Why Is Quality So Expensive?
We've almost always had to pay up for good companies, but things are getting ridiculous.
This post is inspired by this note:
Quality Stocks is right, some of the more well-known “quality” companies are expensive. Yes, these types of companies will often trade at a higher multiple. Yes, you should be willing to pay up for them. But remember Buffett’s quote:
Price is what you pay, value is what you get
What do we get when we pay nearly 50 times earnings for these companies? Let’s start with #1 on the list - Cintas and do some math.
Cintas
Cintas is a boring business that I’d love to own at some point. I did a write-up on it a while ago. Find it here.
Cintas runs a very simple business. They rent uniforms and entry mats to businesses like hospitals, auto repair shops, and restaurants. Cintas will make custom uniforms for your business. Then they’ll regularly deliver clean ones, collect the dirty ones, launder them, and bring them back to start the cycle over again. They’ll do the same thing with floor mats.
In addition to uniforms and mats, Cintas will keep regularly used products replaced and in stock. Think stocking your restrooms with toilet paper, soap, and paper towels. Cintas will also make sure you never run out of cleaning supplies like mops, cleaning chemicals, towels, and trash can liners.
Growth
Cintas management thinks they have lots of room to grow, and they’ve grown at good rates in the past. Looking back about a decade, Cintas tends to grow revenue at about 8% a year, and earnings at 18%. Analysts expect about 12% growth from Cintas going forward. This seems reasonable to me, so we’ll go with that.
Valuation
Let’s keep this simple to start with. Flipping the P/E multiple to earnings/price get us an earnings yield. In other words, how much are we paying for a dollar of earnings?
EPS (TTM): $14.47
Current Price: $692.14
Do the math and you get 2%. A free cash flow yield calculation will get you the same number.
DCF
Ok, but growth is the reason to buy Cintas. Let’s take growth into account with a DCF:
Using the TTM earnings, a 12% growth rate and a PE of 25, for a 10% compounded return over 10 years, Cintas is worth about $360 a share.
Bumping the PE to 30 gets us to $430.
Reverse DCF
We can also flip a DCF upside down and see how much growth the market has priced in for Cintas. Using this technique and a 3% perpetual growth rate after 10 years, Cintas has to grow at 21% a year for the next decade to get us a 10% return.
We can run lots of valuation models, but the bottom line is this: Cintas has to grow at very high rates for a very long time and you have to hold the stock through the inevitable ups and downs to get a decent return.
Costco
You know Costco, I’m sure. If you don’t, just find an interview where Charlie Munger talks about the company. You’ll know more than you want to when you’re done. Costco is a membership-based retailer that sells in bulk at low prices.
Again, there’s no question it’s a great business. The question is this - is Costco a great investment?
Growth
Again, on a 10-year basis, Costco grows revenue at about 10% and earnings at around 15%. Analysts have Costco growing around 10% a year for the next 5 years. Again, that’s probably reasonable. One thing to understand about Costco - they sell everything at a 15% markup, so you cannot calculate in margin expansion.
Valuation
Let’s start with earnings yield again.
EPS (TTM): $15.28
Current Price: $795.81
Do the math and you get about 2% again.
DCF
Using the TTM earnings, a 10% growth rate and a PE of 25 in 10 years, for a 10% return, Costco is currently worth about $380 a share.
Bumping the PE to 30 gets us to $460.
Reverse DCF
Using the same 3% terminal growth, Costco has to grow at 24% a year for the next decade to get us a 10% return.
What’s going on?
In a word, multiple expansion:
Check out Cintas from 2017 to 2018, investors were willing to pay 10x more per dollar of earnings.
Costco sees a jump from 2019 to 2020. Investors are simply willing to pay more for these companies in the last few years than they have been in years past. Why? Interest rates and bond yields have to be at least part of the story.
Above is the 10-year treasury yield. Look at the first half of the chart - bond yields were low and trending lower. This was the TINA era - there was no alternative to stocks. If you were looking for steady returns and couldn’t buy bonds, stocks like Cintas and Costco were pretty good choices.
Equity Bonds?
In May of 2018, Cintas was selling at about $170 a share. 2017’s EPS was $4.38, so you got an earnings yield of 2.5%, equal to a treasury bill.
This is all assuming you’re willing to hold Costco or Lotus Bakeries long enough to benefit from the growth. Most people aren’t.
The average holding period for a US investor is less than 6 months.
So, the idea that people are buying quality stocks as stable, and better returning bond replacements probably isn’t the whole story.
Inflation Fears?
Why would you buy something like Costco at 50x earnings for a 2% yield, when you could buy a 10-year treasury bill at more than double that? There is a part of me that wonders if the market isn’t quite convinced that inflation will come down the way we hope it will.
If inflation keeps going at 3% or 3.5%, or even worse, goes higher - then a 10-year at 4% isn’t a great investment.
Think about the 80’s when inflation was raging. In 1981, you could buy a 10-year treasury that yielded 15%. Official inflation was at 10% at the time, down from 13% the year before. Don’t forget that investors had just been through the stagflation of the 1970’s, so a 15% 10-year probably didn’t look as good then as it does now. In retrospect, it was a home run. Believing inflation will stay the same or go higher while also believing that the Fed will cut rates isn’t exactly rational. Then again, the market isn’t always rational, which brings me to…
Quality is a momentum trade.
Now we’re getting somewhere. This is an idea I can start to believe!
This data is from March, but I’m sure it still holds true. Quality is outperforming the index (as it usually does) and momentum is outperforming quality. But BlackRock has looked at the momentum names and found that the companies are less speculative than normal, with more stable earnings, high profitability and good balance sheets.
A 10-year chart of Cintas looks great. It’s up and to the right. Sure, 2020 shows a big dip, but when you service in-person businesses and they all shut down, what would you expect? 2022’s bear market looks more sideways for Cintas. No wonder momentum investors and algorithms have locked on to this stock.
There’s Costco. 2022 wasn’t as kind to Costco, but 2020 barely looks like anything on that chart. Pretty quick sideways movement, but certainly nothing like the sharp Cintas dip.
One more - that’s Lotus Bakeries. These charts all look pretty similar. A relatively slow, steady climb to around 2021, sideways to slightly down in 2022, then off to the races after that.
The companies all have steady earnings and growth, but the business performance doesn’t match that of the stock.
I think the era of very low interest rates we just left certainly inflated asset prices, but that doesn’t explain these charts. I can’t believe that enough investors are so long-term oriented that they’re willing to hold these quality companies for decades. I think BlackRock offers the best explanation of the extreme PE multiples many quality companies trade at.
Quality has become a momentum trade. We’ll see how long it lasts.