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Looking at Wal-Mart

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By thelegendoftomvu
February 23, 2010

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Walmart has finally reached my criteria for a low-hurtle, 20% after-tax investment. Even though it is a large capitalization, closely-followed company, it seems cheap enough to be an exception to the rule that large capitalization, closely-followed companies are a bad place to look for good investment returns. I bought a load of it at everyday low prices this morning (an average cost-basis of $53.4 a share). Here is why roughly:

In the middle years of his annual letters (80s and 90s), Warren Buffett wrote that he looks for businesses that consistently earn 20% plus returns on a growing equity capital base. That narrows the investment universe considerably to a few great businesses. Walmart is in this universe:

From fiscal year 2010 (fiscal year ends in January for WMT) back through fiscal year 2000, Walmart had the following returns on a growing equity capital base:

21.19%, 20.4%, 20.4%, 21.2%, 21.9%, 22.1%, 21.3%, 21.6%, 20.1%, 22.0% and 23.8%

OK, so Walmart meets this Buffett criteria, and it is obviously operating with some sort of competitive advantage to throw up business performance numbers like that through the thick and thin of the last decade. Remember we suffered TWO popping bubbles (first the stock market and most recently the real-estate/credit bubbles) and one bubble inflation during this time period (Thank you Easy Al Greenspan). All the while Walmart performed well with 20%+ returns on growing equity despite the manic ride. It has a moat around its business and it has the ability to perform in both good and bad times.

So what about a good price to pay for the stock of a company like Walmart? After all, the stock price has gone nowhere for a decade. I mean no where. Buffett bought it in 2005 and it still has gone nowhere in share price from there.

Over the last decade starting from fiscal year 2010 going back to 2000, the stock price demonstrated the following ranges:

(55.2, 47.00),(63.85-43.11),(51.44, 42.09), (52.15, 42.31), (54.60, 42.31), (61.31, 51.08), (60.20, 46.25), (63.94, 43.72), (58.75, 42.00), (69.00, 41.44), (70.25, 38.68)

The story of the share-price going nowhere is largely the story of working off the effects of over-valuation. In the first couple of years of the decade, the PE multiple was frequently in 50s, and the last two years of the decade, the PE has frequently been close to 13. If a PE of 50 was way too high. I think PE of 13 on a business as sound as Walmart is too low, and I will give two reasons for this.

First, Buffett bought shares of Walmart in 2005, at an average cost basis of about 47.33 dollars a share. Buffett, thanks in part to Charlie Munger, believes in paying a fair price for great businesses and letting the performance of the business effect the share price over long periods of time (five to ten years). We could assume that Buffett paid a fair price, given his incredible investment acumen and his approach to equity investment. The original price paid by Buffett in 2005 gave a price to core operating earnings (2.67) ratio of 17.7 for the year's trailing numbers in WMT fiscal year ending January 2006.

My cost basis today was 53.4 a share which is about about 13.5 x my estimates of fiscal year 2011 core operating earnings (3.95). That is a sizable discount to the ratio at which Buffett originally bought his WMT position, which I think was a fair price for different reasons (more on that later), and it may be a reason why he is rotating out of some other investments and buying more Walmart in recent quarters.

What about those earnings I am estimating for fiscal 2011? Well everyone is pitching a tissy fit about the fact that Walmart experienced same store sales contraction mostly because of price deflation in food and consumer electronics. In addition to this, they are sour on the upcoming quarter because of ongoing pricing pressures. To this I say, BFD.

A couple of quarters of price weakness is not the end of the world; rather, it is a good buying opportunity. I think this company is one of the strongest companies in the world in any environment, as evidenced by its incredible business performance in a variety of environments that I discussed earlier. I also think while the credit contraction and global recession has temporarily weakened some prices, the response to the Great Recession will actually cause long-term price inflation that will ensue from the prodigious money printing episode under Ben Bernanke. As Milton Friedman and Anna Schwartz have chronicled in the Nobel Prize winning work on monetary history, there is a variable lag time for monetary actions and their effects on prices, but the correlations are unmistakable.

