We believe that one of the biggest risks in the stock market today comes from investors overpaying for conservative, income-generating companies. In a sort of mirror image of the 1999 Dot-Com bubble, when investors overpaid for high risk, non-yielding stocks, the market today is characterized by eye-popping valuations for “safe” assets from bonds of all types to the most conservative sectors of the stock market. As an example, it is the “safe”, high-income Utilities sector that today sports a historically high multiple, while the “risky” Technology sector has an earnings multiple below its long-term average.
But broad generalizations are more easily dismissed than specific stories. In our continuous work to identify high quality, “moaty” businesses, we recently researched the long-time steady company WD-40 (WDFC) and in so doing discovered a seeming case study of a “safe” company whose valuation has been bid up so high by yield chasing investors that the stock now represents a very risky bet on a perpetual continuation of today’s abnormal valuations. Just as investors mistakenly thought back in 1999 that high-growth technology stocks would forever command historically high valuations, we believe that investors, deeply scarred by the Great Recession, are making the mirror-image mistake of assuming that income-paying, “safe” stocks will command historically high valuations far into the future.
WD-40, the maker of the ubiquitous household product that people use to make things stop squeaking, is a very solid company. A can of WD-40 can be found in over 80% of US households, meaning about as many people use the product as subscribe to cable TV. This is way higher household penetration than Coca-Cola, Gillette razors or most any other dominant household consumer brand.
With no meaningful competition (famed professor of value investor Bruce Greenwald once used the company in a case study showing how any competitor would lose money and so there was no incentive to compete), the company generates healthy returns on capital. While they face no real competition, they also have limited growth opportunities since most households only buy a new can of this $3 product every couple of years and almost every household already owns a can. This has led the company to pay out a meaningful portion of their earnings as dividends given their limited opportunity to reinvest and grow their business.
Slow growth companies like WD-40 can make for great investments when they command strong returns on invested capital that allow them to return significant capital to shareholders in addition to producing modest growth. For instance, from 2001 through 2007, the stock price appreciated annually by 6.6% while generating 3.2% returns from dividends giving investors a total return of 9.8% per year. Not too shabby given the low-risk nature of the investment, especially when you compare it to the fact the S&P 500 generated annualized returns of just 5.3% during the time period. This strong, steady performance with significant contribution from dividends is exactly what historically made dividend yield-focused investing attractive.
The 2001-2007 time period began and ended with 10-year treasury yields of about 5%. Using this yield as a proxy for the risk-free rate of long-term assets, we can see that the 2001-2007 time period was one with generally stable investor attitudes towards low-risk assets. WD-40 benefited from a little bit of multiple expansion during the period but stayed within the 15x-20x range that has characterized most of the companies trading history.
But the 2007-2016 period saw the onset of the Great Recession and a significant shift in investor preferences for low-risk assets with the last three years, in particular, appearing to represent a sort of bubble in these assets, a mirror image of the 1999 bubble in high-risk assets.
Below is a table showing WD-40’s annualized price appreciation, dividend return, and starting and ending PE ratio.
|Period||Price Return||Dividend Return||Starting PE||Ending PE|
The dividend generating power of WD-40 is essentially unchanged from 2001-2016. Nothing much has changed in terms of demand for their products nor the competitive landscape. Growth expectations for the years ahead are no different from the low, but steady growth that has characterized the last 15 years. But today, investors are paying twice as much for each dollar of earnings as they did during the period prior to the financial crisis. We see a similar willingness to pay excessively high valuations for “safe”, income producing assets in the behavior of the 10-year treasury yield with the yield falling from 5% in 2007 to 3% in 2013 to just 1.5% today. This is the equivalent of the PE ratio on the 10-year treasury going from 20x during the 2001-2007 time period to 33x in 2013 to 67x today.
Here’s a chart that displays WD-40’s PE ratio over the last two decades.
After trading in a range of 15x-20x for 15 years, in the wake of the Great Recession investors started bidding up the price of WD-40 until today its valuation stands at an eye-popping 34x. For those without strong context for historical PE ratios, at the peak of the 1999 Dot-Com bubble, the S&P 500 was trading at a PE ratio of 30x. While certain high growth companies might be fairly valued at these levels, highly mature, low growth businesses like WD-40 have no history of trading consistently at these sorts of rich valuations.
So what happens from here? Our guess is that WD-40, the company, keeps chugging along. Things will keep squeaking and people will keep using WD-40 to fix them. No competition is likely to emerge and the company is likely to continue growing modestly and increasing their dividend. But the high price appreciation of WD-40’s stock has brought the dividend yield down to just 1.4%. Over the next decade, if we assume the dividend is increased at 5% per year, the dividend contribution to total return will be just 1.7%. If we assume earnings grow at 5% per year and the PE ratio stays constant (ie. the bull case which assumes that investors will perpetually assign a historically high valuation to the stock), total return annual will be just 6.7%.
What if the PE ratio returns to the 17.5x pre-crisis average? Then, assuming the same 5% earnings growth rate, the stock will end the next 10-years at a price of $93, down over 20% from today’s price of $117. The total return will be a terrible -0.6% per year.
WD-40 is a good microcosm of how investors, understandably scared by the way risky assets got crushed in the wake of both the Dot-Com bubble and the Great Recession, are making the same mistake again, but this time through chasing what they think are safe assets up to unsustainably high valuations. The fact is these assets — quality, dividend paying stocks like WD-40 as well as high-quality bonds — are “safe” in the sense that their fundamental performance (their ability to make interest payments or pay dividends) is secure. But when investors overpay for these characteristics, they turn a safe company into a risky stock.
The idea that WD-40’s PE ratio (and therefore stock price) could be cut in half seems outrageous. This is, after all, a steady dividend paying company and these stocks of stocks aren’t supposed to be risky. But given how low the dividend yield has gotten today, if the stock price is cut in half the dividend yield would still only be 2.8%. Which just happens to be approximately the average dividend yield that prevailed in the 2001-2007 time period. In other words, if the stock got cut in half, it still wouldn’t appear to be all that cheap, but instead would have just returned to a more historically normal valuation.
WD-40 isn’t an outlier in today’s market. Quality, dividend paying companies of all sorts are trading at abnormally high valuations, while higher growth, more speculative companies are trading at historically lower than average valuations. While much investor concern has been voiced about the overall levels of the stock market, we think the most important risk that investors face today is making sure that they do not buy into overvalued, “safe” assets. These very assets are being bought for their supposed safety, yet they are the stocks that contain the most long-term risk to preservation and growth of investors’ capital.
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