Why Some of the Strongest Firms Disappointed Investors

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar.

With all of the focus we give to economic moats or a competitive advantage at Morningstar, I think sometimes investors may lose sight of the fact that we also pay very close attention to the price we pay for the stocks that we recommend, because, of course, an expensive wide-moat stock is going to deliver you a very bad prospective return relative to a cheap no-moat stock.

And I think, unfortunately, this has colored the experience of a lot of people over the past decade, when perhaps they owned a portfolio of blue chips in say 2000 at very high valuations, and while those companies may have retained their competitive advantages and grown earnings and done very well operationally over the past decade, well, frankly, the shares have either gone down or gone nowhere as the valuation has compressed.

Because taking a step back, there are only three sources of return from owning an equity: you can get a dividend, get the dividend in cash; earnings can grow, increasing the value of the enterprise; or valuations can change, that is the earnings multiple can go from 10 to 20 or 20 to 10 or stay flat. And that is the source of return for owning an equity.

And I thought I might walk through three companies to show just how important the price you pay is on the returns you get regardless of what earnings growth is or how well the company does.

So, let's look at Cisco, which of course, was the poster child for the Internet back in the dot-com era. In 2000, Cisco generated about $5 billion in free cash flow, pretty good. Unfortunately, the company's enterprise value was about $440 billion. So that was only about 1.5% free cash flow yield. Fast forward 10 years, free cash flow has grown from $5 billion to $10 billion, pretty good, and unfortunately, the enterprise value has gone from $440 billion to $100 billion, which basically translates into a share price going from about $60 to about $20; not a very fun investor experience.

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And the problem there is not that Cisco hasn't done well, it's retained its competitive advantages in a very difficult industry over the past decade. It's doubled the free cash flow it generates, but the earnings multiple has compressed. The free cash flow multiple has compressed, and the valuation has declined because simply the valuation was excessive back in 2000--showing the importance, I think, of not paying too higher price because it's going to cause you to have a pretty bad investor experience going forward.

Johnson & Johnson shows what happens when basically earnings growth and valuation compression kind of cancel out. Between 2000 and today, Johnson & Johnson has increased earnings per share from $1.70 to about $4.80, pretty good; almost tripled earnings per share. It's very impressive performance. Unfortunately, in 2000, Johnson & Johnson was valued at about 30 times earnings. Today it's valued at about 12 times earnings. So although earnings have grown, the fact that we're starting out at 30 times earnings made it tough for the security to make any headway, and in fact the shares have only gone from about $50 to about $60, not much of a gain over a decade, essentially flat.

Now, for a happier example, we can look at Yum Brands, which was the spinoff from Tricon Global sometime ago, owns Pizza Hut, KFC, Taco Bell, yummy food, such as that. Now, back in 2000, Yum did about $0.69 per share, and most recently, it's done about $2.22 per share, so $0.69 to $2.22, almost a triple in earnings over the past decade, very similar performance to Johnson & Johnson, great earnings growth. But there the shares were only trading at about 12 times earnings in 2000 and that multiple has expanded to 20 times earnings over the past decade. So the shares have gone from basically $8 to $44--a pretty happy investor experience. And there you had kind of this double-effect of basically earnings growth and multiple expansion.

But even if Yum's earnings multiple hadn't gone anywhere, if it had stayed at 12 over the entire decade, well, the stock would have gone from $8 to $26 over the decade--still not too bad. And the point there is not that the earnings multiple for Yum Brands could have gone from 12 and even lower, but at 12 you had a safety net, at 12 you had some upside to your earnings versus paying 38 times earnings for Johnson & Johnson or 70-80 times earnings for Cisco, the valuation was much more likely to go down than come up and I think that sort of highlights the importance of the price you pay on the returns you get.

I'm Pat Dorsey and thanks for watching.