Warren Buffett of Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) famously said, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Investors looking for stocks to buy in this ten-year bull market would have done well to heed that advice.
Indeed, the market is littered with companies — notably in tech — where stocks have continued to rise despite valuation concerns. Shopify (NYSE:SHOP), even with a recent pullback, and Beyond Meat (NASDAQ:BYND) are two recent examples. But for most of the decade, the strength of the business seemingly has been more important than the price of the stock.
The long-running question is when that will reverse. In the last two weeks, value stocks — generally stocks where price matters — have outperformed growth stocks, where the underlying business seems more important. But two weeks don’t make a trend. And skeptics have been calling for a top in the market, and in valuations, for most of the past decade.
Still, even amid the market’s best companies, there are creeping valuation concerns. For these 10 stocks, the worries seem particularly pressing.
To be clear, these aren’t bubble stocks. They create ownership in truly wonderful companies with long-term permanence: the kind that Buffett himself would buy. (In fact, Berkshire owns three of these stocks.)
And they’re not necessarily stocks to sell. In fact, they’ve been among the best stocks to buy. And if Buffett’s wisdom holds, they will still be stocks to buy going forward. Still, for these 10 stocks, there’s a legitimate question of just how much upside possibly could be left.
It’s probably not wise to question Microsoft (NASDAQ:MSFT) stock at the moment. Microsoft, after all, is now the world’s most valuable company. It just announced an 11% dividend hike and a $40 billion share buyback. That news sent MSFT stock to an all-time high in trading Thursday.
The company’s reach in software is growing. Its Azure cloud business is taking aim at market leader Amazon (NASDAQ:AMZN). If there ever was a stock to buy that would seem to have minimal downside risk, MSFT stock would be it.
That said, MSFT stock is not cheap. It’s trading at over 23x fiscal 2021 consensus EPS estimates. The $40 billion repurchase sounds impressive, but again, MSFT stock has a market cap over $1 trillion. That buyback won’t even cover 4% of outstanding shares. The hiked dividend only suggests a yield under 1.5%.
This is going to be a steady company, but it’s not a fast grower. The company is targeting something like 8-10% annual operating income growth going forward. The shift to cloud from on-premise has helped earnings of late, and will do so for the near future. But that tailwind will fade at some point too.
Again, betting against MSFT stock seems like a bad strategy. (That might seem the case for many of these stocks, admittedly.) But Microsoft stock has stalled out in recent weeks, even with Thursday’s jump, and returns at the least should slow. Investors expecting the next few years to look like the last few likely will be disappointed.
Spice and seasonings manufacturer McCormick (NYSE:MKC, NYSE:MKC.V) has been largely immune to the pressures on CPG (consumer packaged goods) stocks in recent years. While many stocks in the space have struggled, MKC stock has soared. It has risen 134% in the last five years, and 357% over the past decade.
Investors still don’t seem to trust the industry as a source of quality stocks to buy. Forward price-to-earnings multiples for the likes of Kellogg (NYSE:K) and General Mills (NYSE:GIS) sit firmly in the mid-teens. MKC trades at 28x FY20 consensus.
As with MSFT stock, that high multiple comes despite not-exactly-torrid growth. The Street sees just 7.2% earnings-per-share next year. McCormick’s own targets suggest ~10% annual EPS growth, and a PEG ratio near 3x. Many value investors look for 1x or less (or at least used to before the market took off).
Here, too, focusing on valuation has been a mistake. I personally sold my MKC shares at $135 last year; the stock has almost risen 20% since. It may be a mistake going forward. But McCormick’s valuation relative to its growth does look stretched. Like other suppliers, it has increasing competition from private labels (though its own private label business mitigates that effect somewhat).
It’s tough to see how MKC keeps returning 15%+ a year going forward, though investors, myself included, have said that before.
Home Depot (HD)
There’s no question Home Depot (NYSE:HD) is a wonderful business. It’s one of the premier retailers in the U.S. (or anywhere else), with annual revenue now over $100 billion. And by the standards of this list, or even the market as a whole, HD stock isn’t necessarily expensive.
In fact, Home Depot stock trades at a seemingly reasonable 21x forward earnings. But “seemingly” might be the key word there.
Because there’s one core worry when it comes to HD stock.
It’s a cyclical business: sales historically have turned negative when the economy slows. Yet, as I wrote last month, it’s not being valued as such. In fact, its multiples are not terribly different from those of Walmart (NYSE:WMT), a business that actually did reasonably well during the financial crisis as consumers focused on price.
Admittedly, housing-related stocks have rallied this year. The iShares U.S. Home Construction ETF (BATS:ITB), my pick for the Best ETF of 2019, has gained 41% year-to-date. Those gains suggest that investors see the housing market as reasonably well-positioned, which should be good news for HD stock in the mid-term.
Still, Home Depot’s demand is going to shrink when the economy inevitably turns. Even a 21x forward multiple doesn’t seem to incorporate that risk.
There are three stocks on this list that have seen enormous — and somewhat unexplained — spikes in their valuations over the past decade. One is WD-40 (NASDAQ:WDFC).
WD-40 is an excellent company. Its eponymous product is exceedingly useful. Brand equity is huge: like Xerox or Kleenex, WD-40 has become a synonym for lubricant itself. Competitors will struggle to breach that moat.
