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  • Writer's pictureEric Cinnamond

The Blue and Yellow Can

<February 21, 2024>



Last week my son and I went for a bike ride. Before departing, I noticed the chain on my bike was a little rusty, so I sprayed it with WD-40. My instinctive response can be traced back to my childhood and growing up in a WD-40 family. We put it on everything. In addition to our bikes, we sprayed it on window tracks, saws, locks, nuts and bolts, lawnmowers, and anything else that squeaked, rusted, or was stuck. If it was edible, we’d probably have put it on our pancakes!


When I became a small cap analyst in 1996, I was thrilled to learn WD-40 (symbol: WDFC) was a publicly traded company. In fact, it was one of the first stocks I followed and recommended. WD-40 is a classic high-quality small cap that possesses many of the attributes we seek. It’s a mature market leader with a strong brand, consistent revenues, and attractive returns on capital. The business generates abundant free cash flow and has historically maintained a strong balance sheet. Management hasn’t diluted its core business, and for the most part, has allocated capital effectively. Most importantly, it’s a highly profitable business that can be valued with a high degree of confidence. 


During the first fifteen years of my career, WD-40’s stock consistently traded between 15-20x earnings, or a reasonable 5-7% earnings yield. While its valuation was slightly higher than many of the small caps I followed at the time, given its strong brand and dependable results, I felt its modest premium was justified. During the next fifteen years of my career, WD-40’s valuation soared to levels I never considered possible. The company’s price to earnings ratio (P/E) expanded from its historically stable 15-20x range to 50x, or a meager 2% earnings yield! As much as we continue to like the business, we cannot justify its current valuation. 



What caused WD-40’s valuation to reach such heights? While there have been some tweaks to the company over the years, the business and its economics haven’t changed meaningfully. For example, profit margins and growth rates have remained near long-term averages.





Assuming fundamentals are not responsible for the rise in WD-40’s valuation, what are other potential catalysts? Like many of the stocks in our opportunity set, valuation anomalies began to appear shortly after the Federal Reserve began its experiment in quantitative easing (QE). As the Fed’s balance sheet grew, so did small cap valuations. While it’s impossible to know how much of the Fed’s money creation found its way into small cap stocks, WD-40’s valuation turned higher shortly after QE was implemented and has been correlated to the Fed’s balance sheet ever since.    




Another highly correlated variable that may have contributed to the rise in WD-40’s valuation is the growth of passive investing. The two largest holders of WD-40’s stock are Blackrock (iShares) and Vanguard, owning 25% of its shares combined. As price-insensitive index funds have gobbled up shares, WD-40’s valuation has risen along with passive fund assets under management (AUM). The largest fund holder is the Vanguard Total Stock Market Fund. As inflows have been put to work, we suspect passive managers haven’t been overly concerned about WD-40’s valuation!  



A third possible contributor to WD-40’s multiple expansion is the growing popularity of high-quality stocks. The Wall Street Journal article “Portfolio Managers Target Quality” explains why investors have been piling into quality, saying, “high-quality companies tend to do better than others when growth slows.” Further, the article states, “seeking quality provides a way to stay invested while potentially cushioning against some of the blow if markets turn.” In effect, for investors concerned about a slowing economy and an expensive stock market, investing in quality is a risk-averse solution that allows them to remain invested.


In our opinion, years of quantitative easing, growth in passive funds, and the herding into high-quality businesses have all contributed to the increase in valuations of high-quality stocks, such as WD-40. While these trends may continue in the near term, we believe they are all unsustainable.


As it relates to quantitative easing, future rounds will likely confront increased scrutiny considering how much purchasing power was destroyed after the Fed’s “transitory” blunder and its last round of money printing. Moreover, increasingly divisive trends in wealth inequality and housing affordability have elevated the social and political risks associated with quantitative easing. Put simply, whether it’s the cost of living or asset prices, inflation is becoming an increasingly unpopular “solution.”



We believe the influence passive funds are having on valuations will also fade. While flows into passive strategies may continue, a large percentage of assets have already made the transition. Passive equity funds currently represent most equity fund assets. And this doesn’t even include index-hugging funds that claim to be actively managed! In effect, with the pool of active manager assets drying up, there is less capital remaining to funnel to passive managers and their price-insensitive bids.



Finally, as it relates to high-quality stocks, history is littered with Nifty Fifty-like love affairs. Ultimately, these flings end in disappointment as unrealistic expectations clash with reality. We believe today’s market is no different. In fact, the current market reminds us of the late 1990’s when investors were also crowding into tech and high-quality stocks. Stocks such as Coca-Cola (KO) were in high demand as investors looked for ways to participate in the rising equity market while minimizing risk. As investors crowded into Coca-Cola’s stock to reduce risk, its valuation soared along with the risk of overpaying. The flight into quality eventually resulted in losses, as Coca-Cola’s stock declined over 50% from its cycle peak in 1998 to its trough in 2003, reminding us that good businesses don’t always make good investments.




The blue and yellow can symbolizes the dilemma many absolute return investors are currently facing. Should they pay current prices for high-quality stocks they know well and want to own? We admit, riding the quality wave in comfort sure is tempting! Who doesn’t want to own high-quality stocks that are consistently rising? Unfortunately, based on valuations, we’re unable to participate. As investors crowd into high-quality stocks to reduce risk, we believe quality is currently one of the most expensive and riskiest sectors of the market. As much as we want to own good businesses, we are avoiding many of our favorite companies, including WD-40. As portfolio managers, it’s very hard not owning what you want to own. But as absolute return investors that are attempting to generate attractive full-cycle returns, it’s even harder knowingly overpaying and risking meaningful losses to capital. 


Eric Cinnamond

 


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Definitions:

Price-to-earnings (P/E): a valuation ratio measure that compares a company's share price relative to its earnings per share (EPS). The P/E ratio helps assess the relative value of a company's stock.

Earnings Yield: the inverse of the P/E ratio used to determine the how much earnings an investor will receive for each dollar invested in its shares.

Earnings Per Share: Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its common stock.

Wilshire 5000: a market-capitalization-weighted index of the market value of all American stocks actively traded in the United States.

S&P 500: a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.

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