In a recent article, I highlighted why Nike (NYSE:NKE) may be worth a closer look. The idea was simple: due to an above average valuation and below average yield, Nike often flies under the radar of your typical stock screen. Yet shares are down materially in the last year or so, while the business continues to generate solid and growing profits.
Let's focus on the price decline. Back in November of 2015, shares were trading hands around $66. And I think this is an important point to remember: this number is simply a record of what happened at the time. In general, pricing tends to follow business performance (or the expectation of such), but there's no mechanism requiring the prices to react a certain way at a given moment.
A lot of people get attached to past share prices. Just because someone bought and sold at $66, this does not simultaneously indicate that this is now the price. It gives you a clue as to what people are willing to pay, but in the short term, it's merely a liquidity bid. The price at which you could sell if you were so inclined.
Since the end of 2015, the share price of Nike has fallen materially. It went from the high $60's to $65, then $60, then to $55, and as I write this the number is closer to $50 even. All told, we've seen a decline of about 25% in just one year. And for many that sort of thing means "doom and gloom." Indeed, a comment was made to this effect: "when will the bleeding stop?"
The obvious answer is no one knows. Shares could be 25% higher or lower from here this time next year. However, the interesting part to me is the psychology involved. Many investors have a tendency to extrapolate recent events out into the future: seeing Nike decline in price recently makes them wonder, "what if this continues forever?"
Of course, in reality, trees rarely grow to the sky or fall to the earth. Instead, there's a tendency for prices and valuations to come back to a reasonable range. Not always, not universally, but it's still an overwhelmingly common occurrence. And luckily for the investment world, that range is generally increasing as profits rise over the years.
I'd like to use this logic to get a better framework for thinking about the recent share price decline with Nike. Let's start with some history.
Here's a look at Nike's split-adjusted dividends, earnings and share price from the start of the century:
You can see the tale of an excellent business and investment history play out. Note that the above numbers reflect fiscal years and not calendar years. The dividend started out as a small component of earnings, and while it has grown robustly in the last decade and a half, this cash payment still does not make up a huge portion of earnings.
The dividend is impressive, staying the same or growing each year. Yet I'd contend that the earnings record is even more impressive: increasing every single year, recession or not. Nike has truly been a powerhouse of increasing profits.
The share price appreciation has also been impressive: on a split-adjusted basis, going from $5 to $50. And if I told you that over this period dividends grew by 15.5% per annum, earnings by 14.2% and the share price by 15.7% per year, I don't think that would be surprising. The magnitude is impressive, but you had share price performance that was roughly in line with the business gains.
Interestingly, despite the long march upward, the degree to which these increases took place was not always consistent. Here's a look at the year-over-year changes for each component:
On the dividend side, you see very impressive growth and a good deal of consistency as of late. With earnings you have a higher number every single year. This number is not quite as smooth, but it still marches upwards year after year.
The share price is a slightly different story. Despite dividends and earnings growing each year, the share price actually declined on three separate occasions. And, indeed, if you count May of 2016 to today, so far we've seen a fourth period of decline. Moreover, the share price has also grown much faster than earnings on many occasions.
Share prices tend to be a lot more finicky than business results. As we just saw from above, share price performance tracked the business results over the long term, but interesting divergences can occur during shorter time periods.
For instance, from 2000 to 2009 Nike grew its per share earnings by 240%. And yet the share price increased by just 170%. Over this period, you had a security growing very nicely (over 10% per year), but the valuation went from 20 times earnings down to 15. You had share price performance that trailed business results.
From 2009 through fiscal year 2016, the opposite situation occurred. Nike grew its per share profits by 150% - a very respectable amount. Yet the share price increased by 290%. The earnings multiple went from 15 to the high-20's. In this period, share price performance drastically outperformed business results.
So the recent share price decline should not be especially surprising. In the past decade, you had share price performance that not only followed but also exceeded the solid business results. Given an expectation that long-term returns will track (not indefinitely exceed) business results, it follows that eventually you're going to see share price performance that trails Nike's results.
