costco returns

Costco operates mainly in the US, Canada, the UK, Mexico, Japan, and Korea. It had $129 b revenues for (August) 2017, of which $94 b came from the US operations, and $19 b came from Canada. That's about 12% coming from its international operations. So it has some headway for growth out there. But will it fructify? 

Costco is a pretty straightforward business in wholesale and retail of merchandise. W. Craig Jelinek has been the President and CEO since 2012. In 2012, the market value of equity was $42 b (high) and now it is $81 b. A double in five years is nearly a 15% return; not bad. Earnings per share increased from $3.95 to $6.13. Expansion in the PE multiple from 25 to 30 was another reason. A 9% annual increase in EPS lead to nearly 15% in market value in five years. If you had picked the stock when the market capitalization was $34 b (low) in 2012, the returns would have been even better. Operating earnings increased from $2.7 b to $4.11 b; that's 8.30% annual increase.

In the meantime, the number of shares outstanding increased from 432 m to 437 m. Almost 17 m increase came from exercise of options and restricted stock units. To offset that Costco operated buybacks of 13 m shares. Had it not done that, the EPS in 2017 would have been $5.95 in 2017. In fact, Costco has been buying back its shares for long. In 2007 itself, it repurchased 36 m shares; then in 2008, 14 m more. From 2007 to 2017, Costco bought back 90 m shares. If shares were not repurchased, the total number of shares outstanding would have been 527 m, and that would have brought EPS down to $5.08. With the current multiple, the share price would be 18% lower at $152 instead of $186 now. Yet, due to higher number of shares outstanding, the market value of equity would be surprisingly similar to what it is now ($80 b). Of course, Costco would have retained cash of nearly $6 b assuming the buybacks were carried at low prices of each year, or it could have distributed to the shareholders.

So were those buybacks really worth it? To perform buyback, you need two factors: Excess cash, and low share prices compared to the intrinsic value. 

Where will Costco go from here? Revenues increased just over 5% annually during the last five years, and just over 7% during ten years. Assuming 7% increase in the next decade, we have revenues at year 10 of $254 b. With the current operating margins of 3.19% and net margin of 2.08%, Costco's EBIT would be $8 b and net earnings would be $5.3 b. Assuming no further dilution in equity, to get an annual return of say, 7%, the stock would need a PE multiple of, obviously, 30 at year 10. That is a rather rich pricing. When we use a multiple of 25, the rate of return would be 4.91%; at 20, the return would be 2.60%. When dividends are included, those returns would be 8.06%, 6.08%, and 3.90%. Well, why should Costco trade at a multiple of 30 or even 25, why not 20? Then there is dilution due to restricted stock units program.

When I do an intrinsic valuation of Costco based upon its free cash flows for the next decade and using a stable growth rate thereafter, I find that Costco is a 6% stock. I also converted its lease obligations into debt ($2.3 b) for the purpose of this valuation. But then for similar growth rates, the market has rewarded its shareholders nearly 15% return in the past. You can never tell what's with the markets.

Where is growth in revenues, earnings and cash flows going to come from for Costco? I think both Costco and Walmart should have some strategy to tackle the onslaught from Amazon. Online retail is here to stay and grow. 

stock market riches

Business profits
I have an acquaintance, who has a small business in a small town. He has been running the business for long. It is a profitable operation, and most of the profits are reinvested back into the business. When asked about his investments outside of his business, he brushes aside and says that it is not much. He does not invest in properties, be it plots of land, which is a common investment theme in small towns, or houses and apartments. He does throw some cash into bank deposits regularly, but that's about it. He has a rather lavish lifestyle compared to his friends in that town. There are lots of leisurely travel across the country, and then some foreign trips too. He likes to eat, whenever his family does, in higher quality restaurants, and according to his friends, he does not hesitate to pay up for his lifestyle. Yet, when you ask him the question, he says that it is just fine and that he does not find anything lavish about it. So how does he fund his life? Obviously from his business. There are drawings from his profits, which are called dividends in public markets. 

Highly concentrated

The way I see it is that he is a highly concentrated investor, who has invested almost all of his wealth in one asset, which is a profitable business. He knows much about the business, its long term prospects, competitive advantages, and so forth. We can talk about diversification, etc. But the fact is that he has been doing what he is doing for very long. He has made money, is reasonably rich, at least in terms of being able to fund his lifestyle through retirement. Who is going to teach him about investing? You don't have to do it the way he is doing. You can diversify your investments more reasonably. 

Businesses need time 
The key point is that in order to make money in business, you have to be in the business for long. You cannot start a business today, and then ask to become rich instantly. The business will have to face both good times and bad times more than once. There wouldn't be linear profits all through. It will begin as a startup, it will grow, it will mature, and probably, it will collapse when time comes. It is true for a private business and also for a publicly traded business.

