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How Should Stocks Be Valued

|About: AutoZone, Inc. (AZO), ORLY, Includes: ALK, AMZN, BA, BAC, BKNG, CRM, DIS, FB, GE, GM, GOOG, HD, IBM, JPM, KHC, LMT, MA, MCD, MSFT, NFLX, NOW, RTN, SHW, TDG, UAL, ULTA, UNH, V, WDFC, WMT
Summary

Winners of the Past Decade.

Which ones were the best of the best.

When you think of the duds of the last decade, there are a few that come to mind: GM, IBM, KHC, and GE. All experienced anemic or negative sales growth (sometimes rationally so in order to improve ROIC, other times not-so-much). Well performing stocks of the last decade: V and MA, FB, GOOG, AMZN, NFLX, UNH, ALK, UAL, HD, MCD, BKNG (formerly PCLN), ULTA, MSFT, CRM, NOW, TDG, WDFC, LMT, RTN, SHW, DIS, ORLY, AZO, BAC, JPM and BA. These stocks have one thing in common: tremendous sales growth over the time period in question. The winners all have management teams that were focused on at least maintaining market share through good customer retention and growth in the amount they extracted from their customers but also in some senses trying to grow their piece of the pie within their industry. They also maintained good or great ROIC/ROTCE compared to their own enterprise value. Several of the growth names still have room for margin expansion at the same time that they are still growing revenues and it is not shortsighted to consider that as part of the exit multiples that any company implies by its currently traded price. Losers lost/sold off (lots of times rationally so as the subsidiaries might have been unprofitable/non-core assets) market share and started from high “valuations”. Expectations were too high.  I imagine that David Trainer of New Constructs would appreciate these sentiments.  

This is how I see “value” names – not necessarily low price to earnings or price to sales multiples. For this reason I am attracted to growth stories and to stocks whose earnings are either cyclical or misunderstood in some form. ROIC and EV/Revenues TTM mismatching with an eye to sales growth measures must be taken into context. Projecting an exit multiple based on a company’s ROIC has a lot of merit. People understand that they should pay up for quality, but almost nobody knows why. ROIC drives valuation. V and MA deserve EV/Rev ratios of 16-17x because they generate absurd amounts of Free Cash Flows and the business doesn't require them to spend more to get more transactions (which in turn means more revenues).  Operating cash flows of companies are a better measure of profitability than the bottom line. EBITDA is also not a good measure considering that the last 4 letters represent real costs to the company and management/accountants have quite a bit of leeway in deciding how certain costs (especially growth initiatives) are taken care of on the income and balance sheet statements. Take a look at operating margins on these companies circa 2010 and try to think about what you would pay for the asset assuming things don’t change and perhaps guessing at interest rates of 4% today. If you don’t like 2010 because it is after the recession, go to 2006. Operating margins were good or possibly even great for the winners and better yet: stable through the cycle. Perhaps BAC is the only one with legitimate fears of bankruptcy at that time. Despite choosing higher quality, starting from severely depressed valuations, and actually growing sales, this screening method can still make picks which only turn out mediocre. One “dud” that I can think of under this method of valuation for the last 10 years was WMT. Even after growing sales at pace with inflation, despite facing down the barrel of the Amazon deathstar, the company returned “only” 8% compounded if dividends were reinvested to investors since 2010. It also still looks undervalued to me here, though – so what do I know? All others deserved the re-rating they got and as for the losers it remains to be seen if they are going to be good investments.

To summarize:

Winners

  • Good/great ROIC
  • Market share maintenance
  • Growing industries
  • Good starting valuation with respect to its own ROIC (EV too low)
  • Low Expectations for margin maintenance/expansion

Losers

  • Anemic/negative sales growth
  • Loss of market share
  • No growth industries
  • Poor starting valuation with respect to ROIC (EV too high)
  • High expectations for margin maintenance/expansion

Two of the winners stand out to me, in particular: ORLY and AZO.

  • The companies are/were great businesses that were not being disrupted by technology,
  • The industry was stable/growing and allowed all participants to participate in the growth.
  • People were going to drive more miles and they also were going to continue fixing their cars, the company had the power to raise prices with inflation, there was essentially zero chance of bankruptcy and there was virtually no way to disrupt the pretty consistent flow of high margin income from its moderately price insensitive customers.
  • Management teams were focused on tax efficiency for the investors.

There is not much to say about it other than that. As such, the companies levered up (sensibly) and bought back stock hand over fist reducing the outstanding share count by a little more than 40 and 50% (respectively) over the ensuing 10 years while at the same time growing revenues at nearly double the GDP of the US economy creating tremendous value for shareholders. ORLY and AZO have offered taxable investors the gift of a deferred asset in the form of gains where you didn’t have to pay taxes on any of the dividends you received in the form of buybacks! All of the other companies were paying out some portion of their earnings out as dividends. Keep all of these things in mind as you read the rest of this pitch. If you made modest assumptions regarding sales growth and capital structure and margin maintenance/growth, you could’ve bought knowing you were getting a better deal than SPY. However, I also say this as a means of indicating that it doesn’t matter whether you bought your shares 12 years ago or 8 or even 5 years ago. Even having bought AZO at its 2/2014 high of $561/share or ORLY at $155/share have given you market beating returns of 13% and 20% compounded to a relatively tax inefficient 10% from SPY. The stocks have all been huge compounders for the bigger reason of ROIC being high by comparison to their own enterprise value – never mind the outstanding ensuing sales growth that also accompanied the poor starting valuation.

Knowing what you know today, do you believe AZO/ORLY were rationally priced at 6.5-8 times operating earnings in 2010? I still think AZO is still SEVERELY undervalued at 13x operating earnings. In my mind, AZO should be worth 18-20x similar to ORLY as operating margins aren’t too different and it should’ve been valued this way as far back as 2010 at that multiple or higher – the companies were minting money and still have very little threat of market share loss or margin compression coming in the form of oncoming competition with Amazon and others (even as Electric Vehicles reduce the size of the market over the coming years). Also consider how the margin improvement helped ORLY against AZO over the time frame: lots of additional alphas were provided to the ORLY investor given the low base and now industry leading margins. Margin expansion added huge intrinsic value to ORLY that wasn’t afforded to AZO since AZO started high only to maintain the status quo.

To summarize why some of the winners were better than others:

  • Tax efficiency matters.
  • Growth matters, too.
  • Low expectations matter.
  • Margin expansion matters.

This is how you mitigate risk of loss of shareholder capital. Analysis should be done on whether the industry is growing, whether market share will be gained or lost, whether margins will compress or expand, and seeing which management teams are the best allocators of capital. The rest is just details.

Disclosure: I am/we are long BKNG, V, FB, GM.