Costco, Walmart, & Market Inefficiency

Blessed is the man who endures temptation; for when he has been approved, he will receive the crown of life which the Lord has promised to those who love Him.

James 1:12

This verse can easily be misinterpreted. It says blessed is the man who endures temptation. What does it mean to endure temptation? It doesn’t mean that once I follow God that temptation goes away, and it certainly doesn’t mean that I’ve reached some level of perfection, or anywhere even close. What it means is that I’ve realized that my nature is completely sinful and the only way that I can endure temptation is by accepting Jesus Christ and relying on His power through the Holy Spirit.  

My emotions are an important indicator of when I am most susceptible to temptation. The simple saying, ‘be fearful when others are greedy, and greedy when others are fearful’ only attempts to counter emotion with the opposite emotion. This response tends to lead to short-term actions and while it sounds good, it doesn’t really foster an objective stance in line with conviction. Conviction can only be derived from set principles that afford an investor a method based on philosophy, that has been organized into goals, objectives, and management strategies. If done so correctly, emotions and temptation can be endured and not relied upon as a driver towards execution and actions.

Key Takeaways

• COST and WMT are at risk of overvaluation and multiple contraction.

• TGT serves as a good example of how this may play out over the near-term.

• Both companies deserve a premium versus TGT, notably as they have outperformed on a relative basis across key metrics.

• The issue for retail investors to consider is the degree of the premium, which stands well-above historical performance.

• Slowing revenue growth is on the horizon and market inefficiencies are not likely to persist over the longer term.

Introduction

Conviction works in multiple ways. On the one hand, I need to remain convicted in the investment thesis I have derived for the positions I am going to hold for the long term. As an aggressive growth investor, this can be very challenging because I am looking for newer companies that will lead markets through innovation for the future.

But conviction is also important when there are companies that are overvalued, and the best stance is to avoid them until the market’s inefficiency is corrected. It is to this latter point that retail investors need to pay close attention to Costco Wholesale Corporation (COST) and Walmart, Inc. (WMT).

First, there are many who will fall victim to simply believing that COST and WMT are not overvalued and that anyone who claims so is wrong. That’s fine but making statements without any thesis is meaningless. My thesis for COST and WMT is that the pandemic and more recently inflation has masked their performance, and multiple expansion has been the primary driver for their investment returns.

Depending on multiple expansion as a core driver for stock price appreciation is extremely risky. This is especially the case for companies like COST and WMT because the tides that have gotten investors and the market to push valuation to the current degree can quickly change and revert towards lower levels. A great example of this is Target Corporation (TGT), and I view COST and WMT at risk to follow a similar pattern, as the formerly mentioned masked events have clouded investors’ perceptions.

TGT is a poster for implications from the pandemic. The company witnessed a massive jump in operating cash flow per share peaking during the 2023 fiscal year, only to see this trading multiple decline back towards pre-pandemic levels. While 2023’s performance was partially due to an extreme drop in cash flow results, today’s reversion is still well below average 2021-2024 levels.

TGT saw substantial revenue growth during its fiscal year 2021 and 2022 years. This was a key driver for TGT generating stronger cash flow, but that coattail was quickly eliminated during the past few fiscal years. This is important for retail investors because both COST and WMT are at risk of seeing slowing revenue growth, which as time goes by, will trigger a return to a much more modest premium multiple valuation.

Peer Review

Over the past 10 years (this focus accounts for multiple fiscal years), we can clearly see how much greater both COST and WMT premium cash flow multiples have grown versus TGT. Both COST and WMT operate on a fiscal year that typically ends in January, while COST ends in August. Based on this, Year6 reflects the first year of the pandemic. On an annual basis, COST has traded as high as 35 times OCF (and even over 40 times on a daily average), and WMT has traded over 20 times. TGT did briefly hit 20 times a few years ago, but this has been erased, while both COST and WMT OCF multiples have remained near all-time highs.

Revenue performance has been interesting to say the least. Both TGT and COST witnessed substantial increases in revenue during the pandemic whereas WMT benefited more strongly and consistently during the inflationary period that has still impacted consumers today. TGT has also witnessed two consecutive years of negative revenue growth, while both COST and WMT have continued to see growth near the mid-single digits.

The revenue picture is mixed as TGT has seen slowing transactions and the average ticket which has turned negative. At the same time, e-commerce performance for TGT has been mostly flat in the past four fiscal years. WMT has witnessed exponentially higher transaction growth, and positive average ticket while e-commerce has remained north of 20 percent. COST has similarly witnessed strong transactions and average ticket results, while e-commerce growth has remained in the high teens.

Interestingly, TGT has been the stronger cash flow generator among the three companies with OCF consistently being the highest. WMT has witnessed flat margin performance while COST has seen an increase in results over the past decade. TGT’s flattish performance mirrored WMT mostly from a performance standpoint.

Final Thoughts

To be clear, there is little debate to contest COST and WMT justifiably having a premium above TGT. That’s not the issue at hand. The problem lies directly in how far the market has pushed this premium. Should a company like COST be trading at a level that may end up converging with a company like NVIDIA Corporation (NVDA)? The bull may say yes because it’s not about comparing COST and NVDA, but rather how valuable COST has become from a necessity and/or resiliency perspective. The same logic applies to WMT in comparison to Big-Tech valuations.

Essentially one could claim that every top tier company in every sector and every industry could trade 40 times cash flow. But the reality is that the stock market is inefficient. It cannot without emotional extremes objectively determine stock prices. This inefficiency works in a retail investors’ best interests as patient and savvy investors can exploit these inefficiencies. The challenge is having visibility on where the next shift is likely to occur and exercising a prudent approach of discipline towards this.