This week's question is from Jonathan from Cambridge, MA.
Question:
My most fundamental issue with your technique is its use of P/E to judge future valuation -- do you really think this is safe or justifiable? Reading other value investing resources we often hear how poor a metric P/E can be, and how we should avoid it in favor of P/FCF or other such things. In particular, when looking at a 10-year horizon on a fast-growing company moving at 20%/year, is it really reasonable to expect the P/E to remain around 40 10 years out, when they've grown up toward the top of the Fortune 500, and there's just no room left to keep rocking 20% every year?
Answer:
You have the right question -- will the growth rate stay up there at 20% for a long long time? The answer is -- how well do you know the business? If you don't know it well, you can't answer the question, can you? So the first M is very important in determining the future value of a business -- does the business have Meaning to you? Do you understand it?
Let's take Whole Foods as an example: They've been growing EPS at above 20% for 10 years. And the analysts think the next five years will see roughly 20% growth of EPS. So what's the long term PE for WFMI? Depends on the long term growth rate that we expect.
I see the history, I see the analysts' expectations and I listened in on the last phone call with analysts it's on the website -- and I heard that the CEO expects that WFMI can continue their 20% growth rate for many years in the future.
Also, I checked to see how many stores a competitor has to see what's reasonably possible. Albertson's has 2500 stores. WFMI has 175. So WFMI could conceivable double once to 350, again to 700, again to 1400 and again to 2800. That's 4 doubles. If they continue their growth rate of 20% a year, how many years will it take them to double four times? The Rule of 72 says 20 into 72 is 3.5 roughly. So 4 doubles is 3.5 times 4, or 14 years. In addition to that, the existing stores are growing their revenues at over 10% a year. I don't know exactly what that means in terms of additional long term growth except that it means it will be bigger than just opening more stores.
And finally, is it possible that WFMI could become the Starbucks of grocery stores and be everywhere and still keep the prices up and thus keep the growth up for longer than just opening stores and increasing sales? I think the answer is YES. I think they have the magic formula and I don't see how anyone could visit their store at Columbus Circle in Manhattan and not come to the same conclusion. They've taken natural food out of the hippie do-gooder tree-hugger world (with which I am quite comfortable as a result of my many years as a wanna-be hippie river guide) and placed it in a context that is comfortable for your average grocery shopper, who would never in a million years wander into your local hippie food co-op. The result, I think, is going to be Whole Food stores everywhere. Worldwide. More than Albertson's and Safeway combined. But that's just me.
Are there examples of this kind of long term growth? Sure. Starbucks, Walgreens, Walmart, Microsoft to name a few. Are there lots of examples? No. But so what? WFMI is amazing so we should compare it to equally well run and amazing businesses, not to the run-of-the-mill business.
I make this argument just to show you the thinking process I use to determine that I am okay with a 20% growth rate and a 40 PE... so let me finish the logic.
If ten years from now WFMI is continuing to roll ahead at 20%, and if the stock market is still doing okay as a whole, then WFMI will continue to have a 40-ish PE for two reasons:
because fund managers give consistent growth a premium for predictability, and
because businesses that have 20% growth that isn't cyclical get 40 PE's as along as they are predictably going to continue growing into the forseeable future.
But here's the really cool thing about investing the way I do it: even if I'm wrong and the PE starts coming down, the process of bringing the PE downward requires that big institutions sell the stock and that drives the stock price down relative to the TTM EPS... and just like that the PE is reduced.
And here's the cool thing: When the institutional guys bail they create red arrows on the WFMI chart and I get out. I don't worry about why the red arrows are there, I don't guess whether its a short term profit taking ploy or something has changed for the long term... I just get out.
And because I'm out, I'll be in cash when the CEO talks with the institutional investors during a quarterly phone call. And when he says, like Meg Whitman said of EBAY last year, "We can't continue the growth rate of X", I will simply revise the WFMI Sticker Price to reflect the new reality and then only buy WFMI when it is being sold at a large discount to Sticker.
In other words, if you follow the Rule #1 investing strategy you will automatically adjust the Sticker as expectations change -- either historically, via the analysts or via the CEO -- and that will keep you from investing with excessive expectations and a PE that's far too high.
Now go play!
Phil
