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  1. Home
  2. / Investing
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Jim Cramer: Costco's Downgrade Can Be Both Logical AND an Opportunity to Buy

I could list dozens of opportunities to buy high-quality stocks that are expensive. In each case it's easy to say what the Bernstein analyst said about Costco.
By JIM CRAMER
Sep 19, 2019 | 04:34 PM EDT
Stocks quotes in this article: COST, MSFT, WEN, X

The good ones are never cheap. They rarely come in and when they do, you tend to have to take action.

The great news? The breaks do occur. The bad news: when you get one you are deathly afraid to do some buying.

Case in point: Costco (COST) . I think the world of Costco. I am a proud Costco member, gold star, my wife Lisa, is an executive member. Every time I go there I am blown away at the prices. I am a two-cart guy. That's right, I have to have two carts to handle all that I buy. We're like a train when we go. We buy their house brand because it's usually better than the branded product. The place amazes. My trainer, Jim, just bought a car there. Better lease deal than anywhere else. Fish, beef, crab legs, you name it, go to Costco.

But the stock? For ages I have said it is too expensive. My charitable trust, Action Alerts PLUS, used to own it but we sold it years ago. Why? Because we had made a lot of money in it. Bulls make money, bears make money, hogs get slaughtered.

We never got back in. And it never seems to go down.

Today, though, it got hammered. The first real break in ages.

Opportunity?

I would presume so. And then I read why it's been obliterated: A downgrade, a hold to sell piece of research by Bernstein that read so negatively that it would talk anyone out of taking advantage of the dip.

Consider the negatives. First, new competitive pressures as they near peak club counts, members per club and revenue per member. Second, a possible downturn catalyst, although that's not really spelled out. Third, potential stiff competition and fourth, an expansion into China that may not go as well as people think. Or as the piece is headed: "COST: rational exuberance? Downgrading to underperform on valuation, US saturation, competition and a slow boat to China."

The logic's all backed up by charts and graphs showing how Costco is overvalued versus how it has historically traded. While people may think it performs consistently and is therefore worth a higher price-to-earnings multiple than its competitor, "measuring COST on earnings per share stability/growth and growth of related fundamentals, dividend stability/growth, Free Cash Flow generation and variability in returns," the report says, "still shows the stock significantly overvalued over the past couple of years. As a result," the sell recommendation goes on,"we see COST now being overvalued by pretty much every measure."

Wow.

That's terrible. And while the analyst freely admits he missed the big move in the stock by having a hold on it, I felt his logic very compelling.

There's only one problem: Costco is a best-of-breed retailer that has reinvented and reinvented and maybe that's exactly what's happening again. As a close follower of the chain, I remember when it first didn't embrace natural and organic food. Then management realized it had to and it went all in. I think they have the best selection in the world now. Then I can recall that it didn't really embrace the web. I thought it had contempt for digitization and somehow didn't think it would lose business to others. When they realized that they were, they pivoted and became one of the best web operators.

The company's been judicious in raising club prices, but I bet that price increases wouldn't deter people from re-upping. Oh and as far as China's concerned? The company just opened a store in Shanghai and it was so swamped there was little room to push a cart. As Money magazine said: "China's first ever Costco just had to close early because of massive crowds and rotisserie chicken fights."

Hmm, that doesn't sound like saturation to me.

So what do you do? I think you have to accept that Costco's stock is not going to get "cheap" per se. I think that this downgrade could be spot on for the moment. Costco's stock is up 40% this year. It's been on a total roll. It deserves the selloff on this well-reasoned piece. I would give it a day or two more to be sure all of the sellers are shaken out. But I have no doubt that what seems like an expensive stock now will turn out to be cheap later and you have to trust management and ultimately do some buying.

But what about that valuation argument? Isn't it more cogent than how great the company may be? I think its transient. Consider the case of Microsoft (MSFT) . It's been years and years since I last saw Microsoft trade at 27 times earnings. There were plenty of reasons to sell it, not the least of which is the nosebleed level versus its growth rate.

However, if you sold it because of that, you missed out on a gigantic boost in the dividend today and the announcement of a $40 billion buyback. So now it's at 29 times earnings.

Or how about Wendy's (WEN) ? I love going to Wendy's. My wife adores the Baconator. I mean it's her favorite treat. If she's been really good she has a double Baconator. I think Todd Penegor, the CEO, is terrific. Last night I got a call from a terrific viewer who owns a lot of stock and is worried that the stock recently got hit.

What was Wendy's crime? It's decided to expand into breakfast, hiring 20,000 people to do so and it has to take a hit to this year's earnings. Good grief. What an opportunity.

Look, I could list dozens of opportunities to buy high-quality stocks that are expensive. In each case it's easy to say what the Bernstein analyst said about Costco.

But what's the real alternative? It tends to be buying stocks that are cheap but are cheap for reasons that aren't going to change.

The cheapest stocks in the market? The autos. Let me ask you, though, do you want to buy stock in a company that's facing strikes near term and existential threats like ride sharing, electrification and longer term, a president who wants to roll back fuel standards which would pressure the industry to make two kinds of cars, as well as ridesharing as a secular theme?

Next cheapest: the bricks-and-mortar stores that don't have a good omnichannel business and aren't off priced. You can buy them all day and make nothing.

How about the steel stocks, protected by tariffs? They just keep getting hit with U.S. Steel's (X) stock looking like it might be down for the count.

The oils? Are you kidding me? They are the new coal.

So, I think the takeaway here is the downgrade on valuation theory is logical, pertinent, and powerful, but if the company is a best of breed, you have to hold your nose and buy.

Get an email alert each time I write an article for Real Money. Click the "+Follow" next to my byline to this article.

Action Alerts PLUS, which Cramer manages as a charitable trust, is long MSFT.

TAGS: Fundamental Analysis | Investing | Stocks | Trading | Analyst Actions | U.S. Equity |

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