Every Investing Decision Is Relative
"The right way to make decisions in practical life is based on your opportunity cost. When you get married, you have to choose the best you can find that will have you."
- Charlie Munger
Every investing decision is relative. The choice to own Stock A means that money is no longer available to invest in Stock B, thousands of other stocks, bonds, cash, gold, real estate, or any other asset.
I evaluate common stocks along five criteria:
Moat: Does the company have a sustainable competitive advantage? Every good business will attract competition—the moat keeps competitors away. Moats come in many different forms, such as brands, cost advantages, or network effects.
Growth: Revenue growth, margin expansion, and/or share repurchases drive earnings per share growth. I prefer companies with long-lasting, secular growth tailwinds.
Management: Investors trust management to deploy their capital wisely and execute a sensible strategic plan. Management's most important job is maintaining and expanding the moat.
Financial Strength: This includes a healthy balance sheet and robust free cash flow relative to net income.
Valuation: Valuations must be reasonable, accounting for the growth outlook and other factors. Even a wonderful business won't be a good investment if we pay too high a price.
When considering a new stock, I compare it side-by-side against my least-favorite current holding. It's rare for Stock A to be better than Stock B along every dimension: Wider moat, faster growth, better management, stronger balance sheet, and cheaper valuation. Usually there are tradeoffs. Maybe Stock A represents a higher-quality and faster-growing business, but it trades at an expensive P/E. Or maybe Stock B has a discounted valuation, but management has made questionable acquisitions and the balance sheet is precarious. In these cases, investors must use their judgment and experience to decide which stock offers the better risk/reward.
My investment criteria are more qualitative than quantitative. The only data we have is what happened in the past; the only data that matters is what will happen in the future. We can see a company’s revenue and earnings growth over the prior five years, but we have to make educated guesses about the next five years. We can calculate the trailing price/earnings ratio, but we can't know for sure if earnings are sustainable. We can use metrics like return on invested capital as possible evidence of a moat, but nothing in the financial statements will tell us a company is about to be disrupted by new technology or a regulatory change. It's more important to have a roughly correct view of a business' future prospects than a precise understanding of its past.
S&P 500: Top 20 Holdings
With that caveat, the following chart shows the 20 largest holdings in the S&P 500 as of May 10, 2024, along with their current-year P/E ratios and projected EPS growth for next fiscal year (using Bloomberg consensus estimates). There are many limitations to this kind of data: Companies and analysts make different non-GAAP adjustments, fiscal years don't always line up, and I'm ignoring many nuances of business models and accounting policies. It's also just a snapshot in time; current-year earnings may not reflect a mid-cycle environment, and next year's EPS growth is no substitute for a longer-term outlook. Still, a quick screen can be a helpful first step in identifying possible opportunities, or areas to avoid.
A few observations:
• The S&P 500 is top-heavy. The 10 largest holdings account for about 34% of the benchmark, and the top 20 about 44%. That leaves only 56% for the bottom 480 companies. I'll share more thoughts on market concentration in a future post.
• Valuations appear elevated relative to history. The top 20 stocks have an average (harmonic mean) P/E of 23.5x, compared to the entire S&P 500 around 21.3, and the benchmark's 20-year average around 18.2.
• At a glance, Alphabet, Meta, UnitedHealth, and Merck look potentially interesting, with solid near-term growth and reasonable valuations. I wrote about Google's AI Advantages last week. Microsoft, Mastercard, Visa, and Amazon are a bit more expensive on a P/E basis, but they have very wide moats, and growth should be sustainable for many years to come.
• Nvidia is trading for 36x earnings, but growth has been off the charts. Current-year EPS is expected to be up almost 22-fold from just five years ago—an 85% compound annual growth rate! Growth is forecast to slow going forward, but there is a high degree of uncertainty. Are we still in the early innings of the AI computing boom, or have tech companies over-invested in infrastructure that will now take a while to digest? Broadcom is another name worth researching in the semiconductor industry.
• Costco, with a P/E of 49x, stands out as inordinately expensive. Costco is a great retailer, but it's only expected to grow EPS about 10% per year over the next several years. I can't justify its valuation relative to the other options.
• Apple, Procter & Gamble, and Home Depot also seem pricey given subdued growth expectations. Apple's smartphone business is mature; it remains to be seen if the company can reinvigorate growth with new product categories like virtual reality headsets. Procter & Gamble has great brands but it's an established, slow-growing consumer staples business—26x earnings feels like a lot. Home Depot enjoyed a cyclical uplift during the coronavirus pandemic, but I'm not sure about normalized earnings power, especially with higher interest rates making it harder for consumers to afford home renovations.
• Tesla is an outlier on both growth and valuation. Earnings per share for 2024 are forecast to be down about 30% from two years earlier, so even if the company achieves the consensus forecast for 33% growth next year, 2025 earnings will be below the 2022 level. I'm skeptical about Tesla's long-term prospects, for reasons discussed in Does Tesla Have a Moat?
• Eli Lilly has a massive blockbuster with GLP-1 drug tirzepatide for weight loss (brand names Mounjaro and Zepbound). In clinical trials, patients on the highest dose lost an average of 48 pounds! About 42% of American adults are considered obese, along with many more people around the world, so the market opportunity is huge. The real question is how we'll pay for these drugs, with Zepbound's list price north of $1,000/month.
• Analysts don't expect much near-term earnings growth for JPMorgan Chase, Johnson & Johnson, or Exxon Mobil, but at least the stocks trade at modest P/Es. Each of these companies is influenced by factors outside their control: interest rates, clinical trial results, and energy prices. I wouldn't read much into Berkshire Hathaway from this data, since reported EPS doesn’t include the full earnings power of its equity portfolio, and insurance underwriting can be volatile.
Disclosures
Moatiful is an independent publication of Trajan Wealth, L.L.C., an SEC registered investment advisor. The views expressed are solely those of the author, and may not reflect the views of Trajan Wealth. Nothing in this blog is intended as investment advice, nor is it an offer to buy or sell any security. Posts are for entertainment purposes only and should not be relied on when making investment decisions. Please consult your financial advisor for questions about your personal financial situation. All investments involve risk, including the potential for loss. Historical results may not be indicative of future performance. Data from third-party sources is not guaranteed to be accurate, timely, or complete. Links to external sources are provided for convenience only, and do not constitute an endorsement by Trajan Wealth. Clients and employees of Trajan Wealth may have a position in any of the securities mentioned. Data and opinions are subject to change at any time without notice.