Global growth is slowing, and could lead to an earnings recession. The pace of growth in economic output globally is slowing. Furthermore, this slowing growth has found its way into the earnings of companies in the S&P 500. Notably, S&P 500 companies are on pace to see a 4% contraction in earnings per share (EPS) in Q1/2019 based on current estimates.
Stocks are expensive compared to economic output. If global growth is slowing, what does that mean for stock prices? One of our favourite indicators is the so-called “Buffett Indicator” or the total US market capitalization to GDP ratio. The chart below demonstrates a long history of this ratio (recessions are represented by grey shading), noting that the Q1/2019 equity rebound has pushed us back over 143% of GDP, which corresponds to the March 2000 peak of the tech bubble.
We are in capital preservation mode. We always examine the risk/reward ratio on a long-term perspective. As a result of our unfavourable view on equity valuations and the negative outlook for corporate earnings, we have been shifting our client asset allocation towards fixed income and taking profits in equities. However, market timing never works perfectly and we always need to maintain some degree of disciplined equity exposure.
Disciplined equity exposure typically means recession-resistant companies with low beta to the market. We are bottom-up stock pickers, and as a result we do not purposefully build our portfolio based on macro conditions. However, Petmed Express (PETS) recently made its way into our actively-managed portfolios because it scored better compared to other companies on our watchlist. Here is why we love Petmed:
- Plenty of room for growth: Petmed is licensed as a pet pharmacy in all 50 US states to dispense prescription medications. The pet supply and medications business in the US represented a $15.1 billion market in 2017, with the majority controlled by veterinarians. Petmed is expected to generate $275 million in revenue in the fiscal year ended March 31, 2019, leaving plenty of room to grow its market share.
- Online-heavy business model: Petmed generates approximately 84% of its total sales from its online business. Furthermore, it introduced an app in February 2017 that enables users to “ask-the-vet” and bypass a traditional visit to the veterinarian, thereby keeping users within its online platforms to transact.
- Strong returns on capital: Petmed has generated a 29% average return on capital since 2005. Even during the financial crisis (2006-2009), the company’s return on capital averaged over 30%.
- Attractive valuation: Petmed has traded at a P/E ratio of 16.5x over the past 10 years, which we believe is a fair valuation given its solid online presence and stable industry spending patterns. Currently, Petmed trades at 11.3x the fiscal 2020 EPS estimate leaving potential room for normalization to its historical valuation, plus growth in future earnings. It also has an attractive dividend yield of 4.8%.
- Amazon: While the risk always exists for Amazon to enter the pet prescription market organically, the market may just be too small for Amazon to care and take its focus off of larger healthcare-related opportunities. We believe it is more likely that Amazon could see Petmed as an acquisition target, similar to Amazon’s June 2018 acquisition of PillPack.
- Recession-resistant: We started this article by talking about Petmed being attractive because its business is generally recession-resistant. Referring to the chart below, pet spending in the US did not see any downturn during the financial crisis. Furthermore, as we mentioned earlier, Petmed still managed to generate an over 30% average return on capital between 2006-2009.