Folly of the Righteous (Part 1)

 | Mar 06, 2014 | 6:59 AM EST  | Comments
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You can't be righteous in this business. You can't be intolerant. It will cost you money. You can't be doctrinaire. It will ultimately cause you to underperform. You can't be oblivious, unless you are so darned rich it doesn't matter.

Yet, I see some sort of righteousness or intolerance every single day in the stock battlefield and I think it's becoming the fog of war that's causing people to accuse this bull market of bogus bona fides on pretty much a daily basis.

So, in the interest of opening people's minds that are already made up and, more importantly, showing you the biases that are masked by righteous indignation, let me spell out what's driving the enmity to a lot of these moves that we are seeing today and why the moves can continue, regardless of these largely intellectual parlor-game challenges.

First, you have to accept the notion that there is no one way for a stock to go from 10 to 20, or 100 to 200, or 300 to 500 for that matter. There are multiple ways stocks move up and that, to some degree, is at the heart of the religious-like intolerance you are seeing and hearing every day. I think people are comparing what they think is the only way a stock should go higher to what really is nothing more than a normative way that stocks HAVE gone higher.

What's the normative way? Pretty simple. Let's take Disney (DIS). Everyone knows Disney, so it's not hard to understand.

The righteously indignant want Disney to be valued on earnings growth, dividends and how those earnings and dividends will vary over time. In fact, they are often intolerant of any other prism to value stocks.

Disney, under Bob Iger -- a bankable 21 CEO from "Get Rich Carefully," -- has taken this company from a wayward, episodically successful enterprise to one with a consistent earnings stream stemming from the expansion of the un-DVR-able ESPN, the multiplication and enlarging of theme parks and a reliable slate of movies. So, a company that was a bit of a hit or a miss has now become a regular outperformer because of actions taken by Iger, including the purchase of Pixar, Marvel and now Star Wars, which provide for reliable sequels to bolster every quarter.

For that consistency and the regularity of earnings, pretty much regardless of worldwide strength- -- it is a global company -- the stock of Disney gets a premium to the average stock in the S&P 500. That makes sense to everyone, dogmatists and otherwise. Plus, if you get any event out of the ordinary that is positive, you will see a growth spurt coming from the higher earnings that the event may precipitate. So if you see, for example, a new franchise like Frozen develop, you are actually able to estimate that it could raise numbers now and in the out years as the franchise is developed through merchandise, television, the stage and ultimately theme parks.

But now we are going to get our first bout of indignation. If Disney's stock goes up too much without a concomitant increase in earnings estimates, then the purists would say that Disney's going up because of multiple expansion, aka the Greater Fool Theory. That's right, the sticklers would say, "Hey, I am perfectly happy to pay a premium price-to-earnings multiple to the average stock for Disney because it is an above-average company with superior management. But listen clearly. Do not ask me to pay a higher premium for those future earnings as the earnings go up. Or in dollars and cents, if the average stock is trading at 17x earnings and we have historically awarded Disney a premium multiple of 20x over time, three multiple points above average, don't start saying we are now going to pay 21x or 22x or 23x those earnings and think you can get away with it."

Yes, there's anger even about the notion of multiple expansion because the hide-bounders say that's not the way it works. The multiple has to stay the same on rising earnings or all you are doing is paying up and up for those same earnings. Why is this so sinful? The usual justification is something like what our mothers told us: if you have too good a time, someone is going to get hurt.

Me? If an institution is changed and changed for the better and it is becoming even more profitable than I thought, I totally condone paying a higher price-to-earnings multiple. I do it because it's my job to spot when companies have gotten better and aren't the same old companies and because I put a super-premium on superb management that executes in all environments and that's what Iger has done with Disney.

The indignant ones get downright angry when actual professionals continue to pay up and up for a company like a Chipotle (CMG) or Monster Beverage (MSNT) or Michael Kors (KORS). They think no company deserves too much of a premium to the average company, particularly when you are paying well in excess for what might be the hope of an acceleration in earnings, even though when you get it, as was the case with these three, they grudgingly accept that the stock deserved (past tense) to go higher.

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