The “Safe' Stock” Illusion: A Hidden Risk in Compounders
Why “Safe” Stocks and New Dad Footballers Can Both Surprise Us
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Becoming a Dad
No, not me! I last became a dad 16 years ago and have no plans for a repeat. But I was amused by a recent article by Joachim Klement referencing a study by David and Robert Butler which shows that the performance of top players in football deteriorates when they become a dad for the first time.
Joachim’s chart shows the decline in assists in the months before the player became a dad for the first time:
Assists in Months before Birth
Source: Joachim Klement/Butler and Butler
This decline in performance might be the result of shrinkage of the left hippocampus of the father’s brain after the birth. Apparently, testosterone levels drop for new fathers, and this can mean the left hippocampus shrinks, with potential memory loss.
Now my friend Joachim (do read his daily Substack, it’s amazing how much he produces when he is a strategist full-time) publishes these pieces on a Friday and they are meant in fun. I have no idea if this is real, but premium subscribers can read on for an analogy in the investing world, and a trick which every professional investor should be aware of.
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August’s Podcast
My guest this month is Christopher Tsai, an investor with 25 years of fund management experience. I invited him on the podcast as I felt that I had too many value investor guests. My conversation with Tom Slater was fascinating, so I wanted to invite another growth investor.
Interestingly, Christopher bills himself as a value investor, but as I point out in the podcast, the average P/E on his portfolio was on my estimates c.65x, and I considered that conservative as I felt that consensus estimates for some of his larger positions were too high. We have had Q2 results for most of the stocks since, and Tsai’s portfolio is up just 0.2% but that multiple remains the same. So the earnings don’t seem to be growing much.(Somewhat to my surprise, the multiple for Tesla hasn’t moved much, the stock drifting down with earnings revisions.)
We discuss Tesla, his largest position, in the podcast and it’s clear that the market is valuing the autonomous vehicle opportunity highly - that’s understandable but difficult to quantify, creating a significant risk (and potentially an opportunity) in the stock.
We also discuss Costco and Christopher justifies holding the stock at a P/E multiple of over 50x because he believes in holding long-term compounders through thick and thin. You may create a short-term benefit by exiting but in the long term you will regret it. He also has to consider the tax position of his clients and it’s clearly costly to turn over a portfolio and pay tax on gains and find equivalent reinvestment opportunities which can overcome that tax drag.
This was never a consideration for me in my professional life at the hedge funds as they were domiciled in Cayman and tax exempt. And I am sympathetic to this situation and understand Christopher’s philosophy, but I am wary of taking action on investments because of tax implications. Taking no action is no different, it’s still a decision. And I really question whether you should hold on to a stock which is significantly overvalued, almost irrespective of its compounding potential.
I wonder about this Costco valuation; Walmart similarly, albeit not quite as extreme. (Note that I made this point before Walmart weakened in August, but I have written before about my surprise that a $900bn retailer could be expected to grow into a 35x multiple, even without an earnings miss.)
Costco Valuation
Source: AlphaSense
The reason I question the tax-justified holding is that in the UK and US where most readers are based, long term gains are taxed at around 20% - I simplify of course. The tax usually isn’t sufficient to change the decision, depending of course on duration of the shareholding and the size of the gain.
Christopher may have made the correct choice – there is clearly an advantage in eliminating the decision option, because it avoids selling before the stock gets too stupidly priced – I would likely have exited several times before now, given the chart:
Costco Historic P/E
Source: Behind the Balance Sheet from AlphaSense data
The stock traded between 20x and 30x for almost a decade; it traded between 30x and 40x for around the next three years; between 40x and 50x for under a year and it now trades at between 50x and 60x – it crossed 60x in February but hasn’t sustained that. Note that when it was trading at 20-30x, it was much smaller, and its distribution infrastructure was under-utilised - it was therefore under-earning. That’s no longer the case.
In these situations, I find it constructive to look at the price relative chart – the following graph is approximate and relative to the S&P500.
Costco Relative Longer Term
Source: Behind the Balance Sheet from AlphaSense data
And here is the relative picture on a shorter term timeframe:
Costco Relative Shorter Term
Source: Behind the Balance Sheet from AlphaSense data
Costco has lost over 20% relative to the market in the last 4 months since it peaked. It would be hard to finesse the top, but perhaps your next best stock might beat the market. And it’s trading at a hair above its 12 month relative low, which coupled with the steep valuation makes it a potentially dangerous stock in my opinion.
I don’t mean to pick out Costco in particular, it just happens to be the poster child for this phenomenon and one that Christopher owns. I could have picked Cintas, or Walmart, or multiple similar examples. I haven’t found anyone who can explain to me why Costco should trade at this multiple. And to be fair, Christopher wasn’t claiming that it was cheap, simply that he didn’t believe in selling compounders.
And that was why I invited Christopher on the podcast – to see if I had missed something. Spoiler: I don’t think I have, and let’s see if he makes money owning Costco for the next 5 or 10 years.
After writing this, I had a coffee with an old friend, a retired fund manager at a highly successful firm, notable for highly diversified portfolios. Costco was his favourite company and stock, and it had grown to his largest position, at a 4% weighting; he likely had over 100 positions. He still loves Costco the company, but wonders if he would have been able to stomach its 1.5x EV:sales valuation.
I would like to make a more general point for my readers who are not professional equity managers – Costco and others in this group are perceived as safe stocks – high quality compounders. I am not arguing that Costco isn’t a great company, simply that it probably isn’t a great investment today.
To get back to historical valuation levels, the stock may have to fall by 50%. That makes it a highly risky proposition in my view. It also makes it a perfect short candidate – it’s large, liquid, and isn’t about to blow away numbers and rise by 20% in a day. Far more likely, it could underperform for years and be a safe short – that was what I used to look for.
I don’t have space here, but I also discussed with Christopher his philosophy about trimming over-large positions - he sold down his position in Tesla, a massive winner for him, after it reached over 30% of his portfolio. When I interviewed Chris Mayer, author of 100 Baggers, he had a different philosophy - I shall return to this subject in a future article.
Premium subscribers can read on for
where I think there may be a flaw in my Costco argument;
why Costco has achieved this valuation level;
the other popular mega-cap compounder I think Christopher should sell.
Conclusion
I obviously understand and appreciate Christopher’s perspective. And sometimes handcuffing yourself to avoid behavioural mistakes can be a really good strategy. It might well set you up for outstanding performance in the very long term; after all, using rules was a strategy recommended by Daniel Kahneman to avoid behavioural errors. I am not sure it would work for me.
Links
Semi Conductors
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