If we’ve learned anything from the past decade, it is that the stock market can be irrational and it can remain so for long periods of time. As an example, let’s examine a company that just released quarterly earnings earlier this week: Wal-Mart. Wal-Mart’s stock has essentially done nothing over the past decade despite posting impressive and consistent earnings growth over that time frame. The stock is an excellent example of market irrationality because we have seen both extremes: massive over-valuation during the bubble years followed by unjustified under-valuation today. Just as the company was irrationally trading at nearly 40x earnings on average back in 1999-2000, the company is now trading at an irrational discount to the market. Consider the following:
1) Wal-Mart has grown its earnings-per-share (EPS) every year for the past 15 years – through two recessions, including one of the worst in decades
2) The company’s compound annual growth rate in EPS over the past 10 years has been 11% – well above the 2% for the S&P 500
3) Wal-Mart’s guidance for 2010 EPS is over 3x the level reported for 1999, while S&P 500 earnings are expected to come in at just over 1.5x the 1999 level
4) Wal-Mart’s dividend has risen every year over the past ten years and is up nearly 600% since 1999
Despite this impressive performance, WMT has gone from trading at a 50% premium to the S&P 500 in 1999-2000 to a discount, based on estimates for 2010 and 2011. What makes this more puzzling is that Wal-Mart is generally considered a defensive stock. During the most recent recession (which most believe ended some time last year), Wal-Mart benefited as consumers “traded down” to more affordable alternatives. As we look ahead to what appears to be another slow down in economic growth, we would expect investors to more highly appreciate the relative visibility of Wal-Mart’s earnings stream. But instead, Wal-Mart continues to get no respect. We believe this creates an opportunity for longer-term investors.
Wal-Mart is just one example of many quality stocks that appear to be trading at attractive levels in an uncertain environment. In general, we continue to believe that high-quality, defensive multi-nationals with attractive dividend yields are not receiving their due consideration in this market. Why is this the case? We certainly have our theories. First, we believe that the proliferation of hedge funds has resulted in an increased emphasis on “high-beta” stocks. In an effort to improve returns, hedge fund managers pour money into these more volatile stocks in an effort to improve returns while the overall trend in stocks is higher. Given the massive increase in the market since the lows in March 2009, it should therefore come as no surprise that these relatively low-quality companies have outperformed.
Second, we believe that retail investors have a tendency to simply sell all their stock holdings rather than rotate into more defensive names when they become nervous. Recent mutual fund flows would validate this assertion as money has been pouring out of domestic stock funds and into bond funds for many months. The effect of this phenomenon is that investors have driven bond yields down to near-record lows when they could actually improve their yields and returns by investing in high-quality stocks. We have been dumbfounded by investor willingness to accept ridiculously low bond yields when such long-term value exists in high-quality stocks. We believe this is simply a reflection of the fear in the market right now.
And finally, the proliferation of exchange-traded funds (ETF’s) has likely had somewhat of an effect on trading in recent years. Since many retail investors (and hedge funds) have increasingly preferred to use ETF’s for their stock exposure, the sale of these issues leads to more uniform depreciation across the universe of stocks. In other words, we are not seeing the rotation into quality that we might normally see in response to increased fear and apprehension about the economy.
The good news is that markets usually figure it out over a longer-term horizon. Just as internet stocks came crashing down following the bubble near the turn of the millennium, so too will investors recognize the value of high-quality stocks (especially given the returns now available in the bond market). Yet again, investor obsession with near-term performance is creating an opportunity for long-term, fundamentally-focused investors. So stay the course and do your homework. Value exists in this market despite the formidable headwinds!
* Securities mentioned above represent investments we find interesting. They are not recommendations to buy or sell. We may be buying and or selling in portfolios under our discretionary management. If you have questions about the appropriateness of these issues for your investment strategy, please call us.