For most people, it's easier to follow a crowd than to go against what everyone else is doing. That's why some stocks tend to trade in one direction (usually up) for an extended time, depending on how enthused the broader investing community feels at any given time. For Costco Wholesale(NASDAQ: COST), this follow-the-crowd mentality has worked out well for several years now. Crowd enthusiasm has helped the stock outperform the broader stock market, returning 222% over the past five years (compared to 102% for the S&P 500).
It's in cases like this that contrarian investing sometimes comes into play. A contrarian investor looks for opportunities where the popularity of an investment choice in the broader market has led people to drastically misprice certain other securities. Now could be the perfect time for contrarian investors to consider buying Hershey(NYSE: HSY). Here's why.
The air is getting thin around Costco
Costco has a sterling reputation as one of the world's best retail companies, and deservedly so. The company has a cult-like following among some of its members and is known for its wide selections and low prices at its stores. Customers must pay membership fees to shop at its stores, which is how Costco makes most of its profits.
Good companies don't often go on sale, and Costco is no exception. Over the past decade, the stock has traded at an average price-to-earnings (P/E) ratio of 35, a hefty premium to the broader market. Yet the stock continues to deliver stellar investment returns.
But as you can see below, Costco's valuation in 2024 has broken through the glass ceiling and is stuck up in the clouds:
COST PE Ratio data by YCharts
As great as Costco might be, this will likely revert toward the average at some point and potentially drag the stock price down with it. Costco's earnings are only expected to grow by about 9% annually over the long term. It will be hard to justify such a high valuation without more growth.
Hershey is a struggling millionaire-maker stock
Hershey is an entirely different business than Costco (although many Hershey products are sold in Costco stores. The company is one of the leading confectionary companies in the United States, with beloved brands like Hershey's, Reese's, Twizzlers, KitKat, Jolly Rancher, and more. The company has also expanded into the snacks segment and now owns popcorn and pretzel brands like Pirate's Booty, SkinnyPop, and Dot's.
Brand power has allowed Hershey to generate a high return on its invested capital (ROIC), an average of more than 17% over the past three decades, and it has slowly trended higher over time. You won't mistake Hershey for a growth stock, but its steady growth is good enough because the business has such a high ROIC. Hershey is a cash cow that can simultaneously repurchase shares, pay and raise a dividend, and develop and acquire new products.
The result? Generational wealth. Hershey has returned nearly 44,000% over the past five decades, making the company a bona fide millionaire maker for long-term shareholders.
Unfortunately, the company is battling serious adversity right now. Cocoa beans are a fundamental ingredient in chocolate. Bad weather and disease have decimated cocoa crops over the past 18 months, sending commodity prices to all-time highs. This has forced companies like Hershey's to raise their prices to try to offset some of the additional costs, which has, in turn, hurt sales.
Hershey was growing earnings between 8% and 10% annually, but the disruption of cocoa farming has snuffed out its growth estimates and destroyed sentiment on the stock:
HSY EPS LT Growth Estimates data by YCharts
Why now could be the time to buy
Hershey has gotten beaten up so severely that its stock is flashing some rarely seen valuation signals. Its dividend yield has reached 3% for only the third time. The stock has averaged a P/E ratio of 25 over its lifetime but trades at about 20 times earnings today. Remember, Hershey's business is struggling, so earnings are likely somewhat depressed. The last time Hershey's dividend yield was this high, the stock traded near a P/E of 18, which has only happened a few times in the past quarter-century:
HSY Dividend Yield data by YCharts
Unfortunately, Hershey probably won't resolve its short-term issues overnight. Industry experts believe cocoa prices could remain elevated until next fall, so keep that in mind. But Hershey looks like a broken stock, not a broken company. Hershey's stock has enjoyed a sterling reputation and premium valuation for decades, and there isn't any glaring reason why it wouldn't continue once Hershey shows signs that its business is recovering.
These are the opportunities you look for as a long-term investor. Hershey might not make you look like a genius right away, but there's a good chance investors buying shares of Costco right now will look back in five years wishing they had bought Hershey instead.
Should you invest $1,000 in Hershey right now?
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Justin Pope has positions in Hershey. The Motley Fool has positions in and recommends Costco Wholesale and Hershey. The Motley Fool has a disclosure policy.
