Brown-Forman: A Baby Boomer Bubble Stock (NYSE:BF.B)

Introduction

Often when investing, especially if a person is using some sort of fundamental analysis, it takes time for an investment thesis based on valuation to play out. The truth is that the correlations between business fundamentals and stock prices increase the farther out in time one goes. There is very little correlation between earnings fundamentals and price over a period of 12 months, but that correlation increases as time goes on, until, after 5 to 10 years have passed, the stock price returns usually reflect a combination of earnings yield and earnings growth over that time period. My experience has been that unless there is a bad economic recession, typically, fundamentals converge with the price of a stock by about three years, and if there is a recession, usually after five years the correlation is pretty tight most of the time.

I last covered Brown-Forman (NYSE:BF.B) stock a little over three years ago in my article “Brown-Forman: A 10-Year, Full-Cycle Analysis“. Here is what I had to say:

If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years, it will produce a -4.00% CAGR. If the business/shareholder yield and growth are similar to the last cycle, the company should produce a +3.28% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of -0.72%. This is significantly below the 4% threshold I use for a “Sell” rating, and also negative, so Brown-Forman is currently a “Strong Sell” for me.

It’s pretty rare for me to issue “Strong Sell” ratings for quality businesses, but I did in the case of Brown-Forman. Here is how the stock has performed relative to the S&P 500 (SPY) since the article was published.

In a little over three years’ time, BF.B has had a total return of +7.44% compared to SPY’s +34.21%. That is a CAGR for BF.B of about +2.41%. As we will see later in this article, the valuation of the stock actually hasn’t changed much (it was roughly a 37 P/E when I wrote about it in 2019 and a 35 P/E now according to FAST Graphs) so it has most traded on earnings the past three years rather than sentiment change. I expected earnings to produce +3.28% annual price return. Basically, that fundamental analysis was right on the money.

I’ll perform a similar analysis later on in this article to see where the valuation stands today. But first, I want to share a market-wide pattern I’m seeing that could cost many retirees a lot of money over the next 5-10 years. I have been referring to this pattern as the “Boomer Stock Bubble”.

The Boomer Stock Bubble

This stock bubble I believe has two key causes. The first cause is that, according to Pew Research, in 2010 when the first Baby Boomers turned 65 years old, retirees represented about 13% of the US population. By 2030 when the last Boomers reach age 65, 18% of the population will be above that age. (And there is some evidence that the pandemic pulled retirement forward by at least a year or two on average.) So, I estimate we are now about 75% of the way through this process of growing retirees, and the remaining Boomers who aren’t 65 or retired, yet, are approaching quickly, and therefore likely adjusting their investment allocation toward one considered more appropriate to that of a traditional retiree, than an allocation of someone in their prime working years.

Importantly, this will be a 40% increase in the number of retirees in 2030 compared to 2010, and 30% of that increase has probably already occurred. This is a dramatic increase in the number of retirees over a relatively short period of time. Additionally, Baby Boomers are the wealthiest generation in history, so they control the vast majority of money available for saving and investing, making this change even more dramatic in the investing world.

That is a summation of the first bubble cause.

The second contributor is mostly disconnected from demographics and has to do with interest rates. Just as the number of overall retirees began increasing in 2010, interest rates on bonds were near their lowest yields ever. Since the traditional advice for retirees and those approaching retirement is to own more bonds in their investment portfolios, this only increased the demand for bonds, helping to keep yields low.

In every retirement demographic, there are always going to be people who are near the minimum threshold of what they need to fund their desired retirement lifestyle. If one assumes a traditional 60/40 portfolio, if bond yields are 5%, it’s not too hard to fund a 4% annual withdrawal rate mostly with bonds and stock dividends, and let the stock appreciation work to offset potential inflation. That is much more difficult if one has the same amount of savings, but bond yields are 1% to 2%. Faced with this problem, what I believe many retiring investors did was turn away from the bond market and fixed income to the stock market for better returns (and quite rationally so). However, most of these investors never really wanted to own public businesses (stocks), because a great many of them could not accept the price volatility that comes with stock ownership. It’s important to remember that this is a generation that had just experienced two of the worst stock market declines in history in 2000 and 2008 after all. So, they tended to be very risk averse, and they also tended to focus on income via dividends because what they were ultimately trying to replace with their stock portfolio were bonds and other fixed-income assets.

I believe these are the main contributing factors that created a bubble in a subset of stocks with a certain profile these investors found attractive. My observation has been these “Boomer Stocks” often possess a handful of particular attributes. They:

• Have well-recognized brand names like McDonald’s, Walmart, Coca-Cola, Pepsi, Procter & Gamble, Home Depot, Disney, IBM, Apple, Microsoft, Chevron, Union Pacific, J.P. Morgan Chase, Wells Fargo, and so on.
• Have a perception of safety and stable returns like Paychex, Rollins, Church & Dwight, Brown-Forman, etc.
• Have a dividend yield, preferably a bigger-than-average one, like utilities, REITs, MLPs, BCDs, CEFs, or dividends that have a long streak of payouts like MMM, LOW, or TROW.

There are different dangers for each of these categories of stocks. For the higher-yielding ones, business quality is the biggest danger. But for most of them that I write about, the main problem is that investors are simply willing to pay too much for the future earnings of the businesses in exchange for stability and perceived safety. In these cases, investors are paying too much for peace of mind in being familiar with the business, or the business having steady earnings.

As the stock prices of the quality businesses rose, their earnings yields fell, implying lower and lower future returns for the owners of the businesses.

