Thursday, March 30, 2017

What to do about slowing earnings growth?

Successful dividend growth investing relies on finding companies at an attractive price which can grow earnings and dividends over time. A long track record of annual dividend increases is an indication of a strong business model that generates a lot of excess cash, beyond the needs for growing the business. This is the characteristic for most of those dividend champions, which shower their shareholders with more cash every year.

One of the monitoring tools at my disposal involves checking the list of dividend increases, and analyzing companies every 12 – 18 weeks. I have noticed that several of the companies I own have been unable to grow earnings per share over the past few years. Some recent examples include Coca-Cola, Procter & Gamble and Colgate Palmolive.

Some of it could be due to the changing competitive and business nature at an individual company basis. The other reasons for slowing earnings growth is due to external factors such as:
  • The strong US dollar
  • Weaker International Economic Growth
  • Weak energy prices
  • Higher Competitive Pressures

The above factors have also hit earnings for S&P 500. We may also need to add the shock from the financial crisis which wrecked earnings in the financial sector. The most interesting fact to consider is that S&P 500 has been unable to grow earnings per share over the past decade. Most returns have come from the expansion in the valuation multiple and dividends.

For example, S&P 500 earned $81.51 in 2006. The S&P 500 earned $94.54 in 2016. This is a very anemic growth in earnings per share. My expectation is that earnings should double roughly every 10 – 12 years ( equivalent to a 6% - 7% growth in earnings each year). Otherwise, using 2% dividend yields today, you can hardly expect a good return on investment over the next decade.

So it seems that slowing earnings growth is not limited to mature dividend growth companies. It is widespread across US companies.

You can see the data from 1977 - 2016 used for this spreadsheet below:

If we go all the way back to the late 1800s and early 1900s we can find whole decades with minimal growth in earnings per share. Unfortunately, those were the times where a larger portion of returns were derived from dividends, rather than capital gains. The past 40 or so years have trained everyone that capital gains are a more important factor in total returns than dividends. A large part of capital gains of the past 40 years were driven by the decrease in interest rates, which pushed valuations of cheap stocks in 1979 upwards.

I find it unfortunate that all of those hundreds of billions in buybacks that S&P 500 companies have spent my shareholder money on have resulted in a negligible increase in earnings per share.
The sad reality is that without growth in earnings, future returns will be dependent on dividends and expansion/contraction in valuations. Perhaps this is why investors are being told to lower their return expectations for the next decade.

So what could happen from here?

A potential outcome could be seen from the performance of international companies over the past decade. International investing and emerging market investing were all the rage a decade ago. This was probably driven by people who were chasing what worked well before.

Unfortunately, over the past decade, earnings for international and emerging market indices have been declining.

As a result, these markets didn’t do so well for their investors. For US investors with international allocations, they had stagnating returns in foreign markets, compounded by weakening foreign currencies against the US dollar.

Over the past decade, the US markets were the place to be. If earnings do not start growing soon, we may not get a very nice return over the next decade. So if we have equities yielding 2%, which do not grow earnings and dividends, the most we can reasonably expect is to generate 2%/year.  That is unless people do not start valuing equities at 30 times earnings of course. Under this scenario, I believe that a dividend focused portfolio will do fine, assuming we are focusing on the income and ignoring wild stock price gyrations.

On the other hand, it is quite possible that earnings per share are just temporarily in the doldrums. After all, American businesses are some of the most resilient in the world. They stumble occasionally, but then always come roaring back up. There have been situations before, particularly in the 1980s, when earnings per share went nowhere for 6 – 7 years. During that time, investors generated handsome returns. The difference is that in the late 1970s valuations were very low. For example, in 1979 S&P 500 earned $14.86, sold at a P/E of 7.26 and yielded 5.20%. By 1986 the S&P 500 earned $14.46, sold at a P/E of 16.70 and yielded 3.40%. After that earnings per share increased gradually ( though we did see a temporary decline to $15.79 in 1991).

Unfortunately, todays valuations are high. S&P 500 sells for over 24.50 times trailing earnings, but 18.30 times forward earnings. However, the relative valuation on equities is still better than valuations on fixed income.

We are all investing for several decades into the future however. So if equities manage to double earnings over the next 12 years, and increase dividends proportionately, we may get some pretty decent returns from here. A 6% growth in annual earnings is required to double starting earnings per share over a twelve year period by the way, if you are not familiar with the Rule of 72.

So why should the slowdown in recent earnings growth really matter?

I believe it matters, because the impression that earnings, or stock prices are not going anywhere can wear out even the most patient investor out there. You do not want to see stock prices falling down, realizing that earnings are not growing and that valuations may have been overstretched, thus triggering an anxiety attack that forces you to sell everything and moving into bonds. If you develop the blinders that will help you to stick to your plan, you will persevere, and ultimately wait until things start working in your favor. If you expect low returns going forward, you will be prepared to spend more of your time beefing up your savings rate. You have to invest for the future, which is why even if earnings go nowhere for another decade, this doesn't mean they won't be materially higher by the time you retire. This is why we need to keep investing through thick or thin.

Using history as a guide, earnings will start growing sooner or later, which would ultimate drive future growth in dividends and intrinsic values. Holding tight on to your diversified dividend portfolio, focusing on the dividends, and ignoring the stock market will likely be the winning attributes of successful investors through the end of the next decade.

If earnings per share do not grow materially over the next decade, the only returns will be generated by dividends. The only thing that a dividend investor can do to protect their nest egg is to diversify, avoid overpaying when buying companies, and to sit patiently on their investments. For those who are retired, you are already living off dividends, pensions and Social Security anyway, so you should not care much as long as your dividends are sustainable. For those in the accumulation phase, it may pay off to reinvest dividends selectively, and avoid adding money to companies which are not growing earnings per share.

Of course, an investment does not need to grow net income, in order to generate investment income. A dividend paying company can generate very respectable returns from dividends alone. A prime example is Phillip Morris International (PM), which has not grown by much, but has showered investors with high dividends and somehow has managed to do better than the S&P 500 since we profiled it in 2014.

Today we discussed the slowdown in earnings growth for many blue chip companies, which is perfectly mirrored in broad market averages. Those are due to temporary factors such as strong dollar, weak international economies, weak energy prices and high level of competitiveness. It is also due tot the fact that financials were decimated during the crisis, and their earnings may just now start to recover. We examined the historical record of the largest US blue chips, as evidenced by the S&P 500 index and found out that earnings do not grow in a straight line. There have been previous periods of flat earnings growth. The historical record suggests that those periods were always followed by periods of rising earnings. Depending on where earnings go from here, we may either get good returns or poor returns. For example, if earnings go nowhere for a decade, the only returns will come from dividends. However, if earnings grow from here at a 6% annual rate, an investor can expect generate 8% returns ( before accounting for any potential valuation compression).

Either way, I believe that patient investors who put money to work on a regular basis, and who are patient and have a long-term horizon, will do well. But do not be dissapointed if returns over the next decade are lower than the 10% annual average returns. Focus on things within your control, and stick to your plan.

Relevant Articles:

The most important metric for dividend investing
The advantages of being a long-term dividend investor
Reinvest Dividends Selectively
Dividend Champions - The Best List for Dividend Investors
The most important rule about dividend investing

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