You can't ignore Colgate-Palmolive (NYSE:CL) when you are looking for a safe, stable and durable enterprise to invest in. It appears that you can sleep safe if you take into consideration its field of activity, its fame and its growing figures, but is the situation really so "rosy"?
I was watching a presentation from the company, which I am sure would excite any rookie investor. As you can see below, both its sales trend and operating profit are constantly increasing, while the gross margin is very high.
The company's after tax Return on Capital is around an impressive 30%. As a result of their trustworthy profile, the company has a low cost of debt, thus allowing the giving of dividends and buying back of shares. Therefore, the balance sheet remains leveraged and the equity is very low.
According to the above, Colgate-Palmolive's high return on capital is due to its history and well-known products. If the generated cash was used for new, significant investments, then the returns would not follow a corresponding rate. The company's products share is so high that it cannot count on better growth rates unless it expands to new products and sectors. The numbers the company brazenly presents - 1,018% in 20 years, 149% in 10 years and 51.8% in 5 years - would far and above outperform its competitors and the S&P 500.
(source: Barclays Back-to-School Consumer Conference presentation)
The real situation, however, can be better illustrated in the following graph.
Notice that the reason for this outperformance is basically attributed to the share's gains up until 2009, as well as to the fact that the stock kept these gains during the crash of 2008. The great return over the last 5 years, which of course may be incidental, automatically improves the overall image for the last 10 or 20 years. This trick gives the impression that this result is sustainable and not merely a brief show. In reality, Colgate-Palmolive does present a higher return than the S&P 500 in the long term and it is possible to keep this outcome, since it steadily increases its intrinsic value, but this effect is being exaggerated by the recent stock rising.
The basic fundamentals unravel the tangle. The graph below shows P/E. When the stock price is rising at a higher rate than the earnings, the metric is getting bigger, pointing towards overvaluation.
In our case, you can see that the stock compared to its earnings is overreacting at the final period and nothing groundbreaking is on the horizon. In 2012, the earnings reached $2.5 billion and the company is currently valued at $58 billion. The turnover of $17 billion is worrying me a lot, because it is a very small amount compared to capitalization. Namely, the earnings occur through a high profit margin instead of through large sales. This equals stability in profits, but high margins are notoriously difficult to get higher. Therefore, I believe that the company's future profit growth is limited by its sales growth. That is why my conclusion, as you can see in the end, derives from my reasoning that the stock will follow the orange line, meaning that we will see a correction in the mid-term.
If we take as a given fact that the stock is expensive, the mass buyback of shares might represent the wasting of produced profits. In some ways, the company gives money by pumping shares, thereby facilitating the exit of shareholders, instead of creating value for its future and remaining stockholders. This tactic helps the stock's behavior at the moment, but I think that it's only a good practice if the stock is cheap enough. I hope this is not a sign of bad management.
If we were analyzing another company, the finding would be that the stock is extremely expensive. This company, however, bears unique characteristics, and in the long run, it will perform better than a bond, a bank deposit or a real estate property. Therefore, especially for long term investors, I would not say that the pricey stock makes it prohibitive to buying. On the other hand, in the next stock market crash, it will most likely fall to a lower price than its current one.
To sum up, Colgate-Palmolive is a great company, but now is not the best time to buy into it. It is only suitable for very long term investors. Instead, mid-term investors could short this stock under a highly diversified portfolio with long and short positions.
Disclosure: I am short CL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.