March 22, 2004
A basic property of religion is that the believer takes a leap of faith: to believe without expecting proof. Often you find this property of religion in other, unexpected places â€“ for example, in the stock market. It takes a while for a company to develop a â€œreligiousâ€ following: only a few high-quality, well-respected companies with long track records ever become worshipped by millions of investors. My partner, Michael Conn, calls these â€œreligion stocks.â€ The stock has to make a lot of shareholders happy for a long period of time to form this psychological link.
The stories (which are often true) of relatives or friends buying few hundred shares of the company and becoming millionaires have to fester a while for a stock to become a religion. Little by little, the past success of the company turns into an absolute â€“ and eternal — truth. Investorsâ€™ belief becomes set: the past success paints a clear picture of the future.
Gradually, investors turn from cautious shareholders into loud cheerleaders. Management is praised as visionary. The stock becomes a one-decision stock: buy. This euphoria is not created overnight. It takes a long time to build it, and a lot of healthy pessimists have to become converted into believers before a stock becomes a â€œreligion.â€ Once a stock is lifted up to â€œreligionâ€ status, beware: Logic is out the window. Analysts start using T-bills to discount the companyâ€™s cash flows in order to justify extraordinary valuations. Why, they ask, would you use any other discount rate if there is no risk? When a T-bill doesnâ€™t do the trick, suddenly new and â€œmore appropriateâ€ valuation metrics are discovered.
Other investors donâ€™t even try to justify the valuation â€“ the stock did well for me in the past, why would it stop working in the future? Faith has taken over the stock. Fundamentals became a casualty of â€œstock religion.â€ These stocks are widely held. The common perception is that they are not risky. The general public loves these companies because they can relate to the companiesâ€™ brands. A dying husband would tell his wife, â€œNever sell _______ (fill in the blank with the company name).â€ Whenever a problem surfaces at a â€œreligion stock,â€ it is brushed away with the comment that â€œitâ€™s not like the company is going to go out of business.â€ True, a â€œreligion stockâ€ company is a solid leader in almost every market segment where it competes and the companyâ€™s products carry a strong brand name. However, one should always remember to distinguish between good companies and good stocks.
Coca-Cola is a classic example of a â€œreligion stock.â€ There are very few companies that have delivered such consistent performance for so long and have such a strong international brand name as Coca-Cola. It is hard not to admire the company. But admiration of Coca-Cola achieved an unbelievable level in the late nineties. In the ten years leading up to 1999, Coca-Cola grew earnings at 14.5% a year, very impressive for a 103-year-old company. It had very little debt, great cash flow and a top-tier management. This admiration came at a steep price: Coca-Cola commanded a P/E of 47.5. That P/E was 2.7 times the market P/E. Even after T-bills could no longer justify Cokeâ€™s valuation, analysts started to price â€œhiddenâ€ assets â€“ Cokeâ€™s worldwide brand. No money manager ever got fired for owning Coca-Cola.
The company may not have had a lot of business risk. But in 1999, the high valuation was pricing in expectations that were impossible for any mature company to meet. â€œThe future ain’t what it used to be” â€“ Yogi Berra never lets us down. Success over a prolonged period of time brings a problem to any company â€“ the law of large numbers. Enormous domestic and international market share, combined with maturity of the soft drink market, has made it very difficult for Coca-Cola to grow earnings and sales at rates comparable to the pre-1999 years. In the past five years, earnings and sales have grown 2.5% and 1.5% respectively. After Roberto C. Goizuetaâ€™s death, Coke struggled to find a good replacement — which it acutely needed.
Old age and arthritis eventually catch up with â€œreligion stocks.â€ No company can grow at a fast pace forever. Growth in earnings and sales eventually decelerates. That leads to a gradual deflation of the â€œreligionâ€ premium. For Coke, the descent from its â€œreligiousâ€ status resulted in a drop of nearly 20% in the share price â€“ versus an increase of 65% in the broad market over the same time. And at current prices, the stock still is not cheap by any means. It trades at 25 times December 2004 earnings, despite expectations for sales growth in the mid single digits and EPS growth in the low double digits. It takes a while for the religion premium to be totally deflated because faith is a very strong emotion. A lot of frustration with sub-par performance has to come to the surface.
Disappointment chips away at faith one day at a time. â€œReligionâ€ stocks are not safe stocks. The leap of faith and perception of safety come at a large cost: the hidden risk of reduction in the â€œreligion premium.â€ The risk is hidden because it never showed itself in the past. â€œReligionâ€ stocks by definition have had an incredibly consistent track record. Risk was rarely observed. However, this hidden risk is unique because it is not a question of if it will show up but a question of when. It is very hard to predict how far the premium will inflate before it deflates â€“ but it will deflate eventually. When it does, the damage to the portfolio can be huge.
Religion stocks generally have a disproportionate weight in portfolios because they are never sold — exposing the trying-to-be-cautious investor to even greater risks. Coca-Cola is not alone in this exclusive club. General Electric, Gillette, Berkshire Hathaway are all proud members of the â€œreligion stockâ€ club as well. Past members would include: Polaroid â€“ bankrupt; Eastman Kodak — in a major restructuring; AT&T â€“ struggling to keep its head above water. That stock is down from over $80 in 1999 to $18 today.
Emotions have no place in investing. Faith, love, hate, and disgust should be left for other aspects of our life. More often than not, emotions guide us to do the opposite of what we need to do to be successful. Investors need to be agnostic towards â€œreligion stocks.â€ The comfort and false sense of certainty that those stocks bring to the portfolio come at a huge cost: prolonged underperformance.