Fundamentally, performance has been solid. Earnings are likely to decline in fiscal 2019 (ending September), but only due to tax rate changes. Pre-tax income should climb 7%+ this year. Revenue is guided to increase roughly 6%, on top of a 7% rise in fiscal 2018.
Still, those growth numbers are in the single-digits. But WDFC trades at a whopping 40x that EPS guidance. As a hedge fund noted in a recent letter, for two decades WDFC received an EV/EBITDA multiple between 8.3x and 13.5x. That multiple now is around 30x.
It’s not clear what has driven the spike. It’s possible passive investing, particularly so-called “factor” or “smart-beta” exchange-traded funds, are a cause. But WDFC is just one of those stocks that has seen this huge — and continuing — expansion in its multiples.
Another is Rollins (NYSE:ROL), owner of pest control business Orkin. ROL stock actually has pulled back: It’s down about 21% from its 52-week high, and touched a 17-month low last month.
Even with that pullback, ROL stock isn’t anywhere close to cheap. The forward P/E still sits well above 40x. The dividend yields just 1.2%.
And that’s with a disappointing performance of late. Adjusted EPS actually is negative YTD. Q4 and Q1 results missed expectations. Skeptics have long questioned ROL’s valuation; recent results seem to only confirm that skepticism, even if the long-term outlook still seems attractive.
J&J Snack Foods (JJSF)
J&J Snack Foods (NASDAQ:JJSF) is another stock that has seen enormous multiple appreciation. Through 2013, JJSF historically traded at less than 10x EBITDA. The figure now is almost 20x. Even backing out net cash, the stock trades at 36x FY19 consensus EPS.
It’s hard to see why. Performance has been much better in fiscal 2019, but growth largely stalled out in preceding years. The portfolio of ICEEs, soft pretzels and high-sugar snacks would seem to be a tough fit in an environment where parents increasingly are focusing on nutrition.
Indeed, the likes of Kellogg and General Mills are seeing investor nervousness about sugary cereals. JJSF trades at more than twice the P/E multiple, with presumably more cyclical exposure through sales at amusement parks, stadiums and the like.
Of course, as with many stocks on this list, the skeptical case has been roughly the same for several years now. And it has been wrong so far. Perhaps it will be going forward as well.
Procter & Gamble (PG)
The gains in Procter & Gamble (NYSE:PG) truly have been stunning. As it neared $70 early last year, PG stock had been dead money for five years. It looked like an AT&T (NYSE:T) or an IBM (NYSE:IBM) — an old-line consumer giant struggling to adapt. Multiple turnaround efforts had failed, as market share declined and margins compressed.
Eighteen months later, the narrative is very different. Organic growth has accelerated to 5% in fiscal 2019 (ending June) from 1-3% in previous years. Core EPS rose 7%, but 15% excluding the impact of currency.
And PG stock has skyrocketed as a result, gaining some 70%. It’s fair to wonder at this point if the gains can continue. The stock trades at 23.6x FY21 EPS estimates, which is a huge multiple for PG. It’s in line with the highest levels the stock reached before the financial crisis, when its growth was higher and broad markets were about to plunge.
Private label competition remains an issue here, too. The overseas opportunity was newer, and growth faster, last decade. Currency remains a headwind. PG could be seen as a “set it and forget it” play, and it’s one of the three stocks owned by Berkshire Hathaway. But even ardent shareholders have to consider taking at least a bit of profit.
The story at McDonald’s (NYSE:MCD) seems somewhat similar to that of PG, albeit earlier. MCD stock also saw years of sideways trading earlier this decade. In this case, a new CEO, Steve Easterbrook, brought in a new plan and it has worked well.
McDonald’s earnings have started rising at a nice clip. “Refranchising” efforts have helped margins. And MCD took off starting about four years ago … the stock has more than doubled over that stretch.
But like with PG, there do seem to be some concerns at this point. A forward P/E multiple of 24x is the highest seen in decades. Broader trends don’t necessarily seem to be going the company’s way. Competition is intense, and the comp boost of all-day breakfast has long since been lapped.
It’s possible MCD can still rise. It’s a reasonably defensive stock, as consumers trade down from higher-priced options during a recession. Franchise models have been hot: Domino’s Pizza (NYSE:DPZ), for instance, gets nearly the same valuation. Still, there’s an awful lot of success priced in at this point.
Visa (V) and Mastercard (MA)
The case for Visa (NYSE:V) and Mastercard (NYSE:MA) is obvious. The use of cash continues to trend down and will continue to do so. That creates years of growth ahead, even in developed markets and decades of expansion in countries like India.
Margins are enormous. The competitive situation is basically set, with American Express (NYSE:AXP) and Discover Financial Services (NYSE:DFS) well behind the two leaders. These are classically wonderful companies, one reason why Berkshire Hathaway owns both of them.
But the gains so far have been staggering. Over the past decade, MA has returned 1,200%, and V 925%. Forward-looking valuation is potentially stretched as well, with the forward P/E at 28x for V and 30x+ for MA.
For investors who believe long-term interest rates will stay low, those multiples perhaps aren’t absurd. Steady earnings in almost perpetuity are exceedingly valuable. But it does seem like at some point multiple expansion has to end. And at the very least, that means the enormous run in both payment stocks will slow.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.