The Blue-Chip Stocks People Ignore

Here’s some Rodney Dangerfield footage to get the mailbag questions started, because I’m going to be talking about the companies that don’t get no respect.

http://www.youtube.com/watch?v=m4qe4QcymLM

From reader Klaas:

“Hello Tim,

I admire your articles and investing philosophy quite a bit!

My question/comment is in regards to the stocks on your Master List of Stocks that I have never heard you talk about.  I would love to hear your comments on the un-mentioned stocks on your list.

Best of luck to you!”

 

There are usually three main reasons that explain why a company may be perfectly excellent—something I would want to hold for my entire life, but nevertheless, doesn’t get a whole lot of attention of this site.

My seeming neglect is usually due to one of three reasons:

(1)   The company on the “Master Stock List” is substantially overvalued

(2)   The company contains some kind of irregularity that would need its own analysis

(3)   The company’s management team does not impress me as much as the business model

(4)   The company is not particularly accessible for use as an example.

Let’s talk about the first element—overvaluation. The entirety of our investment returns will always be entirely dependent upon the price that we pay for the stock. General Electric currently trades for $27 and will mail you a check for $0.19 every ninety days for each share of the stock that you own. Someone that paid $50 per share at the changing of the millennia is going to have substantially different results than someone that paid $6-$12 per share for GE during the worst of the recent recession.

Take two companies whose business models I love: Brown Forman and Hershey Chocolate. Both of those companies will exist and be profitable twenty years from now, barring some extreme black swan event or gross mismanagement that I cannot currently fathom. Brown Forman has a very extensive portfolio of alcoholic brands, ranging from Jack Daniel’s to Southern Comfort to dozens of beverages I’ve never even heard of, that allow the company to keep chugging along and grow profits because beverages can be a very lucrative area to invest when you’re dealing with well-branded products that have strong distribution networks.

But here is the catch. Brown Forman is currently priced the same way it was during the tech bubble. Right now, Brown Forman costs $75 per share (I’m talking about the Class B shares). By the end of the year,  that share will represent $2.90 in profits. That means the company is trading at 25-26x current earnings. Basically, you are buying a 3.86% earnings yield plus growth. It could work out well for investors the next ten years if everything goes well, but that is speculation, not investing.

 When I put money towards something, I want the odds to be in my favor. Take a company I’ve made no secret about purchasing—BP oil. I primarily bought it between the $39 and $41. The company pays out $2.28 in dividends, and makes overall profits of over doubled that amount. Although search engines and stock screeners will note that BP is making $7-$7.50 in profits, it’s really only making over $5 per share in sustainable profits. But that’s not bad, considering the dividend is still well covered and the price is only $46 per share. When you buy a share of BP, you get a 10.86% starting earnings yield plus the future growth of the firm. Yeah, it’s more cyclical than Brown Forman so the comparison isn’t exactly apples to apples, but BP is paying a higher dividend per share than Brown Forman is generating in profits per share, including the retained earnings that the company keeps. That’s why I write about BP non-stop and haven’t touched on Brown Forman at all—the odds of investing in BP today are so much more favorable than investing in Brown Forman today.

The same type of analysis could be applied to Hershey and a few others at current prices. Around Halloween, Hershey was crossing the $100 threshold and coming up 30x earnings. Now, it’s retreated  a bit to 27x earnings. In the long run, people will demand a 20x earnings valuation because that is usually what high-quality non-cyclical blue chips sell for in normal times. I don’t want to pay 20%, 30%, 40% premiums for excellent companies because that means the returns I experience will be less than the earnings per share growth rate of the firm. And, if you overpay by that kind of amount, a few years of 4-5% growth would actually result in merely breaking even on your investment.

That’s one reason why Brown Forman and Hershey don’t get many mentions in my articles—their prices are so high that I’ve avoided discussing them now because they wouldn’t be good investments today. That’s why I’ve slowly been phasing Colgate-Palmolive out of my writings as its valuation has been approaching 25x earnings. The underlying business is excellent, but the returns you’ll experience over the next 5-10 years will likely be less than the growth rate of the company because of the elevation today. That’s why I don’t mention them—you’re not setting yourself up for good medium-term returns if you buy today, and you’ll do poorly if those companies grow less than 4-5% in the next 5-10 years.

The second kind of company that doesn’t get mentioned is an excellent long-term holding that has certain irregularities that would need to get referenced. A company on this list would be something like Pfizer. It would be hard to use Pfizer as a shorthand example for anything because I’d have to discuss the dividend cut of 2008-2009, the nature of owning a company that is heavily reliant on patents and new drug production, the reason why it is more important to use cash flow analysis rather than earnings per share analysis when discussing drug companies, and so on. All of those factors would be useful in an article strictly dedicated to analyzing Pfizer, but it would be hard to quickly mention Pfizer as a side point when I’m talking about general principles. Plus, the shares are fairly valued (maybe 5-10% overvalued) so I haven’t felt a need to discuss.

The third element has to do with a company’s business management. Take companies like Kraft and PepsiCo. The individual brands that make up those businesses are excellent, and I don’t think it’s crazy to think they will exist in a profitable way 100+ years from now. Potato chips, soda, macaroni and cheese, and so on, are remarkably resilient through the years (also, both companies have an incredibly deep bench of brands—visit the company’s websites and look at the total brands under each corporate umbrella, if you want to be amazed).

But the management teams at both companies disappoint me. The timing of the stock buybacks, the sale of excellent individual businesses, acquisitions that issued stock during a recession, and so on have not impressed me with these two companies, and I haven’t discussed either one much for that reason. If I think Coca-Cola is being managed competently and Pepsi has excellent brands dragging along borderline incompetent management, and Coca-Cola is trading at a slightly cheaper valuation, why wouldn’t I spend all my time talking about buying Coca-Cola stock? If I had already owned Pepsi or Kraft, I would continue to do so, but since I like to write about intelligent things to do now, I don’t see much of a reason to discuss excellent businesses that lack excellent management when I can talk about great companies that have great management teams.

And lastly, there are some companies like Becton Dickinson and McCormick that I don’t discuss much because their business models aren’t easily relatable. When I write an article, everyone can relate to Coca-Cola. It doesn’t matter if you are reading this from Alaska, Missouri, West Virginia, Germany, Canada, Ireland, Australia, or Zimbabwe—you know what Coca-Cola looks like and can comprehend its business. That makes it really easy to use as an example.because we all know what it means. If I started talking about Becton Dickinson’s supply chain of medical devices or the spices that McCormick is shipping, I might start to lose people because those businesses aren’t as easy to picture, and it would make my points less effective.

It’s all contextual. For instance, Disney is an excellent long-term holding. But it only pays out its dividend annually and spends 4-5x as much money on buybacks as dividends. The money is a cash machine, and shareholders are getting rich. But it’s not quite as easy to talk about as Johnson & Johnson, which pays out dividends every 90 days, and they go up by 7-10% each year. In a diversified portfolio, the difference between the two companies will become a distinction with a difference. But when you’re just starting out, I find it more useful to speak in terms of straightforward income growth. That’s why some companies get mentioned far more than others—when you adjust for valuation, business models, dividend payout styles, histories, and so on—they’re more relatable and useful to discuss.