Every now and then, I come across some slight spin on an investing truth that I already think I know that makes me see everything in a new light all over again, afresh. Take something like reinvested dividends. I’ve known for about, oh I don’t know, five years now, that the reinvestment of dividends at low prices is one of the reasons why compounding works so well, and has historically had an outsized effect on the returns of companies like Exxon, Chevron, Altria, and Philip Morris International because the dividend payments mixed with attractive valuations give you total returns in excess of what you would otherwise calculate by examining a company’s growth rate and adding the dividend yield.
What I failed to appreciate is that the reinvestment of dividends, provided they are on an upward long-term trajectory, can also provide you with additional compounding benefits while the performance itself is disappointing or falling short of expectations in some significant manner.
Take, for example, the signature company that I mention quite a lot around here, Coca-Cola. Right now as about as unfashionable a time as any in the past generation to talk about initiating a long-term position in the stock because its earnings per share growth rate has not been particularly impressive these past few years.
Since about 2011, the earnings per share at Coke haven’t kept up with the long-term 8-11% earnings per share growth rate that investors have come to expect since Coke became a large-cap American stock. The profits in 2011 were at $1.92, and they only grew to $1.97 in 2012, before advancing to $2.08 and $2.10 in the past two years respectively.
But here is where things get interesting: While Coca-Cola’s growth has slowed down, the P/E ratio of the stock has come down to 18-20x earnings after spending large chunks of the 1980s, 1990s, and even 2000s with a typical P/E ratio in the 25-35x earnings range. Even while the growth has slowed, the dividend keeps rising.
The implication is this: For the truly long-term investor, even this period of slow to moderate growth could be seen as a blessing of sorts because the P/E ratio at which you are able to reinvest your dividends is lower than what it would be if the growth was stronger and the P/E ratio shot up.
Imagine if you are sitting on 500 shares of the stock. When Coca-Cola paid out its most recent dividend on December 15th, the reinvestment price was around $41 for a P/E ratio of 19.5x earnings. That check for $152.50 would have bought you 3.71 shares.
Now, although I don’t believe this will happen, let’s see what would happen if Coca-Cola grew its earnings and dividends by 11% in 2015, and investors responded by getting excited and pushing the P/E ratio up to 27x earnings, in line with Hershey, Colgate-Palmolive, Brown-Forman, and the other blue-chip stocks that are currently performing exceptionally well. That would bring profits up to $2.33 per share, the dividend up to $0.339 per share, and the stock price up to $62.91 per share. If you owned 500 shares at that moment in time, you would receive a check for $169.50 that would get reinvested at $62.91 which would add 2.69 shares to your account. You were acquiring more shares of ownership when the business performance and growth was lower!
Be careful with the takeaways—I’m not saying that Coca-Cola will have a banner 2015, nor am I saying that you want the operational results of the businesses that you own to perform poorly. Instead, what I am saying is this: When you own a share of a business for a very long period of time, you will encounter times when that business has slow, moderate, or no growth. What I find interesting is that when you review decades of reinvested dividends, you will find that during times of so-so business performance you were able to reinvest at a better price than you would get when the company is growing by 8%, 9%, or 11% and the P/E ratio tends to rise rapidly.
That’s why I find myself at odds with the popular commentary surrounding Coca-Cola that has become fashionable of late, with investors say they aren’t buying the stock because its growth has been slower than usual these past couple of years. In my opinion, the P/E provided by a company of Coke’s caliber during this period of slow growth (the 18-21x earnings range) is providing a great opportunity for investors to gradually build a large position in the stock that will be particularly enjoyable once you see years of higher growth accompanied by a P/E ratio that expands into the mid-20s.