Having recently written about Lindt & Sprüngli stock over on Seeking Alpha I’ve noticed that a bunch of globally diversified consumer defensives are down big time recently. Lindt for example is down 13% since the start of August; Swiss food behemoth Nestlé has shed 11% over the same period; toothpaste giant Colgate-Palmolive is down 13% from its September highs; Philip Morris International has dropped nearly 10% since the election; and shares in Anglo-Dutch firm Unilever have lost 23% since the start of October. Those are just the ones that I’ve happened to notice too.
I think the reasons behind this are a combination of “Trumpflation”and also growth factors relating to certain stocks. The former point basically boils down to Trump’s campaign pledges for massive fiscal stimulus (the individual plus corporate tax cuts and a huge infrastructure program); and those expectations have pushed bond yields up. Given that a large part of the run up in these high quality defensives was a chase to yield, then consequently a whole load of high quality dividend names have sold off. The opposite effect is probably at play in certain cyclical sectors.
Anyway, when I noticed that some of the premier blue chip dividend names were in sell-off mode it got my mind thinking about the prevalence of dividend growth strategies nowadays. It’s not really a coincidence that these ideas have gained traction as bond yields have been hitting historical lows. If we go back to when I was born, 1990, you would’ve seen risk-free 30-year T-Bonds yielding about 8.25%. Now imagine somebody hitting retirement at that time with a $500,000 pot. In effect they could buy around $3,450 a month in income which is virtually risk free.
Go back eight years earlier to the midpoint of Ronald Reagan’s first presidency and you’ll find the annual coupon was at 14%. That’s cast iron guaranteed, investment-protected, 14% annual returns for three decades. As long as Uncle Sam doesn’t go bust (it won’t) then you get to collect that 14% coupon every year. Seems impossible to imagine in this environment doesn’t it? Today, that same investment would only throw off around $1,250 a month as the yield on the 30-year has fallen to the 3% range. It goes without saying that is a huge income gap to make up, which is where high-quality dividend stocks came in (especially those ones that tend to increase their annual payments like clockwork).
That income investing aspect is one thing for retirees (or those close to retirement), but the value situation is a real issue for younger buy-and-hold investors now. Take Kimberly-Clark stock for example, which I covered in a separate piece a few days ago. Assuming the stock hits its estimated earnings this year then shareholders will have seen earnings-per-share grow at a rate of 5.1% compounded annually over the past six years. Let’s imagine a scenario in which the valuation multiple doesn’t change between then and now since they’ve been such a big driver of returns. In other words we’re going to see what they look like when you only look at the business performance.
First and foremost you’ve got that rate of earnings growth translating directly into capital gains. The other thing you’ve got is all the cash dividends paid out over that time frame, which in this case amounted to around 33% of the initial investment total. Throw it all together and you get compounded annual returns of around 8.5% compared to actual shareholder returns of 14.25% compounded annually.
In a potentially low growth scenario that shows how important getting value right is. Another good case is that of Coca-Cola stock. We’ve already looked at the insane valuations that were put on the shares in the late 1990s, but between then and now it has really only spent a tiny fraction of that time trading at what you could call an attractive valuation. In fact, it took until the beginning of 2005 just to get around the 20x earnings mark. At its most attractive point – during the worst of the financial crisis – the valuation went down to 13x earnings alongside a 4.35% annual dividend yield. That was in March of 2009.
In other words if you were a new dividend investor back in the late-Nineties looking to build up a meaningful position in Coca-Cola stock then you had to be pretty patient. The rewards, though, would’ve been worth it. A $100,000 investment in Coca-Cola stock at the start of 2005 has returned $270,000 to date: that’s equivalent to a shade under 9% compounded annually. Not at all bad for paying 20x annual earnings for a global beverage company. From the beginning of March, 2009, the same starting capital would have returned a similar total – $260,000 to be precise. That is equal to compounded annual returns of around 13%, along with a current dividend yield on cost of 8.85%. Over a period of seven years that looks like pretty good going.
Remember the three components of stock returns: earnings-per-share growth, dividends and changes in valuation multiple. When the latter is proving favorable it’s easy to get lost to strong confirmation bias. Lindt & Sprüngli stock is a good example. If we look at the period between January, 2011, and January, 2016, then we see that Lindt has grown its earnings-per-share by 8.8% annually whilst paying out around 13% of its start-of-2011 share price as cash dividends. The “business performance” returns work out to around 10.4% per-year on average. However, the actual shareholder returns over that period have been somewhere in the region of 16.2% compounded annually (and that’s including the 20% drop since last year). The temptation is to justify a permanently higher multiple and ignore the effect a contraction will inevitably have on forward returns.
So where do we stand today if you’re looking out over the long-term? Mainly it’s all about appreciating that recent valuations haven’t been that great for future returns. It’s easy to come into the game in 2009 as a young investor and only ever see valuations expand. If you’re expecting to hit it rich from the regular old consumer defensive stocks then it’s hard to make the numbers add up.
The other option is to commit to some kind of regular investment program. Any investments made in periods of high market valuation, such as the last couple of years, will get nicely balanced out by the return accelerator effect of buying in during periods of low valuation. All you ever have to worry about is seeing the underlying businesses maintain their profitability and reinvesting cash dividends along the way. Outside of that we’re just going to have be patient for opportunities in the mould of a 2003 bear market, or a 2008/2009 style meltdown, to come knocking. When they do history shows it will probably be worth it – even for stodgy consumer defensives.