Graco Part 3

Sold out my position in Graco at 85.65 two days ago. I first bought it at 66.98 in July 2015. That’s 30% return in 19 months in USD, including dividends. After adjusting for exchange rate gain, thanks to stronger USD, the net return is around 33% in SGD. During this 19 months, I also bought additional shares at 72.37 in July 2016 and sold out those shares at 81.4 in November (see this earlier post).

Reason for Selling

The reason I sold out now is the same reason why I sold partially in November. I thought Graco was fully valued to slightly overvalued at 81.4 in November. Now at 85.65, I think it’s even more overvalued in my opinion. US market turned bullish after Trump’s win, and valuation multiple expands.

For 2017, Graco is likely to grow its earnings by mid single-digit rate, which is lower than the growth rate during 2011-2016 period. But, it is trading at 24.5x P/E now, which is higher than the multiples during 2011-2016. So, we have got lower growth and higher valuation multiple. Is that appealing to you?

Valuation Multiple - 2017-01-13.PNG

Source: morningstar.com

Upside vs Downside 

Graco should be earning EPS of around 3.4 for FY16. It’s expected to earn around 3.5-3.6 in FY17. Assuming EPS of 3.6 as base case, at current price of 85.65, its P/E is 23.8x, which is still higher than the average during 2011-2016. If the P/E expands to 25x, then the price could reach 90, which is just 5% higher than the current 85.65. So, we are looking at 5% upside for base case.

For bull case, the earnings could rise to 3.8 this year. That could generate around 11% return, which will be satisfactory.

What about bad case? It can be anything, really. Last year, we already saw the share price falling by 9% in one day. S&P 500 is reaching even higher valuation multiple now. Just a minor correction of 10% can bring down the whole level, and it’s still higher than the historical average valuation multiple!

Market Efficiency

For big cap like Graco, it’s followed by many analysts and fund managers, and we should expect the price to be quite efficient. Why is the market willing to pay 24x P/E for 5% growth in earnings?

One way to explain is that Graco is a good quality company with competitive advantage. It has stable earnings history and is expected to continue so. It’s perceived as safe and low risk, so, in terms of valuation, we can use a low discount rate. When the discount rate is very low, the valuation is very high.

Another explanation is that market actually believes that Graco can achieve higher earnings growth this year, so it has priced it in forward. That means the 5% earnings growth estimate for FY17 is wrong.

These explanations assume the market is efficient. If it is indeed efficient, then you are not expected to earn above average market return. Do you think Graco is priced efficiently at the moment?

My Strategy

My strategy in buying Graco for now is to wait for bad news and buy on dips. I hope it reports disappointing quarterly earnings, and the market sells off like it did last year. In that case, you’ll be able to buy at lower price, and wait for it to get back to normal level to sell for above average return.

From 2014 to 2016, there are at least two dips every year. Hope it happens again this year.

Graco - Share price dips - 2017-01-13.PNG

Source: Google Finance

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