The Difference Between a Great Company and a Great Stock

By CFO Story Club.

Overview

In mid-1998, Coca-Cola‟s stock price (KO) traded at a high of about $88 per share. Almost eight years later, Coca-Cola‟s stock price stood at half that mark at $44. Could Coca-Cola have lost its incredible competitive advantages?

Around the same time, an incredible stock price run was taking shape. A major discount retailer watched as its stock price soared more than tenfold from 1996 to 2000. It wasn‟t Wal-Mart, Best Buy, or some other popular store. It was AMES Department Store, which was bankrupt by 2002.

On the contrary, Coca-Cola continues to generate adjusted return on assets (ROA‟) at some of the highest levels. The flagship cola product is still regularly heralded as the world‟s top brand. Its venerable product distribution system may be called nearly unparalleled. As you read this, you are most likely less than 50 feet away from a place to purchase a Coke or one of its other products. So, what‟s the problem with KO?

The Difference Between a Great Company and a Great Stock

How do we decipher the problem of business profitability levels and stock returns seeming so greatly out of sync?

Coca-Cola was a victim of its own great prior performance. At exactly midyear 1998, Coca-Cola was trading at a record high of $88 per share, having achieved a record 40% adjusted return on assets (ROA‟). But at that share price, what did the market expect Coca-Cola to continue to do? In other words, what levels of performance would KO need to achieve to create the cash flows necessary to maintain its all-time stock price high?

KO‟s stock price at the time reflected cash flow return levels that would essentially never, ever fall. It also embedded significant organic growth of more than twice U.S. GDP levels for decades.

The problem was not that KO had not achieved incredible performance. The problem was a question as to whether that performance was sustainable. Even if sustainable, where was the upside in owning the stock with that level of expectation already built into the price? There was really nowhere to go but down.

Eight years later we see the result of that unrealistic exuberance with a stock trading at half the price. This occurred not because the company isn‟t a great one, but because the stock‟s valuation simply wasn‟t justifiable.

Great stock prices and great companies can accompany each other, but one needs to examine sufficiently long time periods. Over 20 years, KO is still outperforming the market by two or three times. That time period is marked with periods of unrealistic expectations; so, we see the stock price falling for eight years. Ames Department Stores (Delisted as AMES Years Ago)

Around the same time that Coca-Cola‟s stock price hit its spectacular highs, a different, yet incredible stock price run was taking shape. A major discount retailer watched as its stock price soared from 1996 to 2000. Through that period, its shares rose more than tenfold, and investors and management seemed as happy as can be.

The retailer in question was not Wal-Mart, Costco, Best Buy, or any of the like. The firm was Ames Department Stores. Unfortunately, the epilogue is described too sadly by a string of empty buildings and emptier parking lots. By 2001, the firm was already seeking bankruptcy protection. How could company performance and company stock price send such different messages?

At AMES, investor forecasts simply exceeded reality. The original march upward from lows of $2 in 1996 to $30 and higher was not because the company was incredibly profitable. During the five-year period, AMES cash flow returns never once exceeded its cost of capital.

At $2, the stock was priced, for the most part, with the expectation that the firm would go into bankruptcy. However, AMES began avidly restructuring, divesting its least-performing assets. When a firm expected to go bankrupt doesn‟t go bankrupt, its stock price rises—sometimes by leaps and bounds.

At the time, you had to scratch your head as an investor, watching a retailer divest assets, close stores, yet demonstrate stock returns that were better than those of Wal-Mart. But stock prices are what they are. As expectations go from low to high, the stock price goes up. Or in this case, as expectations went from “abysmal” to “potential survival”, the stock price ran from $2 to over $40 per share.

The closure on this case is interesting because it shows management‟s folly in not understanding the real drivers of stock price. Somehow, the company saw a signal to grow its business and shifted its strategy to acquisitions and store openings in 1998 and 1999. The management team had previously shown discipline in shutting down problematic stores. By this time, it showed the folly of growing a business model that had not yet proven economically profitable. At no time did AMES cash flow returns appear to exceed even lower bars of opportunity costs.

By 2000, that folly had run its course. Growing a bad business is always a bad thing, no matter how well the stock price is doing. AMES death came relatively quickly, as the share price fell fast and the chain finally closed for good in late 2002.

The Expectations Conundrum

With valuation levels based on expectations and not actual performance, there are troubling issues for investors and other decision-makers.

As a fundamentally-based investor in 1998, would you short a stock that had risen for over ten straight years? The market had priced in exuberant expectations; however, if expectations had reached that high level, maybe they could still go to ridiculously exuberant levels before the bottom fell out, so to speak. The entire Internet bubble was a case study in this kind of market behavior.

As a board member, how do you align management‟s interests with those of shareholders, when options and stock shares priced at such levels can only serve as reverse motivators? As a company manager, how do you have the faith to know whether or not you are „doing the right things‟, when the stock begins to fall precipitously despite profitability levels that remain the envy of the entire market? Cash Flows Reveal the Truth

Many examples exist of companies that are often thought to be great companies simply because they are great stocks, and vice versa. IBM and Federal Express stand out as two companies that continually receive high marks in the financial press such as “most admired” status. A simple look at the firm‟s cash flows, however, tells the tale: great turnarounds, not necessarily great companies.

Stock price alone can never reveal anything but changing expectations in a company‟s performance levels; nothing about the quality of the performance itself.

Sharp investors live by what many novice investors fail to understand: that great companies can be terrible investments and vice versa. Therefore, great investments are made by better understanding the fundamentals behind the expectations. Those fundamentals need to be linked to long-term cash flow expectations, and only long-term forecasted cash flow analysis can explain the story that is built into any stock price.

The goal of corporate management remains the maximization of shareholder wealth, but that doesn‟t guarantee premium shareholder returns. The market‟s cash flow expectations set the bar that determines the company‟s future stock price returns, regardless of the caliber of the management team. In the end, knowing the difference between a great company and a great stock is what differentiates great managers and investors from poor ones.