Buffett's Dollar Store Bet Is Wrong: Opinion

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By James Brumley

NEW YORK ( StreetAuthority) -- Did Warren Buffett's Berkshire Hathaway ( BRK.A) recently commit an error in judgment?

It's tough to be critical of one of the world's greatest value investors, but even the best of the best can occasionally get caught up in the hype and forget the disciplined rules that earned them their fortunes in the first place.

Warren Buffett

In question is Berkshire's bet on dollar stores via its potentially overpriced investment in Dollar General ( DG).

To be fair, making a $48 million investment in a $15.6 billion company while its stock is trading at a high price-to-earnings ratio of 18 doesn't seem like a call Buffett would make. Instead, Berkshire's new manager, Todd Combs, probably made the pick.

Still, Berkshire Hathaway is Buffett's baby, and knowing how he likes to do things, the pick may not exactly be one that investors want to mirror. Here's why.

From Good to Great

Dollar stores and deep-value retailers such as Dollar General, Family Dollar ( FDO) and Dollar Tree ( DLTR) are new, but they really didn't reach their full stride until 2008. Prior to that time, consumers for the most part felt rich and acted rich, and didn't want or need to shop for bargains.

But once economic Armageddon struck, many consumers quickly made the switch and started shopping at these deep-bargain stores in order to save their hard-earned money.

And the numbers verify it. Between 2005 and 2007, Dollar Tree's bottom line grew by an average of 15% per year. Since then, its net income has expanded by a little more than 31% per year on average.

Dollar General's earnings growth since 2007 has been even more phenomenal. The company moved from what was essentially a break-even year in 2007 to per-share earnings of $2.37 last year, which isn't bad for a stock priced at roughly $46. Before 2008, Family Dollar's average annual earnings growth rate was 6%. Since then, it has averaged 23%.

By all accounts this is exactly the kind of growth investors love to see from the companies in which they've invested. And this new bargain-focused paradigm apparently is here to stay -- even during a stronger economy -- supporting this industry's earnings.

So why do I say Buffett and Combs likely made a big mistake in buying shares of Dollar General?

Because the stock wasn't even close to being cheap when they bought it. Although the earnings growth from this group of retailers has been red-hot for the past four years, the underlying stocks have appreciated even faster -- perhaps too fast.

Take Dollar Tree, for instance. Annual earnings now are 138% stronger then they were in 2008, but the stock has gained nearly 300% between then and now.

As a result, the price-to-earnings ratio has soared from a palatable 16.4 at the end of 2008 to the current 23.5.

And Dollar Tree isn't alone.

Family Dollar is the same story. Although EPS has grown from $1.66 in 2008 to $3.40 for the past four quarters as consumers have become loyal to the stores, the stock's price grew nearly 200% during the past four years.

And while the trailing P/E of about 18.6 makes it the cheapest among the three stocks in question, that's still an unusually high P/E for a retailer.

Dollar General wasn't a publicly traded company in 2008, but just for reference, earnings of 47 cents per share in 2008 swelled by an incredible 400% to reach $2.37 last year.

Since Dollar General went public in late 2009, the stock has roughly doubled, while income has only been 81% higher. The trailing P/E has moved up to a pricey 19.5.

Risks to Consider: The rallies from these stocks are becoming flimsy, as market saturation will likely make it more difficult to maintain earnings growth rates. But to give credit where it's due, these deep-discount business models can somewhat justify growth-like valuations because of their double-digit earnings growth rates.

Action to Take: There is more room for each of the companies mentioned in this article to crank out top- and bottom-line growth. But for the stocks, there's more vulnerability than opportunity at this point.

Their valuations have simply just gotten out of control as the market has fixated on growth and promise. All three names could make for solid investments if timed right, but the right time and price for an entry is probably going to require about a 25% correction from peak levels.

James Brumley does not personally hold positions in any securities mentioned in this article.

StreetAuthority LLC owns Class B shares of Berkshire Hathaway (BRK.B) in one or more of its "real money" portfolios.

ALSO SEE: