Stocks and Shares

The investor’s greatest weapon

The world of retailing is being turned upside down by the internet. Vast, out of town stores are struggling as more and more people opt to buy online. Today we take a look at the battle between two giant retailers: Wal-Mart and Amazon. The old heavyweight champion is slugging it out with the new challenger. Does either stock make sense as an investment?

Recently I received this question from James M.

“There’s a lot of confusing info out there. One person says a company is doing great…another says it’s got problems. It gets even more difficult when it comes to tech stocks. Do you have any tips on how to cut through it all? Btw, I’m really enjoying OfWealth.”

First, thanks for the question. Keep them coming. (robmarstrand@ofwealth.com)

When we thought about how to respond we realised that a lot of people, a lot of the time, could get a long way just by using good old common sense. It’s often our greatest weapon when making decisions.

To show a bit of common sense at work I’ll compare the stocks of two giant, but very different, retailing companies. It’s all about the threat or the opportunity presented by the internet, and who’s geared up to win or lose from it.

The internet is causing a revolution in the business of retailing. We can easily see this by comparing two of the sector’s heavyweights who are slugging it out for market share.

In the old school red corner we have 62 year old veteran fighter Wal-Mart Stores Inc. (NYSE:WMT) – short and squat and solid. In the new blue corner we have the relatively young upstart Amazon.com Inc. (NASDAQ:AMZN) – tall, bronzed, light on its feet and with a long reach.

Wal-Mart sells most of its goods from huge, out-of-town mega stores. Amazon sells online, and delivers goods that are dispatched from massive warehouses. Old model, meet new model.

At the current stock price, Wal-Mart weighs in with a market value of US$216 billion. Amazon has quickly piled on the pounds and is valued at US$263 billion. At first glance a fairly even match, but there the similarities end.

Wal-Mart’s sales last year were US$482 billion, which was 4.5 times as much as Amazon’s US$107 billion. But sales are stagnant at Wal-Mart as shopping habits change. They were down 0.7% in the last year. By comparison, Amazon’s sales grew a massive 20% as more and more people shop online.

But Amazon’s shares have an eye watering valuation. The P/E ratio is a staggering 448, compared with Wal-Mart’s reasonable 14.5. On a price-to-sales view (P/S) Amazon stock trades at 2.5 versus Wal-Mart’s 0.5. On price-to-free cash flow (P/FCF) Amazon is at 52, whereas Wal-Mart’s at 13.6.

(Free cash flow is cash profits less capital expenditure. Capital expenditure is cash spent on buying or maintaining fixed assets like land, buildings and equipment.)

Clearly investors are prepared to pay a massive premium for Amazon’s high growth, even though it’s much less profitable than Wal-Mart. The question is whether this makes sense.

Which is the better investment at the current stock price? Amazon or Wal-Mart?

As investors we need to make a clear distinction between the prospects for the business and the prospects for the stock.

We can never know what the future may bring. But applying a little common sense gives us plenty of clues. As investors we need to make a clear distinction between the prospects for the business and the prospects for the stock.

Amazon’s sales and profits may grow to many multiples of today’s level in future. But if that’s already baked into the price of the stock then it could still be a bad investment. In fact, even if Wal-Mart’s business model is stagnant, if its stock is cheap enough it could be the better bet.

Here’s one simple way, common sense way to look at it. Wal-Mart is 54 years old this year. Amazon was founded 32 years later, and is aged 22.

Now let’s say that Amazon’s sales grow to be as big as Wal-Mart’s when it’s 54 years old. That’s assuming everything goes to plan and some new challenger doesn’t knock it off its perch as the leading online retailer.

The company would have to multiply sales by 4.5 times over 32 years. But that’s in today’s money. There’s also consumer price inflation to take into account.

Let’s assume inflation is the same as for the past 32 years since 1984. Using an online inflation calculator for US prices tells me they went up 2.3 times over that time. (It works out as 2.6% a year.)

Multiplying 4.5 by 2.3 means Amazon’s sales would have to go up 10.2 times in 32 years to match the equivalent of Wal-Mart today. At that point they’d be US$1,091 billion (yes, that’s US$ 1.1 trillion of sales!).

Now let’s say that, once that Amazon reaches maturity, the profit margins are the same as Wal-Mart’s today. That’s a reasonable assumption, and much better than Amazon’s current reality. My friend Bill Bonner has dubbed Amazon as “the river of no returns”. But one day that may change.

Let’s also say it has the same price-to-sales ratio (P/S) as today’s Wal-Mart, of 0.5. That would make the company worth US$546 billion.

That’s just 2.1 times as much as today’s market capitalisation (market value), at the current high stock price. That’s just over double in 32 years, so let’s guess that it takes 30 years to exactly double.

Using the rule of 70 for working out doubling times (read “Make mine a double” to see how easy it is), that means the stock price will go up about 2.3% a year on average. That’s 70 divided by 30. (Note: the actual figure is also 2.3% a year.)

That’s certainly nothing to write home about. But we should get some income as well.

Somewhere along the way Amazon would probably start paying out cash to shareholders in the form of dividends or stock buybacks. The current payout yield is zero, and Wal-Mart’s is 4.8% (dividends and buybacks). Let’s say it averages 2.5% over the whole period.

In other words Amazon shareholders today should expect to make 4.8% a year, all in. That’s the same as Wal-Mart’s current cash yield, including dividends and buybacks.

Put another way, if you had to own the stock of one of them, you may as well own Wal-Mart. You get the near 5% cash yield and own a piece of a much less risky business.

Plus there’s a good chance that Wal-Mart will get better at online retailing eventually, and move back to (modest) growth. There’s also a good chance that the excruciatingly high Amazon stock price will crash one day, offering a better entry point.

I have little doubt that Amazon will continue to grow its business, for now, at a rapid pace. But, as is so often the case with the big business winners from tech, it’s not necessarily the stock investors who benefit. It’s all about the price.

Avoiding overpriced stocks is mainly about common sense. There’s very little that’s worth a P/E of over 30 or 40, let alone Amazon’s 448.

If you want to find out more about a safer way to invest in tech stocks then take a look here and here.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.