is a bad company, but it is a bad stock because it is too expensive. At $50/share, the current valuation implies the company will grow profits (NOPAT) at 15% compounded annually for 10 years.
In isolation and compared to its historical growth in NOPAT, those expectation may not seem that high. But they are. 15% compounded annual growth in NOPAT for another 10 years means Starbucks' after-tax cash flow will, in 2022, be higher than the 2011 NOPAT for Goldman Sachs (GS), Morgan Stanley (MS) - two businesses that have built rather large franchises and substantial competitive advantages.
SBUX's NOPAT would also be higher than 2011 NOPAT for Kraft (KFT), which has a slightly larger product offering than Starbucks. It would also be higher than 2011 NOPAT for 3M (MMM), Home Depot (HD), Eli Lilly (LLY) and Altria (MO). (My ratings on these stocks are here.)
You get the point: SBUX is already priced to become one of the most profitable companies in the US. For an investor to own the stock at these levels, he/she must believe that the company's cash flows will exceed the current expectations by a significant margin. Maybe you believe Starbuck can do that, but I do not.
With all the cheap stocks in the market (e.g. Most Attractive Stocks), why would any investor want to place a bet that SBUX's future profit growth would be better than what is already baked into the current stock price. It is not as if SBUX has a monopoly on selling coffee. It has lots of competition. The more success the business has, the more competition it attracts.
When I review the list of publicly traded companies in the coffee-selling business, I think "wow, the coffee business is in boom times at a time when nothing else is booming. Investors in these stocks should be careful."
Here is a quick list of publicly traded companies that focus on selling coffee. I doubt anyone would attempt to argue that all of these companies will be more profitable than Goldman Sachs, Kraft, Home Depot, etc. Something has to give.
- Green Mountain Coffee (GMCR)
- Caribou Coffee (CBOU)
- Peet's Coffee & Tea (PEET)
- Einstein Noah (BAGL)
- Dunkin Donuts (DNKN)
This list does not include three other major sources of coffee-selling competition: (A) home-made coffee, (B) local, private coffee shops, many of which offer excellent "atmosphere" and (c ) stores that sell coffee along with a host of other things, the best example of which is McDonalds (MCD), which get my "Very Attractive" rating. Here are my ratings on the other coffee stocks.
As I have stated before, SBUX cannot compete with the global brand and distribution capabilities of McDonalds. In-home, single-serving coffee is not likely to be free of competition either. Firms that already have great household brands, such as Kraft, will get a piece of the action.
Bottom line: I recommend investors take the profits and run from SBUX. I cannot predict exactly when the stock will drop, but I am confident that it will. I also recommend selling the following ETFs and mutual funds that allocate significantly to SBUX.
- Fidelity Select Portfolios: Leisure Portfolio (FDLSX) - 18% allocation
- Trust for Professional Managers: Smead Value Fund (SMLVX) and (SMVMX) - 8% allocation
- FundVantage Trust: Polen Growth Fund (POLRX) and (POLIX) - 7% allocation
- PowerShares Dynamic Leisure & Entertainment Portfolio (PEJ) - 5% allocation
- Advisors Series Trust: Chase Growth Fund (CHASX) and (CHAIX) - 5% allocation
Disclosure: I am long RIMM.