As a Dividend Growth Investor, my investable universe is the group of companies that have managed to increase annual dividends for at least 10 years in a row.
Once I have my investable universe of 500 or so companies, I spend some time narrowing the list down by:
1. Requiring growth in earnings per share over the past decade
2. Focusing on companies that have more than a token dividend growth
3. Focusing on companies with competitive advantages and recurring revenue streams
For a while now, I've scoured my lists, and ended up with a few companies for research, that seem like great businesses to own. These companies have every characteristic that would qualify them as a quality business. They have the moats, the competitive advantages, the dominant position in their niche, the growth in earnings per share, the high return on investment, etc etc
Unfortunately, once I get to the valuation part, I end up having to put them on hold and not buy them.
That's because a lot of these companies seem wildly overvalued.
In the short run, the market is a voting machine.
In the long run, it is a weighing maching
- Warren Buffett
As an investor, your returns are a function of:
1. Dividends
2. Earnings per share growth
3. Changes in valuations
Over the long run, earnings growth and reinvested dividends account for over 99% of total returns. Changes in valuation account for pretty much zero of historical total returns on equities.
In the short-run however, changes in valuation affect expected returns.
For example, let's revisit the lessons we learned from this post Microsoft During the lost decade
Microsoft delivered poor returns between 1999 and 2012, despite the business growing FCF/share from $1.15 to $3.45. The reason was because the stock was overvaluaed as it was selling at 51 times FCF/share in 1999. By 2012 the valuation went to another extreme, when the stock was selling for 8 times FCF/share.
Investors who bought Microsoft $MSFT stock $58.38/share at the end of 1999 were sitting at an unrealized loss by the end of 2012, when the stock declined by 54% to $26.71/share.
Fast forward to 2024, Microsoft now generates $9.97/share in FCF (Free Cash Flow). However, it sells for 42 times FCF/share. The stock has gone up from $26.71 in 2012 to $426 today.
You can see that the valuation can expand and contract in the short run, which can cause share prices to move much more than fundamentals. Even if fundamentals are pretty growing at a nice step forward, like a ladder.
I am all for investing in quality companies, that will compound earnings, dividends, intrinsic value over time. However, I am not a fan of overpaying wildly for even the best business in the world.
When I overpay, I am essentially paying for all the growth in the immediate future (e.g. next 5- 10 years).. This leaves me with little in forward expected returns for quite some time. Only if I could hold for 20 years or so would I be likely to generate a decent amount in returns. Provided of course that those businesses would indeed be around in 20 years, still have strong competitive positions and would thrive in the process as well.
The downside is that when I overpay, I have a lower margin of safety. When a business is priced for perfection, even the smallest dent in the overconfidence can produce negative spiraling effects.
Historically, we've had situations in the US when good businesses were sold at highly inflated valuations. That happened with the Nifty Fifty in 1972 for example. You may enjoy this article refresher on the topic: The Nifty Fifty: Valuing Growth Stocks
Back in the early 1970s, there was a group of companies which are referred to as “The Nifty Fifty” in the US. These were companies which were expected to grow earnings forever, by taking advantage of trends in demographics and the economy of the future decades. The stocks were often described as "one-decision", as they were viewed as extremely stable, even over long periods of time.
The most common characteristic by the constituents were solid earnings growth for which these stocks were assigned extraordinary high price–earnings ratios.
A P/E of forty times earnings, far above the long-term market average, was common for these one-directional glamor stocks.
By 1973 investors lost interest in the stock market, and by the bottom in 1974 lots of the Nifty-Fifty stocks were down by 70 – 80 – 90% from their highs just a couple of years earlier. Many of the companies did not deliver price increases for a while, with the majority of their returns coming from dividends in the first decade since the top. Some of these Nifty-Fifty companies ended up failing outright, while a few others ended up becoming successful beyond their original investors dreams.
In reality, an investor who bought a portfolio of these companies and held through thick and thin for the next 30 years did well in the end. The truth however is that few investors probably held on through the carnage long enough to not only realize a profit, but also come out ahead as well.
Another historical situation where we had wildly excessive valuations occured during the dot-com bubble in 1999 - 2000. There were a lot of promising technology companies, which were destined to rule the world. Those companies sold at high valuations, because investors were overpaying for expected growth that way many years into the future.
Investors in those companies lost money in the first decade. Investors did make money in Oracle and Qualcomm, provided they were willing to sit patiently through gut-wrenching 80% declines, and holding for 15 - 20 years before breaking event.
You may like my review of how Cisco Systems (CSCO) investors from the dot-com bubble did over the past 20 - 25 years here: Cisco Systems (CSCO) : Lessons from the Dot-Com Bubble
Right now we have several companies in the dividend growth investing universe, which have been selling at very high valuations. Those valuations have also been increasing as well.
While the businesses themselves seem to be doing well, and would likely continue to do so, investors today are overpaying for the stability and growth of the future. This could impact near-term returns for them over the next 5 - 10years, mostly because these securities are priced based on growth that is not going to occur until 10 years from. These securities are thus priced for perfection.
Any hiccup along the line, could result in a double whammy of lower valuation ratios and P/E shrinkage.
I will illustrate this example of the risks and possible paths using a favorite company - Costco.
