One of the best-performing stocks in recent memory could not be further from the tech sector or the ongoing artificial intelligence (AI) boom. I'm talking about Costco (NASDAQ: COST) . Shares of the warehouse-club operator have produced a total return of 233% in the past five years, outpacing the S&P 500 by 96%.
While the retail stock has continued its momentum throughout 2024, I'm not bullish as we look ahead. I predict that Costco will underperform the S&P 500 over the next five years.
Costco is a quality enterprise
First, it's important to set the tone. Costco is a very fine business and has many positive attributes that investors appreciate.
It's the world's third biggest retailer, a standing that gives Costco tremendous scale advantages. Because of its huge sales volume coupled with far fewer stock-keeping units at its stores, the company can leverage its incredible buying power with vendors, obtaining favorable pricing on its merchandise. The costs are constantly passed to shoppers in the form of everyday low prices.
This advantage adds durability to Costco's business -- there's minimal chance the company will get disrupted. Additionally, the company's membership model creates a high-margin, recurring, and predictable revenue source. Given the worldwide renewal rate of 90.5% in the latest fiscal quarter (Q3 2024 ended May 12), customers are very loyal.
It's no wonder Warren Buffett's longtime right-hand man, the late Charlie Munger , was such a fan of this business. "I love everything about Costco," Munger once said. "I'm never going to sell a share."
Where's the margin of safety?
Steady and consistent financial performance -- namely, solid revenue and earnings growth over an extended period -- have made Costco stock an investor favorite. But I think the market's love affair with the business has gone too far.
Let's consider the valuation, which should be a critical component of any investor's analysis. As of this writing, Costco shares trade at a price-to-earnings ratio (P/E) of 52.9. Throughout its entire history, the most expensive they have sold for was a P/E of 56.4, which was in 1999. The stock is very expensive today, and I don't think anyone would disagree.
There's absolutely zero margin of safety inherent in the current stock price. The market is pricing the stock as if Costco can do nothing wrong, so there's meaningful downside risk. If Costco misses Wall Street estimates by even a tiny amount or investors become slightly less optimistic about its prospects, the stock could tank, leading to portfolio losses.
To be fair, if Costco was going to rapidly increase the bottom line, then it might make sense to pay 53 times earnings. That's not the case, though. According to consensus analyst estimates, the company is projected to grow earnings per share at a compound annual rate of 10.7% between fiscal 2023 and fiscal 2026. This is a massive and mature enterprise, so the gains are likely to decelerate over time.
Astute readers will counter my argument that the stock is expensive by saying that this has always been the case. For example, exactly 10 years ago, shares traded at a P/E of 26.6, which was pricey back then. But since then, shares have soared 616%.
It's worth mentioning that the P/E expanded by nearly 100% during that time period. Can a rational and reasonable investor really believe that Costco stock will see not just that same doubling of the P/E, but any positive multiple expansion over the next five years? I believe there's a strong likelihood the valuation ratio will come down.
This will create a powerful headwind working against investors. That's why I think the stock will underperform the broader index between now and 2029.
Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Costco Wholesale. The Motley Fool has a disclosure policy .
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