Friday, February 20, 2015

Buying Quality Companies at a Reasonable Price is Very Important

I like to buy quality companies at attractive valuations. I look for quality in the companies I put my money to work. This means that I look for wide moats, strong brands, unregulated monopolies, strong competitive advantages and I don’t like to see change in the business models. If you are the player number 1 or 2 in a given niche, and you don’t have much change in your industry, you can make a lot of profits over time, and earn high returns on invested capital. In addition, chances are that you will generate a lot of cash each year, and will be able to distribute those excess profits to shareholders. This “monopoly” position could translate into stable earnings and profits throughout various phases of the economic cycle, high margins, and much lower likelihoods of cutting dividends during the next recession. Since I plan on living off dividends in the future, it is important to have a reliable stream of cold hard cash deposited to my account even during the darkest of times.

I have a few quality companies I like such as Church & Dwight (CHD), Moody’s (MCO) and Hershey’s (HSY). They are all selling for very high valuations today – above 20 times forward earnings each. Another high quality company I like is Brown-Forman (BF.B). It sells for close to 30 times forward earnings. Luckily I do own some shares in Brown-Forman, although not enough.

Despite the fact that I am very confident in the abilities of each one of those companies to keep printing money for shareholders in the next 10 – 20 years, I do not want to pay too much for those dollars. As a passive long-term buy and hold investor, my returns are largely dependent on the performance of the business I invest in. If that business increases earnings per share over time, and growth the dividends, I will do well. This would occur of course, as long as I do not overpay for that business. After all, my capital also has opportunity costs – meaning that I am better off in a dividend compounding machine at a lower valuation, if everything else is equal.

I want to generate good returns on my money. When I find a good compounding machine, it might make sense to allocate the money to it right away. The problem of course is that there are a few competing arguments to think about before doing that:

For example, Hershey is selling for 24.30 times forward earnings for 2015 of $4.36. The company has not cut dividends since 1974. It has raised dividends in every single year since 1974, except for 2009. It pays $2.14 in annual dividends, for a current yield of 2%. Earnings per share increased from $2.30 in 2004 to $3.77 in 2014. The company paid out $0.84/share in 2004 in dividends to shareholders. The stock price at the time of this writing is $106.02.

At that price, I do not think there is much margin of safety in the company. It seems as if most of future profit growth is already priced in the company’s stock. As such, the returns over the first decade of ownership are not going to be very high. The returns beyond the first decade will be harder to forecast. This is because the longer the period you are studying, the higher the possibilities for something changing for the worse. Before I buy a company, I ask myself the following questions:

- What happens if there is a change in the product or the competitive landscape?

- What happens if there is a valuation compression? For example, is it worth it to pay a premium at 25 – 30 times earnings for a company which could sell for 15 times earnings in 10 or 20 years.

- What happens if growth slows down? Are current growth expectations overly rosy or overly pessimistic? After all, once a certain size is reached, growth could be very difficult to achieve.

- Are there other compounders available at better valuations? Just because Hershey is a wide-moat compounder that will likely do well in the next 20 years, that doesn’t mean that other quality compounders might not be available at better starting valuations. For example, a few weeks ago, PepsiCo and McCormick were available at cheaper valuations than today ( less than 20 times earnings).

In the case of Hershey, I expect it to earn $4.36 in 2015, and pay $2.14 this year. I would then expect it to grow earnings per share by 7%/year over the next 2 decades, and to pay approximately 50% of earnings each year in the form of dividends.

This means that the company will be earning $8/share in 2024, and would have paid $30 in dividend income between 2015 and 2024. At a P/E of 15, this could translate into a price of $120/share in 2024. This means that an investment in Hershey today could translate into a 42% return in about a decade. At the time of writing this, the shares are selling for $106. A 42% return in 10 years is not an adequate return on investment for my money. I would much rather have my principal and income double every 10 years at the very worst. If we use historical equity returns of 10%/year as a benchmark, I would expect that buying a stock and reinvesting dividends there will result in doubling of my capital and income roughly every 7 years or so.

The P/E of 15 of course assumes an increase in interest rates, which translates into lower P/E ratios for large-cap common stocks. A 7% annual increase in earnings per share is slightly lower than forecasts, but it is more conservative, given the competitive nature of the confectionery industry, exposure to commodities on the cost side etc. I essentially came up with the estimates by averaging out the various possibilities times the expected probability of event occurring.

Therefore, we saw that in the first decade, even the best dividend compounder might not be worth purchasing at overvalued prices.

However, if the company keeps growing earnings per share at the same rate of 7%/year for the next 10 years, the picture is somewhat mitigated. By 2034, the company could earn $15.77/share, and be paying $7.88/share in annual dividend income. Using a P/E of 15, the stock price translates to $236/share. In addition, between 2015 and 2034 the company would have generated $89.33/share in dividend income to the shareholder. This translates in over $325 worth of money at the end of the 20 year period. If the dividend is reinvested at 20 times earnings, the investor in 2034 is left with 1.50 shares for every share invested in February 2015. The total worth is approximate $355. You could see that even if a high initial price, the consistent growth, and even with reinvesting dividend at an inflated price, the investor came out ahead and still realized a good return.

This is why Warren Buffett says that "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." A great compounder will produce best results if left uninterrupted for a couple of decades. Even if the original price is a little too high, it will deliver good returns on investment. Of course, given the fact that we have limited investment timeframes, it is not efficient to waste the first decade of the compounding process, and only hoping that the subsequent decade afterwards bails you out. I assume your investment timeframe is 30 years. In reality, my investment timeframe is hopefully 40 – 50 years.

Very often, the price returns generated from companies comes unexpectedly. This is why I believe it is important to just sit tight, and do nothing for as long as possible, even if companies you own experience temporary setbacks. It would have been very difficult for an investor to hold for a long ten years, while generating a meager 42% in total returns. This is because patience usually would run out, and they would start questioning themselves and their strategy. If they sold after year 10, they would have missed out on most of the gains. This is why it is important to purchase shares only at valuations that make sense, and to avoid overpaying for companies. It is also important to not just look at the stock price, and not avoid the folly that you will be selling off assets to live in retirement. By selling off assets in retirement, you are exposing yourself to sequence of return risk. Sequence of return risk is the risk that volatility in year to year stock returns could result in you running out of money in retirement. I do not know about you, but I would like to reduce the risk of outliving my money in retirement.

This is why I focus so much on the growing dividend income stream. If I can live off the dividend income stream, I am much less likely to panic if the other stock market participants disagree that the company’s shares should be worth more. I view relying on stock prices alone, and selling off chunks of your portfolio, to be very risky. This is because stock prices are unpredictable – it could easily be feast or famine for the investor who sells off shares to pay for their retirement expenses. Dividends on the other hand provide always a positive return on investment, which is realized in cash, is more stable, and cannot be taken away from you. Even the study behind the current 4% rule, covered a time period when stock dividend yields were closer to 4% (1926 - 1993). Hence, I have a much higher confidence in the ability of a dividend portfolio to generate the necessary dividend income over time, than the ability to correctly guess stock prices and sell off shares to live during my golden years. Having a diversified portfolio of quality dividend growth stocks, purchased at attractive valuations, will mitigate the risk of outliving my money in retirement.

Full Disclosure: Long PEP and MKC

Relevant Articles:

How to never run out of money in retirement
Six Quality Dividend Companies For Long Term Investors
Dividend income is more stable than capital gains
Dividend investing timeframes- what's your holding period?
Why I am a dividend growth investor?

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