Costco Stock vs S&P 500: Which Is Best?

If Warren Buffett encourages his own heirs to invest their inheritances into the S&P 500, a company needs to be pretty special to warrant an allocation in its favor versus the broader market. 

Famously, Buffett’s sidekick Charlie Munger has been a strong advocate of Costco (NASDAQ:COST) for decades, so is he right?

In a battle between Costco stock vs S&P 500, does Munger’s favorite retailer come out on top?

Why Buffett Favors the S&P 500

Warren Buffett hasn’t spelled out precisely why he favors the S&P 500 over even his beloved Berkshire Hathaway (NYSE:BRK.B) but he has offered some breadcrumbs to his reasoning.

One of his primary concerns is leadership risk. Specifically, the influence of a CEO is wide reaching and, in Buffett’s view, if a fool runs the business, it can be very detrimental to long-term returns.

While this is a concern for any single business, the odds of 500 individuals who are not a good fit for the top job taking over all 500 of America’s best companies is low, if not zero, making the S&P 500 more attractive on that dimension.

Another key metric in favor of the S&P 500 is performance relative to active managers over time. Some statistics show that as many as 79% of active managers underperform the S&P 500 over a decade long timeline.

If Buffett were to entrust his fortune, which has outperformed the market for so long, to an active manager who severely underperforms, it could undo much of his life’s work over an extended period.

Perhaps one of the key attributes the S&P 500 enjoys that no single company can emulate is it’s inherent mix that discards poor performers. The natural result is the only companies that warrant inclusion in the S&P 500 are the best companies in America.

Any single company can run into all sorts of woes from growth hurdles to macroeconomic challenges, and from regulatory risks to leadership battles. The S&P 500 is naturally buttressed from many of these risks because where one company is hurt another benefits. For example, oil stocks and airlines stocks are inversely correlated.

Costco Has Outperformed The S&P 500

After making the case for the S&P 500, it seems a near impossible task to suggest Costco eclipses it and deserves your attention, but that’s precisely what you’re about to discover.

There’s a reason Charlie Munger has been a staunch advocate of this grocery retailer for decades, and its return on invested capital, or ROIC, offers a clue as to why.

Costco’s ROIC stands at 18.8%, a figure so high that it’s the envy of just about every other retailer. For comparison, Walmart’s return on invested capital is an impressive, but inferior, 11.7%. And Kroger, which Buffett has favored in the past, sits at 11.9%.

What is Costco doing so much better than other retailers and grocery chains?

For one, the membership model is very successful. With over 71 million households participating, Costco starts each year with a virtually guaranteed massive revenue stream. 

Where every other retailer must generate a profit from items sold, Costco delivers so much value that the number of paid households grows year after year as consumers derive value relative to other stores.

The company’s business model has translated to massive outperformance relative to the S&P 500. Consider this startling statistic.

Since 1987, the S&P 500 is up 877.6% while Costco share price is up 28,070%. You didn’t read those two figures incorrectly – Costco has outperformed the S&P 500 by over 30x in the past 30+ years.

It’s no wonder perhaps the second most famous investor in the world, Charlie Munger, has been so loyal to it.

Will Costco Continue to Outperform?

Costco’s track record has been scintillating but its future determines whether it’s worthy of investment and, on that count, the answer appears to be a resounding yes, even if not now. Let us explain the apparent contradiction.

A primary characteristic of Costco’s business model that attracts investors is its revenue predictability. Over the past decade alone the world has gone topsy turvy when it comes to Fed rate policy, international wars, presidential politics, and healthcare scares. Amidst it all, Costco has grown its top line each and every year.

That revenue predictability is forecast to continue for the next 3 years according to analysts, with the consensus expectation that the top line growth will not experience any kind of negative blips. Between fiscal years 2023 and 2026, Costco’s top line is estimated to climb from $242 billion to $289 billion. So too is operating income and earnings per share forecast to follow suit.

If the future looks bright then why may Costco be worth buying, but not quite now? 

To answer that we turn our attention to valuation. As Buffett likes to say a great company is best bought at a good price and Costco appears to be trading right now at a premium price.

A good indicator of its overvaluation can be found in the PEG ratio, which sits at 5.05. A company is deemed undervalued when the PEG is below 1 and is generally perceived as overvalued when the PEG exceeds 2.

The upside to analysts average price target is just 7.6% now, though we are a little more pessimistic and see the stock 4.1% overvalued using an analysis of cash flows discounted to present day.

Costco Stock vs S&P 500 Which Is Best?

While Costco has far outperformed the S&P 500 over the past 30 years by a margin of over 30x, it appears overvalued by 4.1% using a discounted cash flow forecast analysis. For that reason, the S&P 500 is likely the better bet for investors over the short-to-medium term.

With that said, Costco’s return on invested capital is so high at 18.8% that, over the long-term, it is likely to continue outperforming the S&P 500.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.