OB Report
July 2020
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The Right Blend is All About Balance

Murray Leith By Murray Leith CFA, Executive Vice President & Director, Investment Research

Starbucks has been in the news as it announced store closures in Canada and the U.S. Some wonder if there is cause for concern, while others believe the recent weakness in the share price is a good buying opportunity.               

Unfortunately, the answer is nuanced and complicated, in part because there is so much uncertainty in the world and the range of economic possibilities is wider than usual.

Before digging into the details, I should declare my biases. I love my morning Pike Place, and I’m even more jazzed now that I’m able to grab a higher-octane cup from my local store, which is open again. It could be psychological, but I think the store-brew tastes better than my homemade Starbucks Keurig pods.

More so than the coffee, I have to admit to loving the company. It’s treated me very well as a shareholder. I’ve owned shares for more than a dozen years, and they have grown to be the second-largest position in my personal portfolio, next to Amazon. Starbucks is also the stock with the greatest gain relative to cost in the Odlum Brown Model Portfolio.* Selling it now would trigger capital gains taxes for many, adding another layer of complexity.

I’ve also been proud of the leadership that Starbucks has shown around the fight against COVID-19. They were one of the first businesses to react to the dangers of the virus. As they shifted to a drive-thru and delivery-only model at their 9,600 company-owned stores in the U.S. and Canada in late March, they also committed to paying employees for 30 days whether they worked or not. They ultimately closed stores around the world before such precautions were mandated by authorities.

Being responsible comes with a cost; analysts estimate that the company’s fiscal 2020 adjusted earnings per share (EPS) will drop by two-thirds to $0.97 from $2.83 last year. That’s more than three times the 18% drop in EPS Starbucks experienced in 2008 during the Great Financial Crisis.

What’s remarkable is how much better the stock has held up in the face of a much harsher hit to earnings in this current crisis.

At a recent price of around $75, the stock is down about 25% from an all-time high of $100 in July 2019, and up more than 30% from its low of $56 in March of this year when markets were at their worst. Sentiment toward the company and the stock remains generally upbeat, a stark contrast to how investors felt during the last major crisis a dozen years ago.

Indeed, we remember Starbucks being the most hated stock at the firm in 2008/09. Equity Analyst Stephen Boland showcased the nerve-racking experience at our Annual Address event two years ago.

In 2007, we recommended Starbucks after it had fallen to $13 from a peak of $20 in 2006. With the 35% decline in the share price, the price-to-earnings valuation multiple was near its lowest level ever – half of its peak of 45 times EPS in late 2006. We thought we were getting a bargain. But then the banking crisis happened, and the stock dropped to a low of $3.50 in the months following the bankruptcy of Lehman Brothers. At that level, the stock was down more than 80% from its peak and priced at less than 10 times expected 2009 EPS.

Today, Starbucks is priced at close to 30 times expected fiscal 2021 EPS – three times its trough valuation multiple in 2008 – and that’s assuming the company’s fiscal 2021 EPS recover to more than 90% of their pre-crisis level.

Analysts were similarly optimistic about EPS rebounding in the aftermath of the banking crisis. The positive sentiment toward Starbucks now is not unique; the valuations of other high-quality growth stocks are somewhat elevated relative to history and especially high compared to the depressed levels experienced during the Great Financial Crisis. We can think of four reasons why investor attitudes toward growth stocks like Starbucks are more constructive today than they were then:

1) Fiscal and monetary policy. The authorities’ response, worldwide, to the COVID-19 crisis has been several fold greater than the support provided in 2008/09. In the United States, in particular, the amount of fiscal and monetary funding is monumental. The U.S. federal deficit will approach $4 trillion this year, which is close to 20% of GDP. On the monetary front, the U.S. Federal Reserve committed to injecting $2.7 trillion of liquidity into markets through its fourth installment of so-called quantitative easing (QE). QE1, following the banking crisis 12 years ago, amounted to just $200 billion. When the Federal Reserve buys fixed income securities, the cash it injects into the financial system has a tremendous influence on all risk assets, including stocks.

2) Valuation. Growth stocks were out-of-fashion during the last cycle, as valuation multiples were still contracting from the sky-high levels experienced in the late 1990s. In other words, the valuation pendulum was in the process of swinging from an overvalued extreme to an undervalued extreme. Growth stock valuations bottomed in the aftermath of that crisis and have been rising ever since, contributing to significant outperformance of stocks like Starbucks. With valuations still reasonable relative to fundamentals, it is quite possible they will swing higher. Not only are growth company fundamentals relatively strong compared to value-type businesses, it is also human nature to keep doing what is working.

3) Adaptability. We have long believed that the best will get better in a slow-growth world, and that argument seems stronger than ever given the economic hurdles ahead. Starbucks is better equipped than most to leverage technology and evolve its business model. Starbucks’ plan to close up to 200 stores in Canada and as many as 400 in the U.S. over the next 18 months merely accelerates the company’s pre-COVID strategy of opening locations with better pick-up and drive-thru capability. Before the virus landed in America, 80% of U.S. transactions were considered “on the go.” The availability of great locations, at better prices, may also increase as weaker businesses fail.

4) Learning to hold for the long term. Perhaps the valuation of Starbucks is higher today because history has taught investors the benefits of holding great companies for the long term. An unlucky investor who bought the stock near its 2006 peak of $20, and held on through the subsequent 80% peak-to-trough plunge, has earned a near-fourfold total return over the last 14 years, or 12% compounded annually! Investors were clearly wrong to be pessimistic back then.

Still, we’ve highlighted the difference in attitudes toward growth stocks then and now so that investors appreciate the possible downside risks. There is no guarantee that investor sentiment toward Starbucks and other great companies won’t sour, even if only temporarily.

We don’t know how long COVID-19 will be with us or how changes in consumer habits will affect Starbucks and other companies. Governments and central banks have been extremely successful in keeping the global economy on life support thus far, but the next phase of reopening will be more challenging. Figuring out how to get individuals and companies off government aid and back to business is a complicated yet critical endeavour. In a divided world, governments may struggle to do the job well.

It’s potentially going to be a long and bumpy recovery, and therefore we continue to stress the importance of quality and diversification. While the odds remain very good that great businesses like Starbucks will produce satisfying long-term rewards, it’s a good idea to balance portfolio holdings of popular growth businesses with less popular yet solid firms, fixed income and even some gold.

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*The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.

Odlum Brown Limited is an independent, full-service investment firm focused on providing professional investment advice and objective research. We respect your right to be informed of relationships with the issuers or strategies referred to in this report which might reasonably be expected to indicate potential conflicts of interest with respect to the securities or any investment strategies discussed or recommended in this report. We do not act as a market maker in any securities and do not provide investment banking or advisory services to, or hold positions in, the issuers covered by our research. Analysts and their associates may, from time to time, hold securities of issuers discussed or recommended in this report because they personally have the conviction to follow their own research, but we have implemented internal policies that impose restrictions on when and how an Analyst may buy or sell securities they cover and any such interest will be disclosed in our report in accordance with regulatory policy. Our Analysts receive no direct compensation based on revenue from investment banking services. We describe our research policies in greater detail, including a description of our rating system and how we disseminate our research here.

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