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The Worst Mistake Costco Investors Can Make Right Now

By James Brumley - Mar 11, 2021 at 7:10AM

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If you've held on through this year's selling, you've already done the hard part.

Costco (COST 1.92%) hasn't been an easy name for investors to stick with of late. Last quarter's top line was better than expected, but it was an earnings miss in the view of some investors and it sparked more selling of the stock since the report was released last week. Share prices are down about 14% just in 2021, wiping away a significant part of the rally sparked just after the onset of the pandemic.

If you've stuck it out this far, though, there's little point in bailing out now. This year's retreat has merely pulled the stock back to its typical, pre-COVID levels in terms of average valuation. This should be enough to reset the stock's long-term advance.

Young woman holding out her hand, halting the observer.

Image source: Getty Images.

Red flags spook investors

There's no denying Costco's been a big beneficiary of the coronavirus contagion. With consumers largely stuck at home and cooking for themselves, the warehouse retailer boasts double-digit percentage sales gains for every month since March 2020. Its e-commerce sales growth has been enormous.

We're now one full year into the pandemic, however, and not only is the growth abating, the year-ago comparisons are about to be considerably less impressive. We're close to seeing how much -- if any -- of this new business Costco is going to keep.

Last quarter's numbers aren't encouraging in this regard. Same-store sales in the United States improved by 11.4%, down from the previous quarter's 17% adjusted growth. Meanwhile, February's same-store sales growth of 10.3% is notably slower than January's improvement of 16.4%, when excluding the effect of changes in gas prices. The shift suggests a slowdown is already underway.

Costs are rising more than revenue too. Sales for the fiscal second quarter ending in mid-February were up 14.6%, while selling and administrative expenses grew 16%. End result? The per-share income of $2.14 barely improved on the year-ago comparison of $2.10, coming in well short of the consensus estimate of $2.42.

The retailer cites bigger employee paychecks as the culprit, with many hourly associates receiving pandemic-related premiums. With rival retailers like Walmart and Target making a point of raising their minimum hourly wage to the $15/hour rate that may be federally mandated sooner than later, though, last quarter's steep selling expenses seem to be Costco's new norm.

Just a return toward normal

The backdrop isn't a grim one for Costco, but it is troubling. From high to low, Costco share prices have fallen nearly 19% from their late-November peak.

Keep the sell-off in perspective, though. That pullback follows a 32% gain from June's low to that high, and the incredible 106% run-up from its late-2018 low to November's all-time peak. At least some degree of profit-taking was inevitable. Yet, that profit-taking didn't actually snap this stock's long-term uptrend. It merely pulled it back closer to its historically palatable valuation.

The graphic below tells the tale, plotting Costco shares' historical price-to-sales ratios and its price-to-earnings ratios all the way back to 2011.

Costco stock trailing 12-month valuation chart

Data source: Thomson Reuters. Image by author.

As you can see, shares have always been expensive relative to earnings, but particularly so since 2019. The stock's sales-based and earnings-based valuation flew through the roof last year, however, once the pandemic got going in earnest.

The company did well last year to be sure, but it was never going to do as well as the stock's frothy valuation suggested. The pullback since November simply dialed back these valuations to historical norms, although it's worth noting shares are still trading a bit above their historical norms.

A hold isn't the same thing as a buy

So, yes, Costco shares are arguably closer to a major low than a major high. If you're still holding your shares, there's little point in letting go now. It's the same company it was a year ago, with the same growth opportunities. You don't want to miss out on a rebound whenever it may come, and selling it might needlessly create a tax liability.

Just because existing shareholders should stick with it, however, doesn't necessarily mean newcomers should step in. It appears a rebound effort is brewing here, but shares still have a small valuation problem. The stock's trading at just under 30 times next year's projected profits, which is a bit above its pre-2019 earnings-based valuation. That's going to work against the stock even if it doesn't drive the stock meaningfully lower in the foreseeable future.

In other words, if you're interested in owning Costco, put it on your watchlist and wait for this dust to settle.

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