For example, Costco sells for 52.50 times forward earnings today. The stock is at $933/share. The company is expected to earn $17.80/share in 2025. It yields 0.50%.
The company earned $5.41/share in 2015 for reference. The stock sold at around $140/share back then. That was equivalent to almost 26 times earnings.
The company has an amazing business model, and has managed to grow Earnings Per Share consistently in an upwards fashion for years:
If the valuation had stayed at 26 times earnings, Costco stock would be at $460 today. The increase in the valuation from 26 to 52 times earnings resulted in the resulting growth in the share price.
Analysts expect Costco to grow earnings per share to $40/share in 2034. Let's assume for a moment that this happens indeed, due to strong membership growth, recurring earnings streams etc. This means that Costco is selling for 23 times forward earnings for 2034.
If Costco stays at the same P/E ratio of 52 in 2034, the stock would be at $2,100 in 2034. You'd more than double your money, plus you'd get the added benefit of a percent or two of dividend reinvestment over the course of the next decade. I highly doubt the P/E ratio would be at 52 in 2034 however. I believe the major risk in investing today in Costco is not that the business fails, but that the business valuation is revalued to a lower P/E ratio. Not sure what would trigger that revaluation, but I highly doubt this could go on forever.
However, if the stock reverts back to the P/E ratio of 26 from 10 years ago, the price of Costco stock would be $1,040 in 2034. This is roughly a 10% total gain in the share price, over a period of ten years. While dividends would likely grow, and there would be special dividends in place, that could probably account for most of any returns generated over the next decade.
With the annual dividend at $4.64/share today, a doubling in earnings per share would translate into an annual dividend of roughly $10/share in 2034.
It is very much possible that even if growth materializes, that the P/E ratio shrinks to a level below 26. In that case, investors in Costco who overpay for the stock today, would suffer losses, even if they hold for a decade. Any profits they make would be from the growth in the business in years after 2034. That's really long-term investing. Remember, the goal is to make a profit.
It is also possible however that earnings expectations for Costco today are not enthusiastic enough. If Costco actually earns say $80/share in 2034 ( I pulled this number out of a hat to illustrate a principle I am teaching here). In that case, assuming a P/E of 26 in 2024, that stock would likely sell for $2,080/share. That would mean that anyone buying today would double their money. Plus, you'd get the added bonus of reinvesting dividends, which would likely grow from $4.64/share today to perhaps $20/share by 2034 (at the optimistic future EPS figure of $80 in 2034).
Perhaps, I should not discount the possibility that Costco's P/E ratio would increase from here. I find it very hard to believe that Costco's P/E ratio would increase from an already high 52 times earnings. And then also stay there too.
These are just a couple of thoughts I have about the possible outcomes for Costco. I use them as an example of what my thinking goes.
Perhaps my thinking in terms of decision trees, outcomes, and paths is inspired by this chart from Tim Urban
There are several other companies that seem to be following a similar pattern of looking overvalued today. I believe they have decent businesses, that I would likely be willing to buy into at the right price. You can view this as my (non-exhaustive) Holiday Shopping list.
Cintas Corporation (CTAS) sells for 52.76 times forward earnings and yields 0.70%. The company has a 10 year annualized dividend growth rate of 22%.
Costco (CTAS) sells for 52.50 times forward earnings and yields 0.50%. The company has a 10 year annualized dividend growth rate of 12.60%.
Intuit (INTU) sells for 37 times forward earnings and yields 0.60%. The company has a 10 year annualized dividend growth rate of 16.40%.
Eli Lilly (LLY) sells for 61.60 times forward earnings and yields 0.65%. The company has a 10 year annualized dividend growth rate of 9.90%.
MSCI Inc (MSCI) sells for 40.70 times forward earnings and yields 1.05%. The company has a 5 year annualized dividend growth rate of 20.60%.
Moody's (MCO) sells for 40 times forward earnings and yields 0.71%. The company has a 10 year annualized dividend growth rate of 11.80%.
WD-40 (WDFC) sells for 53.40 times forward earnings and yields 1.23%. The company has a 10 year annualized dividend growth rate of 10%.
Note, this is just a representative sample. There are quite a few more such quality companies, selling at very high valuations.
Conclusion:
I hope you enjoyed this article. It got a little long, and wordy at the end. If you finished it in one sitting, congratulations and thank you for reading. Note that this is not a prediction that these companies would decline in price. It's merely stating that a lot of these companies are overvalued today and most likely, considering all possible paths, shareholders buying today are less likely to make money on them over the next decade or so.
To summarize possible outcomes:
It is quite possible that these companies continue enjoying inflated valuations from here on.
It is somewhat possible that fundamentals do much better than expected, which would then mean that valuations today "make sense".
However, it is also possible that these companies continue delivering on the fundamentals side, but their valuations shrink.
The worst case scenario is that one or several of these companies stumbles for a little bit on the fundamentals side (perhaps temporarily so), which then leads to a double whammy of decreased earnings growth and a lower valuation ratio.
In the meantime, the stock market is merely a market for stocks. So I will continue investing every month in the values I could find today. For companies that are overvalued, I would not invest today, but keep them on my watchlist. If I hold an expensive company, I would likely keep owning, for as long as it doesn't hit my sell criteria.
