The Wal-Mart Bear Market – Part 2

How is it possible that a large cap industry leader can grow its earnings more than 90% over half a decade and yet return a negative 15% to shareholders? Did Wal-Mart do anything wrong, and if so, what?

No, Wal-Mart management did nothing wrong from 2000 to 2005. In fact, they did exactly what their job was, to grow the business into the world’s most dominant retailer. The fault lies with the shareholders who bought the stock at $55 five years ago.

Now you might think that accusation is absolutely preposterous. After all, aren’t investors who saw the growth potential in Wal-Mart back then very perceptive? Didn’t they do exactly what a good growth investor should do?

I would argue against that notion. In fact, Wal-Mart investors made a very common mistake, a mistake that hundreds of people fall victim to every single day on Wall Street. They wanted to own shares of WMT but didn’t pay any attention to how much they were paying for them.

I’m not talking about share price. Many people conclude a $5 stock is “cheap” and a $100 stock is “expensive.” In fact, share price alone does not make a stock good or bad, cheap or expensive. Investors who bought WMT shares at $55 in May of 2000 forked over a whopping 40 times earnings for the stock ($55 per share divided by $1.39 in earnings).

Contrary to the common belief that stock prices follow earnings growth, there are many exceptions. When stock have enormous P/E ratios (a P/E of 40 is about 3 times the average stock’s P/E since 1900) it is often a signal that investors are getting a bad deal, regardless of the company’s future growth potential. If the P/E multiple that investors are willing to pay decreases dramatically over time, not even a 91% gain in profits can make up for the damage shareholders will incur.

Today Wal-Mart stock trades at $47, or 18 times this year’s expected earnings. If you have a company’s P/E ratio fall from 40 to 18, and earnings grow 91%, you are left with a 15% loss on your investment. This can explain why the high-flying tech stocks on the late 1990’s are down so much from their peaks. Cisco Systems (CSCO) is making more money now than they ever did during the Nasdaq bubble, but instead of trading at $82, which was its all-time high in early 2000, the stock is under $20 a share today.

This example should help investors realize that oftentimes the key to growth stock investing is the price you pay, and not the future growth of the company you are investing in. Even though the hype for many promising growth companies can be hard to ignore, try not to lose sight of that.