For years, Warren Buffett's investment in Wal-Mart (WMT) looked like a blunder. The legendary investor and chief executive of Berkshire Hathaway (BRKA) bought almost 20 million shares in the world's largest retailer in 2005 and spent three years watching that $944 million investment go almost nowhere.
Now, Buffett's patience is paying off. Wal-Mart's stock recently hit a four-year high, providing Buffett a 22% return.
But how much further can Wal-Mart shares keep rising? While the stock looked like a bargain to value investors like Buffett in recent years, it's starting to look a lot more pricey lately.
Testing Value Investors
Compared with the broader stock market, Wal-Mart's stock performance has been tremendous. While the Standard & Poor's 500-stock index has tumbled almost 9% so far this year, Wal-Mart shares rose 21%.
Patrick Becker Jr., a value manager at Becker Capital Management, bought Wal-Mart stock in 2006, when it was "fairly cheap," but he now says, "We don't think it's expensive, and we don't think it's cheap." Craig Hardy, manager of the Huntington Income Equity Fund (HIEFX) says the stock is "probably fairly valued."
Both those managers said they still hold Wal-Mart stock, but Chris Trompeter of Tradition Capital Management, says he sold most Wal-Mart holdings in May.
"We can like the company but not necessarily like the stock price," Trompeter says. "That's where we are right now. We needed the money for other stocks we thought were more compelling."
Investors use a variety of methods to determine the "correct" value of a stock, with the price-earnings ratio a common shorthand. With a p-e of 18 based on earnings from the past 12 months, Wal-Mart is at its highest valuation in three years, a price that is scraping against many value-oriented investors' upper limit.
(Rival Target (TGT) has a p-e of above 15. J.C. Penney (JCP) has a p-e of less than 9.)
Wal-Mart's Recipe in Tough Times
Al Meyers, portfolio manager of AMBS Investment Counsel, says he might be forced to sell his Wal-Mart stock soon according to his investment criteria. "They've got to deliver [higher] earnings or it's going to be difficult to justify owning the stock," he says.
Many on Wall Street are betting Wal-Mart will keep beating expectations. The tough economy and high gas prices have made things hard for almost everyone, including most retailers and the U.S. consumer.
But Wal-Mart has arguably succeeded because of the tough times: Others' pain is Wal-Mart's gain. Wal-Mart seems to have attracted U.S. consumers not only with its reputation for low prices, but also with its wide selection, which allows customers to save fuel by making one big shopping trip at a Wal-Mart superstore rather than several trips to other stores.
"Consumers are worried, and they're going to be looking for more ways to save money," says Lyn White, a portfolio manager at Christiana Bank & Trust. "We've only started to see the beginning of the consumer shifting away from [more upscale rivals like] Target and the Gap (GPS)," she argues.
Boosted by the Stimulus
Recent sales figures at Wal-Mart have been impressive, particularly in May when consumers began to spend federal rebate checks designed to stimulate the economy. May same-store sales, excluding gas, were up 4.4% from a year ago, nearly double the chain's most optimistic predictions.
Those, like White, who are bullish on Wal-Mart's stock believe the chain will continue to see these positive trends, particularly if gas prices remain high and the weak economy makes Americans anxious about the job market. But investors say Wal-Mart has other advantages, too.
Huntington's Hardy likes the consistency of Wal-Mart's earnings and revenue growth. In uncertain times, "Wal-Mart is one thing that you can set your watch by."
Many investors argue Wal-Mart has learned lessons from past missteps. It has slowed store growth in the U.S.—which was providing diminishing returns—and focused on growth overseas.
Clout in Keeping Prices Low
At a time when inflation is a serious threat, Wal-Mart's size gives it purchasing power, "an advantage over smaller retailers," White says. And, she adds, after failed attempts to sell to more affluent consumers—like its brief stab at selling sushi—Wal-Mart has returned to what it does best: selling basic goods at low prices.
But given the stock's strong run, there are plenty of doubters.
"It's priced for perfection right now," says Georges Yared, of Yared Investment Research . "Any minor slip-up [could] rock the stock." He says American consumers might be looking for bargains at Wal-Mart now, but that's not "sustainable long term."
Utopia Funds (UTGRX) portfolio manager Paul Sutherland says "frugality" is coming into style, which helps Wal-Mart. "But it's already in the [stock] price," which he says is "expensive."
Will Buffett Stay?
Plus, sooner or later, Wal-Mart's rivals will catch on, and start cutting prices to keep customers, Sutherland says. Competitors also have the advantage that Wal-Mart offers a "not very pleasant shopping experience," according to Sutherland.
For decades, Wal-Mart was a favorite of growth-oriented investors as the chain rapidly opened new stores. Then, value fund manager Becker says, as growth in the U.S. slowed, growth investors fled the stock, and shares stagnated. "It went through a no-man's land, where it wasn't growth and it wasn't value," Becker says.
When the stock got cheap, value investors piled in, lifting the shares. But a key question is how long Buffett and other value investors hold on to their Wal-Mart shares despite its now more expensive valuation. The danger is that results falter and this time value investors leave the stock en masse, pushing Wal-Mart shares into yet another twilight zone.
For now, though, Wal-Mart has a precious commodity: momentum. The chain's recent success makes the stock attractive to short-term buyers even if, by most value measures, the stock is no longer an obvious bargain. Value investors may choose to keep their wallets shut until the next time the stock gets a decent markdown.