McCormick: A 15% Price Decline Isn't Spicy Enough

| About: McCormick & (MKC)
This article is now exclusive for PRO subscribers.


McCormick has put together an exceptional operating history.

However, in the last few years’ current shareholders have seen more than their “fair share” of business results.

While a good bit of this is justified (and all of it with the realm of possibility) it’s still important to recognize the gravity of valuations.

Maryland-based spice and flavor company McCormick (NYSE:MKC) has put together an unquestionably excellent operating record. If you do question it, here's some information to put your curiosity at ease:

The middle column indicates the annual per share growth rate in the dividend. While there is a touch of volatility, notably every year is positive - with an average compound gain of 9.75% during this period.

The left-hand column indicates the growth rate in adjusted earnings-per-share. While it does not match up perfectly to dividends, here too you have an exceptional record. It's the sort of record reserved for the Johnson & Johnson's (NYSE:JNJ) of the quality investment world. The range goes from 3% to 20%, and the average compound gain in this metric was also about 9.75% per annum during this period (in turn meaning the payout ratio was the same at the beginning and end as well).

Now if I told you that McCormick grew its dividend and earnings by 9.75% per annum over the past 18 years, you probably would not be surprised to learn that the security's share price increased by an average compound rate of 9.9% during this period. In the short-term all sorts of things can happen, but in the long-term share prices generally track business results.

The part that I find interesting is that despite this great consistency in business and payout results, the share price was still a good bit more volatile. Take a look:

The first three column detail the exact same information as above. The fourth column shows the year-over-year share price movement, using the same fiscal end schedule.

On four separate instances you had an improving business and a higher payout, yet a lower share price. This is the sort of thing that's useful to keep in the back of your mind. Eventually improved business results ought to translate to improved share price performance, but it doesn't have to happen immediately. Indeed, using share price movements instead of business results as your guide can easily lead you astray. Expectations can be finicky, there's bouts of under or over-valuation and the result is that you have this "yoyo" effect.

The range was -22% up to positive 33% - much greater than any growth rate on the earnings or dividend side. And this factor leads to some interesting things. We know that long-term performance more or less matched up, but there were some great disparities in the short-term.

I'll give you some examples.

From 1998 to 2002, McCormick grew its dividend by 31% and earnings increased by 83%. Yet the share price "only" increased by 43%. So you had price performance that trailed business results. In turn, the payout ratio, starting yield and P/E ratio all decreased. The payout ratio went from 45% down to 32%. The dividend yield ticked down from 1.9% to 1.8%. And the P/E ratio went from 23.5 down to 18.

From 2002 to 2004 you had a "snap back" effect. The dividend grew 33%, earnings were up 17% and yet the share price increased 52%. Over the whole period things more or less worked out and the share price followed the earnings-per-share growth (118% and 114% increases respectively). Yet in the meantime, some periods showed outperformance while others had underperformance.

And we see this time and again. From 2004 to 2008 the dividend was up 57%, earnings were up 41% and yet the share price actually declined by 18%. Granted this was during the recession, but that's sort of the idea. If you can point to a business that is improving while the share price is declining, that ought to get more and more interesting. Shares got all the way down to 14 times earnings (the average is closer to 20) with a starting yield of 3% (against an average closer to 2%).

The stage was set for great outperformance in the years to come. And this is exactly what we have seen fast forwarding to today.

From 2008 to 2016, the dividend is up 93% and earnings are 77% higher. These are solid marks. Yet the share price is now 206% higher than it was - easily outpacing business performance and then some. Thus the shareholders during that time got way more than their "fair share" of business results.

If I had to parse this out, I'd think about it as follows. From 2008 to 2016, earnings were up 77%, so the first 77% increase would be a "fair share" if the starting and ending valuation was reasonable. The starting valuation was well below average, so another 75% or so could be chalked up to "getting back to normal" - say 20 times earnings. So that's a roughly 150% increase in the past nine years that's well within reason.

The last 50% or so is what I'd begin to think about as being attributable to a lofty valuation. It's still well within what's possible (it actually occurred after all) but it's not necessarily something that investors should count on. You can't suspect that a security will keep trading at a higher and higher valuation.

This disconnect between price and business performance has what I like to call a "carry through effect." That is, past returns may not tell you what future results will be, but they have a gravity to them. A share price that trailed business results over time could very well "catch up" in the future - a la McCormick from 2002 to 2004 or 2008 to 2016. Likewise, a share price that greatly outpaces business performance is apt to eventually lag - investment valuations rarely grow to the sky.

Let's think about what that could look like.

The expectation for McCormick's intermediate-term growth is in the high single digits: 8% or 9% per annum. Let's scale that back a bit and call it 6% yearly growth.

At that rate earnings (and dividends presuming a consistent payout ratio) would be about 34% higher after five years. Yet should shares trade near their historical average - 20 times earnings - the share price would only be 11% higher. Or over 10 years, earnings and dividends could be ~80% higher and the share price would "only" be ~50% higher.

None of this is to suggest that an investment in McCormick can't work out. Instead, it's simply about demonstrating the gravity of valuations. McCormick has put together an exceptional history, with share price performance closely tracking business results over the long-term. Yet in the shorter-term, a lot can happen.

Despite a moderately lower share price as of late - shares are down ~15% since July - it appears future valuation compression could still be factor. The question is whether this eventually translates to marginal gains with average growth or solid returns with strong growth continuing. Regardless, keeping in mind the "gravity of valuations" ought to serve as an important reminder that business results are intertwined with (and not independent of) a security's investment potential.

Disclosure: I am/we are long JNJ.

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.