by Ivan Martchev | April 12, 2012 1:19 pm
“Should I continue to hold this stock as it just hit an all-time high?”
I’ve been faced time and time again with this question, and while providing short-term insight is beyond my intended scope here — this is up to any reader’s specific financial situation — I wanted to elaborate more on how I think about stocks that have hit all-time highs.
Stocks represent a claim on the company’s stream of earnings. If the earnings (per share) grow, the share price likely will follow sooner or later. It is possible to see the EPS of a company grow diagrammatically and see the shares decline dramatically, but in my experience, this is much less relevant for long-term investors.
One of the most extreme examples I have encountered is Baidu (NASDAQ:BIDU), which from year-end 2007 to year-end 2008 grew EPS from $18.11 to $30.19 (pre-split) — a 66.7% increase — yet the shares declined from $389 to $130 (pre-split) in the same period — a 66.5% decline.
A 66% EPS increase is almost never followed by a 66% share price drop, so you can mark that one for the record books as “a 100-year storm.” Companies that grow earnings faster than their respective industries and the market tend to outperform over time than the relevant industry or stock market benchmark index.
Sometimes, rapidly growing companies will see their share prices get ahead of themselves, and their stock will bounce in a trading range for a long time until the earnings catch up with the share price. But if EPS keep growing, in my experience, the share price tends to react positively sooner or later.
With the above in mind, let’s look at four market leaders that are at, or close to, all-time highs: Apple (NASDAQ:AAPL), Chipotle (NYSE:CMG), Lorillard (NYSE:LO) and MasterCard (NYSE:MA).
When I looked at the four, Lorillard stuck out like a sore thumb. I tend to follow the other three pretty closely in the course of my regular work, but I had somehow missed Lorillard. I thought it was an “interest rate” thing, but there is more to it.
(Since the Fed has chased income investors from the Treasury market by suppressing interest rates, income investors are hiding in high-dividend paying groups like utilities, MLPs, pharmaceuticals and — of course — tobacco stocks, pushing their dividend yields 20% or more below their five-year averages. The same goes for junk bonds.)
The reason for my surprise to see Lorillard in the high-fliers group was the overall state of the U.S. tobacco market. Other U.S. tobacco stocks are at or close to all-time highs, but generally they are not earnings stories. U.S. cigarette volumes peaked in 1981 and have been falling with smoker rates despite positive population growth. In this situation, most U.S. tobacco companies have been paying healthy dividends and cutting costs to boost payouts; Lorillard is doing all of the above, but it also is growing EPS and revenues, which most of its American competitors have not been able to do.
For the latest reported quarter, adjusted diluted earnings per share increased 26.4% versus last year to $2.20, and annual adjusted diluted EPS increased 16.2% versus last year to $7.88 — both record amounts. Net sales in the fourth quarter increased 8.9% from last year to $1.618 billion. Annual net sales increased 9% versus last year to $6.466 billion. (In the tobacco industry, I had become accustomed to seeing erratic earnings and flattish revenues, which clearly is not the case here.)
It appears Lorillard is aggressively taking away market share in a stagnant market. Lorillard’s domestic retail market share once again posted gains in the fourth quarter of 2011, increasing 0.8 share points to a market share of 14%. This is due to the popularity of its menthol brands like Newport (and non-menthol products under the same name) as well as increasing popularity of its discount brands thanks to constantly rising prices in the industry.
Lorillard (NYSE:LO) does not have international exposure, as it sold all such international rights in 1977. Emerging markets are much less hostile to tobacco companies than developed markets, though Lorillard is reporting operational performance like an emerging-market tobacco company — which is absolutely not the case.
I don’t know how long Lorillard can keep it up in the present environment, but it has a 4.5% dividend covered by a 65% payout ratio. The company is small enough to continue to gain market share even in a stagnant or slowing market, but also big enough to be able to flex muscles against the Nos. 1 and 2 players.
It is amusing to hear that Apple (NASDAQ:AAPL) is expensive “above $600.” The shares trade at 17.9 trailing and 12.5 forward EPS, which in my book is cheap given the staggering EPS growth. Faced with the law of large numbers, investors expect the same dollar growth in EPS to be a smaller percentage every time it is reported because the comparison base will be much bigger.
Still, Apple keeps surprising us.
Apple holds a combined 60% market share in tablet and smartphone operating systems. Given that Apple does not license its software, the hardware belongs to it, too. Google‘s (NASDAQ:GOOG) Android operating system has made great progress against Apple in the smartphone market, but when it comes to tablets, the competition is simply pathetic at this point. Sure, better Android tablets will come to market likely this year, but there has yet to be one on par with iPad.
Apple has only 7% market share in personal computers worldwide, and that market share is rising. I don’t know what type of new devices will come from Apple, but I know there is more market share to take away from Microsoft‘s (NASDAQ:MSFT) Windows and that the iPhone, as great as it is, probably can be made better. So a wave of upgrades is likely assured for some time to come, resulting in steady earnings growth over the intermediate term.
MasterCard (NYSE:MA) has had somewhat more erratic EPS growth compared to the four high-fliers discussed here, but this is because of legal settlements. Revenues have shown much steadier growth, and with the leveling of the playing field between MasterCard and main competitor Visa (NYSE:V) — more on that here — it is difficult to see how EPS growth will slow given the low penetration of electronic transactions in emerging markets.
As for Chipotle Mexican Grill (NYSE:CMG), the last of our four high-fliers, there is ample room for growth in the U.S. and especially abroad, where the expansion has just begun to gain momentum. Chipotle has 1,230 restaurants and is looking to open another 150 in 2012. The company successfully tested the ShopHouse Southeast Asian Kitchen concept, and given the massive success it has had with organic made-to-order Mexican food, it will be interesting to see how/if they roll out the new Asian concept aggressively.
Chipotle is not a cheap stock, trading at 39 times next year’s EPS estimates, but there isn’t another major fast food chain that grows as fast, with 23.7% YOY revenue gains in the latest quarter while maintaining healthy operating margins of 15.7%. This growth is unlikely to slow given the international expansion and the exciting new Asian concept.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in Baidu, Apple, Chipotle, Lorillard, MasterCard and Visa for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.
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