The ghost of trades past (and what it can tell you)
Posted on February 22, 2007 by Richard Beddard
Filed Under Investing |
Here’s a conundrum posed by Todd Sullivan of Value Plays:
You bought shares in a company in January 2001. Five years on this is the situation:
- Revenues have grown 80%
- Earnings grew 147%
- The dividend has grown 150%
Life must be good, he says, but no. You’re down 20%, and in 2003 you were down 60%. Who’s to Blame?
To cut a long and entertaining story short, the company is Home Depot, America’s B&Q and its second largest retail chain. And Home Depot’s recently deposed chief executive is not to blame, after all the company’s done pretty well, it’s you:
Because, for some inexplicable reason you paid over 50 times earnings for a company that sells screwdrivers and lawn mowers and was growing at a rate of less than half that.
It’s a salutary tale, laced with corporate backstabbing and desultory comments on Home Depot’s prospects now. The price chart leaves no room for doubt, investors in 2001 backed the wrong retailer, particularly when you consider its more reasonably priced rival, Lowe’s, rose 200%.
The next time you want to pay 50 times earnings or over twice a company’s growth rate for anything, email me and I will try to talk you off the ledge before you and your money fall.
| Starbucks | ||
| eps % | PE ratio | |
| 1996 | 20 | 50 |
| 1997 | 50 | 49 |
| 1998 | 22 | 46 |
| 1999 | 27 | 50 |
| 2000 | 29 | 47 |
| 2001 | 28 | 45 |
| 2002 | 22 | 39 |
| 2003 | 21 | 36 |
| 2004 | 41 | 40 |
| 2005 | 27 | 43 |
| 2006 | 20 | 46 |
I’m inclined to accept Mr Sullivan’s counsel, not just on Home Depot, but also the general principle that you shouldn’t pay too high an earnings multiple (PE ratio) for any stock. That’s one of many reasons I bought Home Depot in December, when its PE ratio was closer to 15 than 50.
An oft-used rule of thumb is not to pay more for the company than its earnings growth rate. But there’s an image that haunts me whenever I apply that rule. It’s a table of PE ratios I’ve seen in Value Line. I popped into the library this morning to reacquaint myself with those nightmarish numbers.
I know a company whose brown cafes sell overpriced coffee and doughnuts. In 2001 Starbucks shares cost an average 45 times earnings. I’m sure you could find many days the PE ratio topped 50. Its earnings growth that year was 28%. Like Home Depot then, investors were prepared to pay a high multiple for relatively low growth. Way above 1:1.
Fast forward. In 2006 the share price was up nearly 200%. You can see from the sequence above and to the right that before 2001 investors routinely paid a higher multiple for Starbucks shares than its earnings growth implies. Since 2001, nothing’s changed.
Every time I see the Starbucks page in Value Line I marvel at the price investors pay for the stock. It seems like they’re overpaying. It’s irrational, surely. But who’s laughing? Here’s the chart:
I’m sure Starbucks is not the only company that’s been a good bet, despite its price. So here’s another conundrum for any value investor, myself included. Somebody calls you in 2001 and says they’re going to buy Starbucks on an earnings multiple of 45, the average for that year. Do you talk him off the ledge? And if you do, when he calls back in 2006, what do you say?
Footnotes:
- I found Value Plays via Value Investing News. Readers submit stories they’ve read there and vote on which ones should make the front page. I’ve put both sites on our blogroll (the list of links on the right of the Front Page).
- In a comment on The cheapest six stocks in the market Dr Anderson, a lecturer in business at Durham University Business School, confirms that high PE stocks sometimes do better than low PE stocks as a group: “In my PhD thesis I tested the new rules over subsets of years, and over the five years 1995-2000 high PE beat low PE whichever way you calculated it.”
- In The fundamental flaw in value investing and the Periodic table of investment returns I discussed growth v. value. The market goes through cycles where high PE shares do better than low PE shares and vice versa. What’s interesting about Starbucks, a growth company, is that it did well between 2001 and 2006 when value shares, on aggregate, did much better than growth. That offers hope to both camps as it suggests clever stock picking can deliver returns even if your style is out of fashion. If only I could work out how those clever growth investors do it!
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One Response to “The ghost of trades past (and what it can tell you)”
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Richard,
Nice job. I think I should have given a market cap disclaimer for the analysis. For instance, since 2005 when SBUX become more than a mid cap stock, its share price has been essentially flat, only up about 12%. While we can always find the occasional SBUX, the road is littered with Dell, Yahoo and others that are stuck holding the bag. We also have to consider the small # of shareholders there were in 1995 vs 2005 of SBUX shares. For the few that have hit it big, there are many more stuck with little or nothing.
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