The beginning of the year is a great opportunity to take stock of one's portfolio. If you invest in high-quality businesses, it's easy to fall in love with the shares, believing that they will always perform in line with the underlying business. Not so! Once it has outrun its fundamentals and is overpriced, no stock will provide acceptable returns, except in the short term (which pertains to speculation, not investing). Below, I've identified five stocks belonging to high-quality companies that look poised to disappoint shareholders.
What goes up, must come down
I evaluated the stocks in the S&P 500 based on their price-to-earnings multiples and prior returns on the notion that periods of high valuations/returns tend to usher in periods of low returns/valuations. That principle works best for indexes, but it also applies to stocks. The stocks in the table below boast top 20% valuations (forward P/E) and top 10% performance (one- and five-year returns). The returns remain in the top 10% even if we enlarge their peer group to include all the stocks in the Russell 3000:
5-Year Annualized Return Including Dividends
(December 2006-December 2011)
|Chipotle Mexican Grill (NYSE: CMG )||Brand||43%||41.1|
|McDonald's (NYSE: MCD )||Brand||21%||18.0|
|Intuitive Surgical (Nasdaq: ISRG )||Niche technology/ intellectual property||37%||34.4|
|MasterCard (NYSE: MA )||Network effect||31%||17.9|
|Fastenal (Nasdaq: FAST )||Distribution network||22%||32.0|
|S&P 500 Index||--||0% [TR Index]||11.7|
Source: Author, S&P Capital IQ. *At Jan. 2.
McDonald's was the top-performing Dow stock in 2011, notching up a tidy 31.7% return. The Golden Arches is one of the great American brands and a terrific business. The company also has one of the best records in terms of dividend growth and consistency -- the stock currently yields an appetizing 2.8%. All these things will quite naturally endear investors to the stock, but -- you knew it was coming -- 18 times forward earnings for a mature business is a bit rich for my blood. McDonald's was a great buy at any point from January 2001 through 2005 as a turnaround stock. That bird has flown, and it is no time to (re)discover McDonald's.
Chipotle Mexican Grill
Like McDonald's, Chipotle has created a powerful brand based on the convenience and the consistency of its product; hardly surprising, since it was spun out of the former. Unlike its parent, Chipotle's image is associated with healthful, high-quality ingredients. Chipotle's model is tried-and-tested -- the key is execution and this Mexican eatery has delivered, richly rewarding its shareholders in the process (43% annualized return over the past five years). Investors must be extrapolating those returns out into the future for them to pay 41 times forward earnings for the shares. At that price, I think this restaurant stock could leave them with a painful indigestion, or a ho-hum meal, at best.
The payment card processing industry is an oligopoly and MasterCard is one of the twin pillars of the industry (along with Visa). De-mutualized from a consortium of banks, MasterCard has performed like a champ since its 2006 IPO, smashing the index. Those returns are partly attributable to solid growth (historical and prospective) and partly to undervaluation at its launch. That discount no longer exists and investors shouldn't expect to earn premium returns from this point forward.
Fastenal sells industrial and construction supplies on a retail and wholesale basis. With more than 2,500 locations, the company has a terrific distribution network and is well-positioned as the industry consolidates. This is a very good business that deserves a premium price-to-earnings multiple compared to the broad market, just not as large as the one it enjoys now (32 times vs.12 times for the market).
The folks at Motley Fool Rule Breakers won't agree with the inclusion of Intuitive Surgical. Who can blame them? This manufacturer of advanced surgical systems is one of the "core" stocks of The Motley Fool's growth stock service, for which it has generated huge returns as a four-time pick. Color me skeptical, but I don't see Intuitive Surgical repeating the same feat over the next five years. In fact, at 34 times forward earnings and on the back of a 70%-plus return in 2011, I expect it to underperform the Nasdaq this year.
Last thoughts and more ideas
If you originally bought these stocks at a discount to their intrinsic value, it may be rational to continue holding them in your portfolio even if you think their current prospects are simply average or even below-average. If you are a long-term investor, you may consider that well-bought high-quality businesses are worth owning through periods of mediocre returns. After all, you can be relatively confident that the return over your holding period will beat the market and selling the shares incurs costs and the risk associated with having to reinvest the funds. In that case, you can focus on the stocks you want to add to your portfolio rather than ones you want to get rid of.
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