As I type Hershey 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. At first glance it’s kind of hard to dispute that. I mean at the start of the year Hershey shares traded for around $105 each on the back of 2018 net profit of $5.36 per share. Dividing the latter figure by the former gives us a starting 2019 earnings yield equal to around 5.10% – a slight premium to its long run average. As it stands that figure has collapsed to around 3.5%.
On that basis the bearish case from this point on is pretty easy to establish. Indeed 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 Hershey stock undergoes something more akin to a great pause. That is to say the stock 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 Hershey shares peaked at a price of $67.37 per share. In the preceding year – i.e. fiscal year 2004 – the company made a net profit of $2.25 per share. In other words at its most expensive folks were paying nearly 30x earnings, quite similar to the environment we find ourselves in right now.
Let’s imagine you were one of those folks buying in 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 become $153.20 as I type. Furthermore, the stock has pumped out cash dividends worth a cumulative total of around $24.70 per share. Overall shareholder returns to date 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 for each Hershey share purchased during the 2005 peak investors have 1.4 shares today. At the current market price that works out to a total return of 230% – 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 January 1st of this year rather than today – i.e. ignoring the 46% run up year to date – then returns still handily beat inflation by 3% per annum.
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 (Q4 1998) to trough (Q1 2000) was nearly 50%. Returns up to January 2019 work out to around 7.85% factoring in dividend reinvestment, beating 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. 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 in terms of total returns relative to the impact of earnings and dividends. Finally, this process is greatly enhanced by following a dividend reinvestment program.