On Thursday, October 3, 1974, the S&P 500 closed at 62, the definitive closing low of the brutal 1973-1974 bear market. The trailing twelve month PE ratio for the index at the time was 6.9. The yield on the 10 year treasury bond was 7.9%, and the Fed Funds Rate was 10%.
On that day, Wal-Mart Stores (NYSE: WMT) closed at $12. Its EPS for the prior fiscal year was $0.93. Its trailing PE ratio on that number was 12.9.
Here is a link to Wal-Mart’s annual report for FY 1974. It’s a fun read–you’ll probably learn more about Wal-Mart’s core business reading this report than you will reading the 2013 report. I doubt that I would have spotted the gem of Wal-Mart had I been investing in 1974, but in reading the report in hindsight, it seems clear that this was an extremely well-run business.
From October 3, 1974, until present, the S&P 500 produced a nominal total return of roughly 12% per year. With dividends reinvested, a $10,000 investment in the S&P 500 went on to become roughly $900,000. In that same period, Wal-Mart produced a nominal total return of roughly 23% per year. With dividends reinvested, a $10,000 investment in $WMT went on to become roughly $45,000,000. That same investment now pays more than $1,000,000 each year in annual dividends–100 times the initial price. Here is a Morningstar chart of the performance on a log scale, starting at the end of December of 1974.
The reason that Wal-Mart produced a fantastic return from 1974 to now is not that it was cheap relative to its present or near-term future earnings. By the standards of 1974, it was actually a growth stock–priced at almost twice the market multiple. In the current market, an equivalent valuation would be something like 30 or 40 times earnings–for a business with uncomplicated earnings that had already been in operation in Arkansas for three decades. It produced a fantastic return because it was a fantastic business, with miles and miles of growth still in front of it.
Suppose that we put $10,000 into your pocket and teleport you back in time, onto the floor of the NYSE at 1PM on Thursday, October 3, 1974. You know what you know now, and you can buy whatever stock you want to buy. When the market closes, we’re going to teleport you back to the present, and your $10,000 investment will have turned into whatever it would have turned into, from then until today.
What are you going to buy? If you’re smart, you’re obviously going to buy $WMT–as much of it as you possibly can. You haven’t looked at any other names, therefore you can’t be sure of their performance. Exxon? Coca-Cola? You would equal perform the market. IBM? You would dramatically underperform. The only present-day blue-chip company that I can think of that would have even come close to matching Wal-Mart’s performance is Walgreen (WAG: NYSE). In $WAG, a $10,000 investment in 1974 would have turned into $10,000,000.
Now, what is the maximum price that you should be willing to pay for $WMT, knowing what it’s going to become? And what sort of valuation would this price imply? One way to answer the question would be to discount $WMT’s total return from 1974 to today at the rate of return of the overall market. $WMT at $12 produced a 40 year annual total return of 23%. It turns out that the price that would bring this return down to the market rate, 12%, is roughly $600.
In 1974, $600 for a $WMT share would have represented a PE ratio of more than 600. In the current market, which is much richer, this would be the equivalent of something like 1500 times trailing earnings–again for a company with undistorted earnings that has been in operation for decades.
To account for risk and uncertainty, which doesn’t exist for you, but does exist for anyone that’s not traveling through time, suppose that we cut our $600 maximum fair price for $WMT by 90%. Then we cut it in half. Then we cut it in half again. Normalized to the 2014 market, the multiple would still be roughly 40 times earnings. Many people would balk at such a “rich” price–but for $WMT, it arguably would have been, and arguably actually was, the single greatest buying opportunity of that generation.
The next time we see an excellent business trading at 40 times earnings, or 75 times earnings, or 100 times earnings, or wherever, and we shy away, it might help to remember the example of Wal-Mart. High multiples can be entirely justified, provided that the growth potential is real. We definitely should remember the example if we ever come under the temptation to short individual names based on valuation concerns. Nothing is riskier or more imprudent than to short a high-quality business with an uptrending stock price, simply because we think the price is too high. It can always go higher–often, it will go higher, for fundamentally valid reasons that we’ve failed to appreciate.
Ultimately, the market has to do what we just tried to do above–figure out how to price the obvious superstars of the future, not for next year, but for the next forty years. And so we should give it some slack when we see it catapult the $TSLA’s, $AMZN’s, and $FB’s of the world to valuations that make us uncomfortable. Depending on how things turn out, those valuations may prove to have been cheap.
As investors, we intuitively conceptualize the P/E ratio as a measure of how much “upside” a stock has, how much juice is left in the can. This is pure anchoring bias–we envision the expansion of the multiple as the ultimate source of our return. If we’re long-term investors, the ultimate source of our return will be the growth that the company generates in its business–not in one year, but over it’s entire lifetime. And so a stock priced at a high multiple can be overflowing with juice left in the can, if the potential to grow is there. It can be a screaming bargain, just as $WMT was.
Now, let’s shift gears for a moment and go in the other direction. Shown below is the FY 2000 10-K for Eastman Kodak (EKDKQ:OTCBB, formerly EK:NYSE):
On April 4, 2001, $EK closed at 38.35. Using FY 2000 diluted EPS, the PE ratio was 8.3. Single digits, yummy! The S&P 500 at the time was trading at around 30 times trailing GAAP earnings. The GAAP numbers were distorted by writedowns, but even on operating earnings, the PE ratio was in the low-to-mid 20s–unattractive. Relative to the market, $EK was extremely cheap.
If you were teleported into the April 2001 market, with a mission to buy $EK and hold it until now, what is the maximum price that you would be willing to pay? If you’re familiar with the story, you wouldn’t be willing to pay any more than $6.78, which is the sum total of dividends that $EK paid from April 2001 up to its eventual bankruptcy a decade later.
Let’s take a couple of dollars off of the 6.78 number to discount it for the 4% to 5% returns that you could have earned in a treasury bond from then until now. We end up with 4.78 as our maximum reasonable price. What trailing multiple does this price imply? Roughly 1 times earnings. Given everything that was in store for this company–a bankruptcy roughly a decade later–one times earnings was the appropriate value. Just think how many foolish bottom feeders, psychologically anchored to higher prices, would have jumped at the opportunity to buy $EK at 7, or 5, or even 3 times earnings. They would have been walking into a death trap.
The next time we see a fundamentally broken company trading at a single digit multiple, it might help to remember the example of Eastman Kodak. Past earnings mean little if the business is decaying, and they mean nothing if the business will soon cease to exist.
Now, my goal here isn’t to question the merits of a systematic value-based investment strategy. Markets put a high risk-premium on businesses that have run up on hard times. This risk-premium statistically overcompensates for the inevitable failures that occur in the lot, and therefore a disciplined strategy of harvesting the risk-premium will tend to outperform over time.
But if we’re going to get into the nitty-gritty of active stock picking, if we’re going to delve into the details of the individual names themselves, we shouldn’t blindly conclude that low multiples offer buying opportunities, or that high multiples imply froth or danger. The truth is sometimes the other way around.