Turn the clock back twenty years to the mid-1990s. Coca-Cola (KO) was dominating the world of soft drinks and had done for years. The business was in great shape and the stock had delivered phenomenal returns over the past several decades. Such a business would surely go on to produce good returns going forward, all else being equal, right? Nope, in fact the stock went on to have an exceptionally poor run over the following twenty years by historical standards. Fast forward back to the present day and let’s look at what a $10,000 investment in Coca-Cola stock would have actually generated in terms of returns.
Firstly, let’s just deal with the rather straightforward consideration of the share price. At this point in 1996 an investor would have had to pay a split adjusted price of $20.80 per share. On that basis, a $10,000 investment would have netted him a total of 480 shares in The Coca-Cola Company. Twenty years on, and those shares would now have a total value of about $22,500, equivalent to compounded annual share price growth of circa 4.15%. By way of comparison the S&P 500 delivered just over 6% compounded annual returns over the same period.
Okay, so that might look a bit disappointing to our investor considering the fundamentals of the business have remained intact. After all, that 1.85% a year underperformance adds up a lot when you are talking about compounding it over the space of a couple of decades.
On the plus side, Coca-Cola remained an absolute profit machine. Indeed it had been for many, many decades – through wars, recessions, depressions and pretty much everything else that has happened since the stock went public in 1919. Check out the performance of the underlying business in the early-to-mid-1990’s. Revenue growth clocked in at 9% compounded annually; net income was growing at a double-digit clip; profit-per-share had almost quadrupled since the late 1980s and the dividend distribution had more than trebled. By any reasonable metric Coca-Cola’s business was firing on all cylinders.
As we know, the reason for our investor’s disappointment is a lack of appreciation for Coca-Cola’s market value in 1996 and how much he was paying relative to his share of the company’s profits. Let’s say our investor scanned the price-to-earnings ratio just after his purchase of Coke stock. Had he done so he would have seen that the shares were trading at 34x prior year earnings. That is insanely expensive given that Coke would not only need to keep up that past growth rate, but also increase it in order to justify that valuation. Today the stock is trading somewhere in the region of 23x earnings, so still somewhat expensive in historical terms. What it does show, though, is that we have had a significantly large contraction of the earnings multiple over that time frame which has eaten into our investor’s capital appreciation.
Of course the above is presenting only part of the history of Coke’s returns for the past couple of decades. After all, the dividend machine remained in full and increasing cash spewing mode over that period. So let’s run the second scenario and assume our investor lost the password to his broker account and the dividends just kept on accumulating. They ended up sitting in the account, but not being reinvested into more Coke stock or any other investments either. Had that scenario unfolded, the total value of all that Coca-Cola dividend cash sitting in thier broker account would have amounted to $6,410.
So, to sum up: we have $22,250 in Coca-Cola stock, plus an additional $6,410 in dividend cash, which makes a total return of $28,660 on the initial $10,000 investment. On a compound average basis that works out to 5.4% annual returns. Suddenly it starts to look a tiny bit better for our investor, even though in hindsight they picked a pretty poor starting value in which to invest a lump sum.
The final scenario is to assume that before our investor forgot the account password they at least managed to change the settings to automatically reinvest any dividends back into more Coca-Cola stock. In this case the returns amount to an investment value of $35,250, equivalent to 6.5% compound annual returns (and a one percentage point per year increase compared to just letting the dividends accumulate).
Now the performance doesn’t look too bad overall. Okay, so it underperformed the S&P 500 which has delivered average annual returns of just under 8% (including dividends) over the same time frame. That said, there are a couple of additional points to consider here. Firstly, the starting market value of the stock was insanely expensive relative to the future growth potential of the company. Indeed the stock topped out only two years later, meaning dividends were being reinvested into even more overvalued stock for two whole years.
Secondly, the share price didn’t actually hit rock bottom until five years after that. Or put another way, our investor was actually looking at seven years before the stock even started to approach a reasonable valuation. That’s a good chunk of the twenty year time frame just spent in the wilderness of dead money territory.
It might seem painful at the time, but putting money to work, even just reinvesting dividends, in periods where the share price is going sideways can have a huge impact in terms of returns twenty years down the line. All things considered, beating inflation by three percentage points every year isn’t such a bad outcome after all. A fact which was made possible because the underlying business continued to be the profit machine that it had been historically.
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