A Good Company vs. A Good Stock

By Sean Casterline, CFA

For one reason or another, investors don't often make a distinction between a good company and a good stock, which is a very important and often emotional error. It is perhaps one of the biggest pitfalls in everyday investing.

It isn't a daunting task to identify a great company on paper. Great companies have great brands, a bullet proof balance sheet, great profit margins, high return on capital, yadda, yadda, yadda. However, everybody recognizes those qualities and this often turns these companies into “must own” issues regardless of cost. These are the “you can't miss” type of stocks that everyone must have and that everybody subsequently pushes to astronomical valuation levels. The sad reality is that you CAN go wrong owning these kinds of stocks.

Pull up a ten year chart for almost any behemoth large capitalization issue. Most of these companies you know from dealing with them in your day-to-day life. Let's face it, they got to be household names because of their historical success. They include: WalMart (WMT), Microsoft (MSFT), Coca-Cola (KO), McDonalds (MCD), Pfizer (PFE), Colgate-Palmolive (CL). I could throw out name after name of great companies whose stock has gone nowhere since the late 90's and are very close to their bear market lows. Everybody will recognize these companies as icons of corporate America. However, their stocks were significantly overpriced in the later 90's, with most trading well over thirty times earnings. Coca-Cola alone was trading with a price-to-earnings ratio of 53 in the late 90's. That number is ridiculous but becomes absolutely absurd when you throw in the razor thin profit margins in the beverage business. One of the funniest side notes to the story is that I can remember analysts speaking highly of the stock and actually mentioning Warren Buffets position in Coca Cola stock. However, what they weren't telling you was that he had bought it years prior when the valuations were much, much lower. Truth be told, he was probably selling his stock to the disillusioned investors that were listening to those analysts.

Most of these companies have grown earnings in the low- to mid-teens but their stocks still have not budged. Earning typically drive stocks. But, in this case, as earnings were growing they were simply contracting the multiples back to reasonable levels. Thus, the stocks were not appreciating in price.

We screen the markets every day looking for quality companies to invest in at various levels of analysis. Often, I find a company I'd like to own because of the quality of its business. However, its stock doesn't meet our valuation criteria. I put that company on the back burner. To be more specific, we look at what the metrics (P/E ratio, P/Cash multiple, etc…) would have to be for us to feel comfortable buying the company. Once it gets to a more reasonable area, we reconsider the company. Cintas (CTAS) is a great example. I reviewed the company in the later 90's and found a very attractive business. They were the dominant player in the corporate identity uniform area. It's a real niche business that they dominate. However, what we found was a great company with a true competitive advantage that was WAY too expensive. In the last couple years, it's become much more attractive but it's not quite there yet. It currently trades at about 1.4 times the multiple for the S&P 500 and that's a bit rich for my blood. Once it gets cheaper, if it gets cheaper, we will re-evaluate their market position and their fundamentals to see if it's worth taking a risk on.