That's the first thing that I'd like to point out. When you have share price outperforming business results for years, it's easy to get used to that sort of thing. Yet eventually valuation acts as an anchor, bringing shares back down to a "reasonable" range. This can take years, but it happens time and again.
With that logic in mind, you can better think about "when the bleeding will stop." If you believe 20 or 22 times earnings for Nike is more reasonable (instead of say 30), then right about now is where you'd anticipate the "bleeding" to stop. (If you believe a lower valuation is warranted, then a lower ongoing price could be anticipated.) From here you might anticipate that shares would more or less reflect business results over the long term.
Now there's a very important corollary. Just because the valuation may now appear more reasonable, this does not simultaneously indicate that a declining share price is now "over." Shares could still decline 25% next year. Eventually, long-term price performance and business performance ought to track each other if the starting valuation is reasonable, but there's no requirement that it happens this week or year. The best you can do is demand a fair valuation, which greatly ups your chances of capturing business performance (not guaranteed, but greater odds nonetheless).
The nice thing is that earnings growth is largely positive (for Nike, always positive thus far). So even if you miss on the valuation a bit, say 23 times earnings instead of 20, there's a bit of wiggle room there. This holds more so the faster the business is growing.
If earnings are say 100% higher 10 years from now, you'd generally expect the share price to be higher as well. If the starting and ending valuation were the same, you'd expect your return to closely track business performance. And if the ending valuation goes higher or lower, your potential returns are likewise affected.
That's point number two. Anything can happen in the short term, but in general, you're going to see a relationship between price and profits, with a factor of valuation mixed in, over the long term. We've already seen it play out with Nike: price performance and business results can vary widely, but eventually you have a logical connection.
Finally, I'd like to make one more point as it relates to investor psychology. When people see a much lower share price, not only do they see "doom and gloom" (what if this continues forever?) but they also treat it as bad news. You see a short-term decrease in the value of your holdings. On a typical scoreboard that's poor news. With investing, the inverse could very well be true.
If you're a long-term owner - happy to hold for years or decades - you're also apt to be a long-term net buyer. That is, you buy more than you sell. This could be the case via "fresh" capital you invest, reinvested dividends or on your behalf via share repurchases.
With fresh capital, your preference is obvious: you'd much prefer to buy at lower rather than higher prices. This allows for your "capital buck" to go a lot further: buying a greater percentage of earnings and future cash flows. A lot of people get this backwards - rooting for higher prices even as they are buying more. It's analogous to stopping for gas and rooting for the price to increase before you're done pumping.
Today, you can buy shares of Nike for $50. Now, if you truly wanted the price to be say $70 instead of $50 - even while you're buying - I'd be happy to make that arrangement. Indeed, I'm certain any seller today would oblige. If you're selling that's a different story, but all too often the same people that are buying are the ones rooting for the higher price.
If you're reinvesting, the same logic holds. And indeed, the same logic holds for a company's reinvestment program. Even if you are not adding new capital and you choose to spend every dividend, your percentage in the business is still increasing on your behalf. Nike is buying out past partners via the company's share repurchase program. Here too it's lower rather than higher prices that benefit the net buyer. You'd much prefer for Nike to but out a shareholder at X as opposed to 1.2X for their ownership in the business.
In all three circumstances, it's lower rather than higher prices that provide a long-term benefit. If you're looking to sell in the short term, that's a different story, but the long-term owner - who happens to be a long-term net buyer - need not be especially concerned about a lower share price with a solid business.
It can be easy to forget that a lower share price could actually be good news. So many investors treat a falling stock price as a great tragedy when so often it's a great opportunity.
In short, with regard to Nike's stock price and, in general, share prices can do all sorts of things in the short term. So one period, even a year, shouldn't disturb the long-term owner - there will be ebbs and flows. Moreover, price performance generally follows business results over the long term. And as the valuation decreases, the likelihood of capturing this performance moving forward increases. Finally, although most treat it as an awful occurrence, a lower short-term share price could actually be good news.
Disclosure: I/we 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.