Investing in businesses
If you want to make money in business, you have two options: One, start a business that will be good enough to grow and feed your long term requirements. Two, invest in a business started by someone else. Not everyone is capable of starting a business and seeing through its growth. It is tough to deal with the competition, regulation, and the macro. You have to be good at investing, financing, and dividend decisions of the business. 

The second option is available to most of us, which if carried out diligently has prospects of enormous wealth creation. This can be done through investments in private businesses or in publicly traded businesses. 

Stock markets are an investor's paradise
Now to the purpose of this post. A stock market is nothing but a collection of businesses, which are rated and priced every moment of trading hours. How can we profit from stock markets? I reckon, there isn't a better place than stock market to make money. These markets are a blessing to most of the lay people, who are otherwise incapable of starting out in a business of their own. Equity markets give that opportunity. 

Unfortunately, though, people look at the stock market as a casino. They throw cash at the stock tickers and expect them to throw back more cash instantly. Their time period is immediate. Stocks are tracked on a quarterly basis; a bad quarter, the prices fall, and vice versa. Every day is like a roller coaster, where prices go up or down, or go up and down. No one knows for sure the real worth of the stock, nor does anyone care. Prices are set based upon perceptions, whims and fancies.

A stock is a business
A stock has a business behind it; and it is a real business. The business has earnings and cash flows. Ideally, stock prices should reflect the value backed by the fundamentals of the business: cash flows, growth, and risk. But they don't as we just saw. Nonetheless, over the long term, they do march towards the true value of the business. For instance, if the business generates high cash flows, compared to the capital invested (return on capital), consistently for a long period of time, the markets will eventually recognize the true value of the business and set the price accordingly. The same will be true for a bad business; there can be mispricing during the short term; but eventually, the markets will have to see poor cash flows and price the stock based upon that.

Of course, there are many ways to make money from stock markets. There are traders, who have been making a living buying and selling frequently. There are investors, who take short positions on bad businesses and make money. There are those who have been able to profit from corporate restructuring such as mergers and acquisitions, spin offs; risk arbitrage. There is more than one approach to riches.

We want a low-stress, low-risk, high-return strategy
Yet the way I see it is, there is no other way that is less stressful than going long on stocks backed by good businesses. If you are able to pick pieces (stocks) of good businesses at the right price, and hold them for long, there are three things likely: One, no stress of trading moments or of quarterly juggles. It's a virtually no-stress investment strategy. You will have time for fun in life. Two, it's also a virtually no-risk investment strategy. Because your investment period is a long time, a decade or longer, the effect of short term volatility in stock prices is nullified. The chances of permanent loss of capital or of earning inadequate returns are brought down to very low. Three, the probability of making more than adequate returns from investments will be very high. This happens for three reasons: Participation in a good business for a long time; Extremely low trading costs since there aren't frequent buys and sells; and Prices paid for the stocks are generally low compared to the growth prospects. 

The probability of low stress, low risk, and high returns shapes up nicely because you are giving time for the business to run the way it should be, and because of that you earn business profits, not market profits. And when the business is good, its profits are almost always good. Remember, you are a partner in that business entitled to your share of its profits. Handing cash to a few chosen, trustworthy business managers is a better game to play than running one business of your own; this is true at least for most people. Five to fifteen handpicked businesses should be able to meet your expectations. A manager, who also has a substantial stake in the business is always more trustworthy (other factors being taken care of) because the skin in the game makes it more dependable. And you can rest assured relax and have fun in life.. 

If you are the owner of say, a private restaurant, would you expect to realize profits within a year, and then sell it off to someone willing to pay you more than your invested capital? Sounds absurd, right? You started the restaurant because you wanted to be in food business that you expect to do well and earn profits year after year. It amazes me, and I wonder why people are so hesitant towards their stock pickings. Stocks too are investments in businesses, albeit in small proportions. So what? A minority share in a publicly traded business is no different from a minority share in a private business. 

Choose the right business, and play long
The moral of the story is that if you are wise enough to pick stocks that are backed by businesses having long term competitive advantages and operated by able managers, who understand where to invest, how to finance investments, and when to payback to the owners, you have a high probability that you will make decent money over the period. A low price for the stocks comes in handy. Because good businesses are often priced very high by the markets, it will be prudent to wait for the right opportunity. And opportunities to pick stocks of good businesses at the right price galore in public markets. 

Time is your friend in this game; show patience
Just show intelligence to identify good businesses, wisdom to buy them at the right price, and patience to hold them for long, and you will be able to show a pile of cash. Patience is a virtue. Making money off inefficient markets is more behavioral than intelligence.