Hershey: Playing The Long Game

by The Compound Investor

As I type, Hershey (HSY) stock is up 46% year-to-date. Needless to say, that is an incredible performance that I’m sure has made the company’s investors very happy. On the flip side, it has led many financial commentators to label the stock as overvalued. It’s kind of hard to dispute that at first glance. I mean, Hershey shares started the year at around $105 each. That price tag comes on the back of FY18 profit of $5.36 per share. Dividing the latter figure by the former gives us an earnings yield of around 5.10% – a slight premium to its long-run average. As things currently stand, that earnings yield number has collapsed to around 3.5%.

The bearish case is pretty easy to establish on that basis. In fact, there are probably two things that could go wrong here. The first is that Hershey stock simply drops back to a lower and more reasonable valuation. Indeed, a retreat back to its January valuation implies a 33% share price drawdown for anyone buying the stock today. The second, and probably more likely scenario, is that the stock undergoes something more akin to a great pause. That is to say it trades flat while earnings eventually grow into the current valuation.

Parallels With 2005….

As it happens, Hershey has left us some pretty good templates for what happens when you buy its shares at such a rich valuation. For instance, back in 2005 they peaked at a price of $67.37 each. In the preceding year – i.e. FY04 – the company made net profit of $2.25 per share. Or put another way, folks were paying nearly 30x earnings at its most expensive – quite similar to the environment we find ourselves in right now.

Let’s imagine you were one of those folks buying at the top in 2005. As far as I can see, Hershey stock didn’t see that $67.37 peak again until mid-2012. That’s a whole seven years for your capital to return to its value at the time of purchase (actually even longer on an inflation adjusted basis). At its worst point, you had to endure a 50% drawdown when the financial crisis was in full swing.

That said, the final outcome hasn’t proved to be all that bad. The initial share price of $67.37 has grown to $153.20. Furthermore, Hershey has pumped out cash dividends worth a cumulative total of around $24.70 per share. Overall shareholder returns over that period work out at around 7.2% on a compound annual basis. The situation improves if you assume those dividends were continually reinvested along the way. In that scenario, investors currently have 1.4 shares for each Hershey share purchased at the 2005 peak. That works out to a total return of 230% at current market prices – or 8.75% on a compound annual basis.

So, despite paying 30x earnings, Hershey shares still comfortably beat inflation over the same period. Note also that this analysis still holds true even if you ‘adjust’ for today’s high valuation. If we take the end point of our investment to be the start of this year rather than today – i.e. ignoring the 46% run up year to date – then returns still handily beat inflation by three percentage points per annum.

…And 1998

A similar situation occurred back in Q4 of 1998. Then, just as in 2005, Hershey stock hit a valuation that was equal to around 30x annual profit. Once again, the drawdown from peak (4Q98) to trough (1Q00) was nearly 50%. Returns up to the start of this year work out to around 7.85% after factoring in dividend reinvestment. That handily beats the 6.15% per annum posted by the S&P 500.

Assuming a $10,000 initial investment, that 1.7% per annum outperformance adds up to around $13,000 – or 1.3x your initial investment. Not only that, but that’s despite Hershey stock’s terminal valuation dropping to 20x earnings from the 30x earnings paid at the time of investment. (If we run the analysis up to the present, that 7.65% per annum becomes 9.6%).

Processing the above leads me to two conclusions regarding the outlook for Hershey shares at today’s valuation. Firstly, anyone brave enough to buy right now has to be prepared to play the long-term game. The risk of medium term underperformance as the valuation retreats to its historical mean is very high. Secondly, the longer you hold, the less relevant your starting valuation becomes relative to the impact of earnings growth and dividends. Finally, this process is greatly enhanced by following a dividend reinvestment program.


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