Price on Value
May, 2000

A Continuing Tale of Two Companies:
Gillette and MGIC Revisited

John Price,  Ph.D.

It is time to revisit Gillette and MGIC, two companies I wrote about last year in the article A Tale of Two Companies. What attracted me to these companies in the first place was that they had many similarities but were treated completely differently by the market. For example, about eighteen months ago they had similar earnings growth, earnings forecasts, return on equity, and return on capital. The difference was that Gillette was trading with a price earnings ratio in the vicinity of 60 while MGIC was just above 10. Let's see how these similar-but-different companies fared in the last year and what the future might hold for them.

Firstly Gillette. This $38 billion company is famous for its razor products, which make up approximately 60 percent by value of total sales of razors around the world. As Warren Buffett, a major stockholder, said, "You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep." Just to make sure they have something to sell to every male, Gillette also owns Braun, a brand that includes electric shavers as well as other household and hair products.

Other Gillette companies include toiletry products such as Right Guard, Soft & Dri and Dry Idea. It has toothbrushes and oral care appliances under the name Oral-B and various writing products such as Parker, Paper Mate and Waterman.

The company seeks to be a leader in its product areas. With a focus on technological improvements and new products, it aims to ensure that more than 40 percent of annual sales come from products introduced in the previous five years.

In March last year, Gillette was over $60. It dropped below $30 in March this year and has now rebounded to around $40.

Turning to MGIC, with a market capitalization of $4.5 billion it helps to make the American dream of home ownership a reality by providing private mortgage insurance PMI to the home mortgage lending industry. PMI covers residential first mortgage loans allowing people with down payments of 20 percent and less to purchase homes. If a homeowner defaults, PMI can reduce and even eliminate the loss to the institution providing the mortgage. By improving the credit quality of low down payment mortgages, it also facilitates the sale of these loans in the secondary mortgage market, principally to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

In March last year, MGIC was around $35. It peaked at over $60 in December last year and then dropped like a stone to below to $35. Now it has rebounded to around $45. So both stocks have traded in the $30-$60 range for the year and both are about $10 above their lows for the year.

The PEG Ratio

A simple ratio that can be a guide to whether you should buy, sell or hold a particular stock is the PEG ratio, the ratio of the price to earnings ratio (p/e ratio) and the growth rate of earnings. For example, over the past five years Gillette's earnings have grown by 8 percent per annum and its current p/e ratio is 32. This gives it a PEG ratio of 32/8 = 4. Or, if you prefer to use 14 percent, the consensus growth forecast of analysts, the PEG ratio is 32/14 = 2.29.

In contrast, the earnings of MGIC have grown by 24 percent over the past five years and its current p/e ratio is 10 giving it a historical PEG ratio of 10/24 = 0.42. Similarly, using 13 percent, the consensus forecast growth rate, gives a PEG ratio of 10/13 = 0.77.

Either way, since the PEG ratio for MGIC is considerably below that of Gillette, conventional PEG ratio analysis would suggest that MGIC is a better buy than Gillette.

Alas, the stock market is not so simple as I found out to my chagrin. A couple of years ago the PEG figures for MGIC and Gillette were not all that different to those given above. This led to my buying a small parcel of MGIC for $44 per share. After all, they had a PEG ratio way below 1 and a few months earlier had hit a high of $74.

Over the next few months I watched in disbelief as the price dropped to the mid 20's. Why would a stock with such a consistent earnings record, with outstanding earnings forecasts drop to a level where its p/e ratio was 7?

The answer lies in what I call the Price Trading Band which I will describe in next month's article. To set the stage for this it will be necessary to analyze more closely the p/e ratios of Gillette and MGIC.

The P/E Band

When you look over the history of company we see that there is band formed by the lowest and highest p/e ratios for each year. I call this the p/e band. For example, the chart shows that Gillette has a p/e band that trended upwards and over the past five years the lowest p/e was 28.6 and the highest was 66. (The last two bars in the chart are the consensus forecasts of the earnings per share for 2000 and 2001.)



Turning to MGIC, the band is at a much lower level. However, it also trends upwards with a five-year low of 7.2 and a five-year high of 24.3. Notice how the earnings have grown much more smoothly from year to year.



If the price of a stock depends on its future earnings, the vastly different levels of the p/e bands for Gillette and MGIC shows that there is a fundamental difference in how these companies are perceived by the market.

Even though the earnings for MGIC have grown consistently by around 24 percent for the past five years, the low level of the p/e band shows that there is a lot of nervousness about it maintaining this growth rate in the future. The consensus forecast is that earnings will grow by a healthy 13 percent over the next five years, a level that would warrant higher price-earnings ratios than we currently see. The reason for this is that there is a fear that its earnings could completely collapse.

The housing industry is very sensitive to the state of the economy and to federal and state housing policies. This sensitivity is even more pronounced with private mortgage insurance since government regulations could change the mortgage and mortgage insurance requirements overnight. 

If Franklin Raines, the Chairman and CEO of Fannie Mae, had his way then legislation would immediately be passed to reduce PMI requirements for home buyers. In a speech last year to the New York Financial Writers' Association he said that the PMI industry forms the core of a group that he refers to as the Coalition for Higher Mortgage Costs. On the positive side, earlier this year Curt Culver, the President and CEO of MGIC, reported that "relationships with Fannie Mae and Freddie Mac have improved considerably over the past year." Still, whatever the case, comments such as these add a layer of uncertainty to the continuing high profitability of MGIC.

In contrast, Gillette's revenues come from items that are more resilient to the state of the economy and to government regulations. For this reason, even though the growth of earnings for Gillette has been lower (and much more inconsistent) in the past than that of MGIC, 8.1 percent compared to 24.1 percent for the past five years, and their forecasts are about the same, 14.2 percent compared to 13.1 percent for the next five years, Gillette trades at a much higher earnings multiple than MGIC.

You can say that the market is wrong. That it is reasonable for there to be a difference in the p/e levels, you declare, but not such an extreme difference. However, this is what the market has been doing in the past and it is likely that this is what it will continue to do in the future. 

So the question is not why has the market got it wrong-if, in fact, it has-but can we be confident that the p/e bands will continue at these levels? If we can, then the second question is how, as investors, can we take advantage of this fact? This will be the topic of next month's article. 

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Next month's article "Price Trading Bands: Adding Cream to Your Quality Stocks" will look at how to use the price-earnings ratios to get even more bang for your buck when investing in quality companies.