What To Do With Your Overvalued Blue-Chip Stocks

Includes: BRK.B, CL
by: Tim McAleenan Jr.

A strict adherence to the philosophy of Benjamin Graham suggests this basic framework for buying and selling stocks: find something substantially undervalued that contains a margin of safety, and then sell the stock once it crosses the threshold of what you think it is worth. There is absolutely nothing wrong with the application of this approach-after all, this is what allowed investors in the legendary Graham-Newman fund to reap returns of around 15% for most of its existence (although the take-home profits for investors was much less due to taxes and Graham's typical charge of taking a fifth of the profits over 5% in the later years).

If you choose to go that route, the advice is pretty straightforward: If a stock is overvalued, and after adjusting for taxes, you can find a more attractive place to put your money, then you should sell.

But for many blue-chip holdings, I take an alternate approach. One of the things that first sparked my interest in investing was the notion that some stocks generate such strong business performance on a consistent basis, year over year, that they are worth holding indefinitely because the reason for originally purchasing the company is because it is an excellent business, as opposed to just an undervalued one. Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B), first introduced me to the notion that some businesses are so fantastic at increasing intrinsic value with consistency that they are worth holding on to even during periods when the stock price seems to get a little ahead of the business fundamentals.

As Munger himself put it:

We're partial to putting out large amounts of money where we won't have to make another decision. If you buy something because it's undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That's hard. But, if you can buy a few great companies, then you can sit on your ass. That's a good thing.

Let's look at something like Colgate-Palmolive (NYSE:CL) as an example. The company currently trades at $115 per share. That is 22.5x earnings. The last time that company traded at an average annual P/E ratio above that mark was 2002. If you use common sense and remove Colgate's valuation during the tech bubble years and during the 2008-2009 meltdown, you can see that Colgate usually trades around 17.5-20.5x earnings on a normalized historical basis. If you use historical P/E multiples as an indication of the company's fair valuation, then it looks like Colgate is a bit overpriced these days. On a historical basis, it should trade somewhere between $90 and $105.

So if the company is currently trading above $10 per share above its highest fair value, why should an investor hold?

Because, as Munger points out, excellent businesses do a fantastic job of raising intrinsic value each year. In 1996, the company earned $1 per share. Now it's earning a little over $5. Over the past 17 years, the dish-soap and toothpaste manufacturer has quintupled earnings. The dividend has more than quadrupled since 2000. As shareowners learned last week, Colgate is raising its dividend from $0.62 per share quarterly to $0.68 per share quarterly. The earnings are expected to grow by 9.5-10.5% annually over the next five years, with dividends expected to grow by a nearly equal amount. And by the way, this is old hat for Colgate shareholders. As they know well, Colgate has been raising its dividend every year dating back to 1964, when Muhammad Ali beat Sonny Liston to become the heavyweight champion of the world. It's hard finding businesses with this kind of predictability.

While I respect the philosophy of selling a stock as soon as it becomes overvalued, I do believe there are a couple dozen blue-chip stocks out there that are worth holding through periods of mild overvaluation. After all, if you bought Colgate in 1990, you have managed to earn 15% per year. Even though you held through periods of overvaluation during the 1997-2002 stretch when the company traded between 22-30x earnings, you still managed to turn every $10,000 invested in 1990 into over $280,000 due to the underlying strength of Colgate's business performance. If you're considering selling some of your blue-chip stocks, I ask that you first take a hard look at the company's performance as a business. Are earnings and dividends growing by 8-12% annually over most five-year rolling periods? Because if they are, it may be foolish to merely rent the stock and sell out now just because the prices have gotten a little bit ahead of themselves.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.