Signs of a 'quality bubble' with soaring valuations
1) Warren Buffett roughly halving Berkshire Hathaway's (BRK-B) stake in Apple (AAPL) was bombshell news... and it might be part of something bigger.
I discussed the Apple sale in last Monday's e-mail. It was undoubtedly driven in large part by the expansion of the company's valuation multiples to nosebleed (read: "dangerous") levels. As I said in that e-mail, as of the previous Friday's close, the stock was trading at 33.5 times trailing earnings – the highest level in 16 years.
For more context on Apple, in his latest Week in Charts blog post yesterday, Creative Planning's Charlie Bilello shared three charts showing how much more expensive Apple's stock has become since Buffett first started buying it in early 2016...
The first shows that Apple's price-to-earnings (P/E) multiple has soared from less than 10 times to more than 30 times:
The second chart shows that Apple's price-to-sales (P/S) ratio has soared from 2.2 times to 8.6 times over the same time frame:
Finally, Bilello also showed how Apple's stock has far outpaced the modest growth in revenues and profits over the past decade:
One reason for this is that, as Bilello notes:
Apple has bought back $646 billion in stock over the past 10 years, which is greater than the market cap of 491 companies in the S&P 500 [Index].
As a result, its share count has declined by 42%, which translates into a 73% increase in earnings per share. Here's the chart he shared:
But even factoring in these massive share repurchases, Apple's valuation has become much richer. And that's despite the fact that its growth prospects have dimmed considerably because of the company's sheer size.
No wonder Buffett decided to take a lot of profits!
And huge expansions in valuation multiples certainly aren't limited to Apple...
Another incredible company, Costco Wholesale (COST) – which I view as one of the great misses of my investing career – has seen its P/S multiple triple in the past decade, as you can see in this chart:
Similarly, its P/E ratio has doubled from 26 times to nearly 54 times today:
If anything, the multiples for these companies should have declined over the past decade because they're much larger (in Costco's case, revenues have more than doubled) – meaning growth will surely slow.
2) It's one thing to pay up for two of the world's greatest companies – Apple and Costco. But when a more mundane business like Eaton (ETN) – which makes electric and industrial components – trades up to unprecedented valuation levels, I have to wonder if there's a "quality bubble."
To be clear, Eaton is an excellent business, with roughly 15% net income margins and a 20% return on equity. But it has barely grown its revenue over the past decade, even though it has roughly doubled profits thanks to margin increases. This chart shows the company's revenue and net income over the past two decades:
Meanwhile, the stock has more than quadrupled over the past decade:
Why? Again, multiple expansion. In this chart, you can see that its P/S multiple – which historically was around 2 times – tripled in four years to roughly 6 times before pulling back to about 5 times today:
And its P/E multiple, historically in the teens, spiked to more than 40 times earlier this year before pulling back to about 32 times today:
Investors who bought at those high valuations just three months ago are down 17%.
I think they're going to lose even more – not because I expect the company to underperform expectations, but because the stock of a good (but slow-growth) business like Eaton should trade closer to its historical multiples than its current ones.
In conclusion, I continue to believe that investors should look to buy high-quality, growing businesses like Apple, Costco, and Eaton – but not at any price.
Just look at what happened to Nike (NKE), which I think everyone would have cited as one such business not too long ago...
As I explained in my August 9 and August 12 e-mails, the stock has crashed by nearly 60% since its peak in late 2021. This is due in large part to management missteps – which caused revenues and profits to suffer – but also the nosebleed levels its valuation reached.
The stock had traded at a P/E multiple ranging from 23 times to 33 times over most of the past decade, but then rose to more than 40 times at its peak – leaving a lot of room to fall if the company stumbled.
One of my friends once told me something very wise early in my career: "There are only two types of companies: those that have problems and those that are going to have problems.
I prefer to look for stocks of companies that are having problems – or at least whose stocks have fallen out of favor for some reason – and then bet on the ones that I think will return to glory.
Best regards,
Whitney
P.S. I welcome your feedback – send me an e-mail by clicking here.