Putting myself in a retiree’s shoes this past decade, when interest rates were near zero, I don’t blame them for taking what they could get from businesses they felt were safe bets. But we are no longer in a zero-rate environment. It now becomes much less reasonable to stay invested in overvalued stocks when you can get a 4% yield in short-term treasuries.

With that context in mind, let’s examine the current valuation of Brown-Forman’s stock.

My Valuation Method For Brown-Forman

The valuation method I use for Brown-Forman first checks to see how cyclical earnings have been historically. Once it is determined that earnings aren’t too cyclical, then I use a combination of earnings, earnings growth, and P/E mean reversion to estimate future returns based on previous earnings growth and sentiment patterns. I take those expectations and apply them 10 years into the future, and then convert the results into an expected CAGR percentage. If the expected return is high enough, I will buy the stock, and if it’s really low, I will often sell the stock. In this article, I will take readers through each step of this process.

Importantly, once it is established that a business has a long history of relatively stable and predictable earnings growth, it doesn’t really matter to me what the business does. If it consistently makes more money over the course of each economic cycle, that’s what I care about.

Since 2004, Brown-Forman has experienced three years when EPS growth declined, and one year when it was flat in 2012. All of these negative earnings growth years were single digits and extremely mild, and the 2020/21 decline was probably caused by COVID shutdowns, when many restaurants and bars were closed down, and therefore not selling as much of Brown-Forman’s Jack Daniel’s bourbon whisky. This makes Brown-Forman a less-cyclical business and therefore pretty easy to analyze using a basic earnings analysis as I will do today. The combination of very reliable earnings along with the very well-known Jack Daniel’s brand, also means this stock fits the profile of those I think Boomer investors have found attractive in recent years.

Just as a side note, below is a chart of the 20-year returns of Brown-Forman compared to the S&P 500 from 1990 until 2010.

While performance fluctuated during this period, it was roughly equal between the two of them. Next, let’s examine the performance since 2010 when the factors that contributed to the Boomer Stock Bubble began to take hold.

Since that time, we have had steady and consistent outperformance from Brown-Forman compared to the index, with the peak spread between the two occurring in 2021, just as the Federal Reserve started significantly raising interest rates. And, just in case you were wondering whether the outperformance was justified, Brown-Forman’s earnings growth rate during this time was about 6-7% per year, while the S&P 500’s was 11-12%. So, there is no rational valuation explanation for the outperformance.

Okay, now back to the valuation analysis.

Brown-Forman Sentiment Return Expectations

In order to estimate what sort of returns we might expect over the next 10 years, let’s begin by examining what return we could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. For this, I’m using a period that runs from 2015-2023.

Brown-Forman’s average P/E from 2015 to the present has been about 32.08 (the blue number circled in gold near the bottom of the FAST Graph). Using 2023’s forward EPS expectations (also circled in gold) Brown-Forman is expected to earn $1.85 per share this year. This creates a forward P/E of about 35.11. If that 35.11 P/E were to revert to the average P/E of 32.08 over the course of the next 10 years and everything else was held the same, BF.B’s price would fall and it would produce a 10-Year CAGR of -0.90%. That’s the annual return we can expect from sentiment mean reversion if it takes 10 years to revert. If it takes less time to revert, the return would be lower.

Business Earnings Expectations

We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected, to the performance of the actual business. In this section, I will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today’s prices and kept all of the earnings for ourselves.

There are two main components of this: the first is the earnings yield and the second is the rate at which the earnings can be expected to grow. Let’s start with the earnings yield (which is an inverted P/E ratio, so, the Earnings/Price ratio). The current earnings yield is about +2.85%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $2.85 per year on my investment if earnings remained the same for the next 10 years.

The next step is to estimate the company’s earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the historical EPS growth rate, taking into account each year’s EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).

Brown-Forman bought back about 9% of the company over this time period so I will make adjustments to control for that. After doing that, I estimate an earnings growth rate for Brown-Forman of +5.36%, which is very close to FAST Graph’s +5.67% EPS growth number.

Next, I’ll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought Brown-Forman’s whole business for $100, it would pay me back $2.85 plus +5.36% growth the first year, and that amount would grow at +5.36% per year for 10 years after that. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $138.38 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +3.30% 10-year CAGR estimate for the expected business earnings returns.

10-Year, Full-Cycle CAGR Estimate

Potential future returns can come from two main places: market sentiment returns or business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for BF.B, it will produce a -0.90% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +3.30% 10-year CAGR. If we put the two together, we get an expected 10-year, full-cycle CAGR of +2.40% at today’s price.

My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. A +2.40% CAGR expectation makes Brown-Forman stock a “Sell”. Because earnings have risen a little bit since 2019, while the price stayed nearly the same, the valuation for Brown-Forman has improved a little bit, but the medium and long-term returns are still likely to be poor given today’s stock price, so the stock remains a “Sell”.

Conclusion

Usually in stock investing feeling “safe” comes with a price. Just because a business has stable earnings and a well-known brand or has paid a dividend for many years in a row doesn’t mean it will produce good returns over the long term. Cash now yields over 4%. It simply doesn’t make sense to own a bond-like stock, which comes with the risk of capital loss when the likely reward is less than that of short-term Treasuries. Fortunately, for astute investors, there is still plenty of time to sell out of stocks like this that are exceptionally overvalued. It may indeed be the case that the Boomer Stock Bubble slowly deflates rather than popping dramatically as many profitless growth stocks did the past two years, but low returns over long periods of time are still poor returns.