I could be wrong about this, however. If the world is indeed falling into a deflationary spiral, then not only should you not own Walmart shares, you should not own any stock period. In times of deflation, bonds and currency rule the day, but in times of inflation, stocks and other assets with pricing power rule the day. I am siding with Warren Buffett in believing that the money printing will push up prices severely. The Fed and the Treasury have shown they will stop at nothing to prevent deflation. They will prop up anything and anyone, so long as they are not poor, with money printing.

The second reason for Walmart being cheap is a deeper reason than buying it at low PE multiple relative to the last decade, or than buying it at a lower PE multiple than Buffett originally bought it in 2005, or than buying it because Buffett has been buying it again lately... To any such argument, it is fair to object, and say, " If you don't know how to fundamentally value the business, then you really don't know what you are talking about. You don't know what the fair PE should be, or what Buffett was really thinking, or why he was even thinking what he was thinking. "

That is really fair. This defeater of the first argument rears its ugly head during times of psychological distress. When times get confusing and people head en masse for the door on an investment, will you have the presence of mind and deeper understanding to weather the panic? After all, sometimes the herd is right. Sometimes an investment thesis falls apart over time and the panic is perfectly justified. That even happens to Warren Buffett sometimes, though much less often than it happens to most people.

If you read his letters every year, Buffett says that value of any investment is the cash that can be taken out of it over its future life properly discounted to the present. That is a philosophical approach to thinking about valuation. It assumes that you own the business, and that the business derives its value based on the timing and size of the free cash flows it delivers to you as the owner of the business... I am not going to rehash how this all works here, but you don't need Warren Buffett or relative PEs to think about valuation this way.

What has been happening to the free-cash flows??? They have been swelling because of two very obvious factors: net income from operations keeps increasing because of strong performance while cap-ex has been precipitously declining because of the planned slowing of store expansion in the US. Starting in fiscal years 2007 to 2010 free cash flows went from 4.6 billion to 5.7 billion to 7.4 billion to 11.6 billion to 14.1 billion. . . This year alone the company returned over 11 billion in share buy-backs in dividend, which is exactly what a maturing stalwart should be doing.

Anyway, with a discount rate of 2% above the 10 year treasury and an assumption that cash-flows never grow again over the long term, the business is still undervalued by roughly 20% at today's prices. I think the future is brighter for Walmart than that, but that is a rough way to think about it in terms of free cash-flow valuation. Of course the size and timing of free cash-flows will be variable, especially if the overseas expansion continues to offer growth opportunities, but I can rest well knowing that a baseline free-cash flow discount is pretty good.

I actually think the shares are worth about $75 to $80 a piece, but I would probably unload them in a year's time at 70 if the opportunity arose, take my 20+ % after tax, and move on to something more interesting. No heroics here. The market would be simply be attaching Buffett's reasonable original 2005 PE multiple of 17.7 to this year's core operating earnings of 3.95 and you are there. Just will take a little time, possibly two years. The reason that shares of this business are such a good deal right now is the majority of the investment community thinks in terms of the next quarter, and the next couple of quarters will be underwhelming at best. If you can see a little farther down the line and wait for Walmart to keep delivering on its business performance through the vicissitudes of Wall Street expectations, I think you can safely get good returns over the next two years.

What about the fact that Walmart is the great satan and represents everything wrong with the world? I know and respect people who feel this way, but, as Ralph Stanley says, "It is a short time to be living and long time to be gone." I get my eggs and vegetables from my chickens and garden and local farmers' market. I buy my stock from the common stock holders of Walmart when it is cheap enough. The depressing disappearance of the middle class that has been exacerbated by the dual forces of globalization and Fed money-printing plays very well into the Walmart business model of providing low prices to the masses. The decision to invest or not in the common shares of Walmart does not change the things that have made us increasingly what Munger has deemed Sorrowland. We got here through a million bad decisions made by a generation of profligate idiots. The best I can do about that problem is try not to be profligate and try not to be an idiot.