Dividend Investing: A Survivor’s Guide For Life

general electric

Over the course of the 20th century, the valuation for a “typical” S&P 500 stock shifted upward from a P/E ratio of about 10 to a P/E ratio of about 17. Unless you happen to have a nice taste and appreciation for history, this might fall into the category of things that you do not think about a whole lot. But still, it can be a question worth examining: Why are investors, on average, willing to pay $17 for each dollar of a company’s profits when a century ago they were only willing to pay $10 for each dollar of profits. Is this an example of permanent irrationality in the marketplace?

Not quite.

Thanks to technological advances and productivity gains, most S&P 500 companies are able to take more profit out of the company than ever before (as opposed to the days of railroads, telephone companies, and steel mills that required heavy capital expenditures and constant capital infusions back into the business to maintain or grow profits).

Warren Buffett’s purchase of See’s Candies for $20-$30 million in the 1970s is the classic example of this. Even though the chocolate company itself does not experience staggering growth, the value to Buffett has been the amount of See’s Candies profits that he has been able to take out of the business and deploy elsewhere. Buffett announced at the Berkshire shareholder meeting two years ago that See’s Candies has now allowed Buffett to make over $1 billion worth of capital decisions elsewhere, because the company has low reinvestment needs and the kind of profits that can be taken out of the business without comprising the company’s long-term competitive position.

Technological advancement is the friend of the long-term investor, but is much less kind to the long-term worker. I’ll share with you a story involving General Electric that might be illustrative.

If you click on this Washington Post article ( http://www.washingtonpost.com/wp-dyn/content/article/2010/09/07/AR2010090706933.html ), you will read about how General Electric shut down an American light bulb factory and is saving costs big time by shifting to compact fluorescent light bulbs that are made much cheaper in China. From the standpoint of an American work, that sucks. There’s no other way around that. If you have been assembling light bulbs for twenty years, you may have a limited skill set that makes it difficult to find a job elsewhere.

Because most S&P 500 companies engage in this behavior to varying degrees, that puts a very real pressure on the middle-class in the United States. That is very unfortunate. But it is always our job to structure our lives in the most intelligent way possible.

As an individual, there are limits to what we can due to change the structural employment figures in our country. But as an individual actor, it is our job to make the most of the opportunity costs that lay before us. In other words, our success in life is not measured by creating the environment that we want, but rather, by making intelligent decisions within the reality we inherit. It sucks that GE workers are losing their jobs, but the translation is that General Electric will be able to generate more profits with lower expenditures. That profit ultimately ends up in the hands of shareholders, both in the form of dividends and the earnings that determine the company’s P/E valuation multiple.

This is why companies have been experiencing rising P/E ratios over the past century. It is a reflection of the ongoing fact that profits are higher quality in the sense that they can be taken out of the business without harming the company’s competitive position.

The implication is that we may be entering a golden age of dividends and stock buybacks over the coming two to three decades. Because ongoing costs are decreasing, companies will have more profits available to pay out as dividends and retire blocks of stock via a buyback mechanism.

In Newton terms, every action has an opposite and equal reaction. When a company outsources, cuts pay, and does other actions that weaken the vibrancy of the American middle-class, the silver lining is that shareholders benefit in the form of more profits generated that can extracted from the company.

The gradual shift in P/E ratios from 10 to 17 reflects this phenomenon. My best guess is that over the next generation or two, the increased selling from the baby boomer population will be offset by the fact that further technology gains and productivity increases will allow ever more money to be extracted from these companies.

The take-home lesson is that it is much better to be a part owner of PepsiCo, Coca-Cola, General Electric and so on than new hire for one of those companies earning $40,000-$50,000 per year. All around us, we are seeing companies make more profits with less and less human capital. That is a bad omen for the middle class. The best defense is to acquire ownership in these companies so that you can receive the profits from your ownership holdings to meet your living expenses.