Those familiar with my investment approach know that one of my key philosophies is to buy shares trading at a Price to Earnings ratio of under 20. Simply put, I do not like to overpay for stocks. It may thus come as a surprise that I purchased shares in the Estee Lauder company (NYSE:EL) whose shares trade at a P/E ratio of 24. No, I have not lost my mind! Neither have I thrown my investment thesis out f the window. Rather, I have bought shares in Estee Lauder due to its high returns on equity (ROE).
To understand the concept of Return on Equity, have a look at the following example. Suppose Company A has a long-term ROE of 11% and currently trades at a PE of 19x. If this ROE does indeed hold for the next 20 years, then assuming 100% of Company A earnings are reinvested at this same rate the total equity of Company A will also grow at a rate of 11% per annum; in line with its ROE. If the PE ratio remains at 19x at the end of the 20 year period, the share price will likewise have appreciated at a rate of 11% per annum. Obviously this is a simplistic example to help you understand the concept of ROE – in the real world, not all earnings are reinvested at the same rates of return and P/E ratios tend to fluctuate over time.
Take then the Estee Lauder Company which currently has a long-term weighted average ROE of 30% and trades on a PE of 24x. Does this mean I would expect returns of 30% per annum going forward? Perhaps, but only if the premium valuations can be sustained. To be more conservative, let’s suppose that over the next 20 year time horizon the company’s PE of 24x might instead fall to match the market’s average of 16x. Under such a scenario, the predicted return of Estee Lauder is still in excess of 20%. If we account for Els dividends pay-out ratio of close to 40%, the return going forward from this point is still over 15% per annum.
When looking at Estee Lauder from a Return on Equity point of view, the shares do appear rather cheap! As an investor, it is your job to look at a combination of factors and valuation matrices when deciding if a certain company’s shares are worth buying. If I were rigid in my analysis and took a pure value investing route of only buying cheap shares, I would not spot opportunities like Estee Lauder and Nike. Opportunities that will build far more wealth in the long run than a portfolio of cheap average companies.
The Nifty Fifty Revisited – Analysing performance of stocks trading at high valuations.
The great Jeremy Siegel’s classic 1995 study ‘The Nifty-Fifty Revisited’ (updated in 1997 for the 2nd edition of ‘Stocks for the Long Run’) re-analyses the long-term performance of a group of stocks trading on high ratings in the early 1970s.
He showed retrospectively that a high quality, well-branded company such as Coca-Cola, with a steady earnings growth record could in fact support extremely high multiples – even higher than Coke’s then PE of 46x. A year or two after the Nifty Fifty stocks had hit their peak valuations this multiple was criticised as having been a severe overvaluation, perhaps with some justification for those with shorter term time horizons. However subsequent price gains demonstrated the opposite as long term holders of Coke’s shares, despite some poor performance from 1972-1985, actually compounded returns at 17.2% per annum total return over the 25 years from 1972-1997. Siegel showed that for Coke to have performed no better than in line with the market between 1972 and 1997 it could in fact have started on a PE of 92x.
The same was true of other high quality companies such as Philip Morris (78x warranted PE) or Merck (74x warranted PE), demonstrating that with decade long periods of compounding at high ROEs, even outrageously high PE multiples could be justified. Over the past 20 years Coke, Philip Morris (now Altria) and Merck have averaged spectacularly impressive
ROEs of 38%, 55% and 30%.
On the flipside, lower quality companies with thinner or unsustainable ROEs failed to justify even mediocre PEs. Unisys for example (another Nifty Fifty member from 1972, then named Burroughs) should have traded on a warranted PE of just 7x in 1972 in order to explain its mediocre performance up to 1998. Unisys has averaged an erratic -17% ROE for the past 20 years.
This cements the fact that the best companies deserve higher valuations.
My Purchase of Estee Lauder Stock (NYSE:EL)
I recently bought 14 shares of EL for $78 each. With the companies current low historical valuation and high return on equities, this is a stock that will compound my wealth at high rates for many years to come. I am sure that when I look back at my investment decisions 20 years from now, I will surely be glad to have made this purchase.
The 14 shares in EL currently £13.44 in dividend income after accounting for withholding tax (LINK). The company currently has a dividend growth rate of 20% a year and I fully expect this to continue in the coming years. Having high dividend growth rates sure does compensate for a low dividend yield.
The great aspect about investing in wonderful companies like Estee Lauder is you only have to make one decision; to buy. After that you do nothing. You simply sit on your backside. You let el and its management do its work and build you wealth.