Donald Yacktman On Investing With Low Expectations

Donald Yacktman once said that investors make serious money when there is a mismatch between an investor’s assumptions about the future of the company and the expectations of the general investor community at large. A lot of times, this shows up in the P/E ratio of the stock. Take Hershey for example. It is aggressively raising prices by 8% in a typical market, and volumes are still growing 3%, 4%, or 5%, depending on whether you use trailing, current, or short-term future expectations to make your projections. All in all, it is working its way through a high point of a cycle where profits could be growing around 12% per year during the 2016, 2017, 2018, and 2019 period.

The problem? The current P/E ratio of the stock already reflects this better-than-usual business performance because Hershey usually trades at 20x earnings but now trades at 27x earnings. That jump of 7x earnings is why the mere recognition that Hershey is performing well right now is not enough to deliver satisfying results. The deep success comes if: (1) Hershey grows by more than 12%, (2) you hold for a very long time and the “terminal” growth rate is higher than current investors price into the stock, and/or (3) the valuation of the stock continues to increase, and Hershey trades at 35x earnings or something like that.

Number one is hard to achieve because the expectations are already so lofty, and number three is something that falls into the luck category and shouldn’t form the basis of an investment thesis (it is okay to bet on a stock going from undervalued to fair value because it deserves that result but it is not intelligent to bet on a stock becoming overvalued because you are relying on others to act irrational). Number two is the best reason for buying something like Hershey today—you would expect nice growth for many years to come, and the eventual P/E ratio compression over the years would be more than offset by earnings growth.

One of the reasons why value investing has a strong following among long-term investors is because you get to benefit from two things when you buy an undervalued stock—you get to capture the returns of the business growth and you get favorable changes in the P/E ratio that are due. Of course, whether you are dealing with cheap, fairly priced, or expensive stocks, you get to keep the dividend. But the dividend has a special effect when the stock is cheap as it, too, can get reinvested at a lower price and benefit from earnings growth and P/E expansion.

If it is such a superior form of investing, why doesn’t everyone do it? Because it can require significant patience. Take Abbott Labs for example. During most of the 2000s, the price of the stock barely budged. It was a situation where earnings would grow 5%, 7% in a given year, and the price would barely inch forward despite the pharmaceutical company’s P/E ratio falling within its historical range, as well as a range in the mid-teens that seemed intuitively appropriate. The valuation went from 18x earnings to around 14.5x earnings, and this meant that shareholders treaded water for much of the decade, not capturing any of the earnings growth and only collecting the dividend payment.

That changed with the Abbvie spinoff (usually, a spinoff, a substantial dividend raise, or truly exceptional earnings growth can act as a catalyst that can drive the price of a stock towards its fair value if it had been slumping for years on end). If you had held onto your Abbott Labs shares over the past ten years, reinvested the dividends, collected the Abbvie spinoff shares and reinvested those dividends, your compounding rate would be north of 13.5% (note: most online calculators do not give figures that properly account for the Abbvie spinoff. This includes Yahoo! Finance).

What is the wisdom in this approach? You received your dividends, reinvested them at a price lower than what the company would be worth, got to capture the earnings growth, and got to experience P/E expansion to explain their returns. Those are the implied benefits when people talk about value investing.

It is an often discussed, rarely practiced, technique that makes for successful investing. But it doesn’t have to be a difficult. First, you make a list of all the companies that would be suitable to be held for a lifetime or so. I guess most people would come up with between forty and one hundred names. With some stocks, like Delta Airlines, you probably won’t have an interest in owning at any price because there is no assurance that profits will be higher twenty years from now, if the business will exist at all. Your list will probably be stuffed with names like Coca-Cola, Diageo, Nestle, PepsiCo, Colgate-Palmolive, Procter & Gamble, Johnson & Johnson, and the other usual suspects.

Then, you apply the second step to your analysis. Ask yourself the question: Which of these companies will experience P/E expansion over the coming five to ten years, and which will probably have a steady P/E ratio or even see it contract in the coming years? You will look at an excellent company like Church & Dwight, see the 28x earnings valuation, and decline to buy now because the valuation will creep towards 18-22x earnings over time. You will look at companies like Exxon, Chevron, BHP Billiton and likely conclude that the P/E ratio is more likely to expand than contract with the passage of time. Those are likely good candidates for investment. The double-screen of quality then value helps you avoid buying cheap trash or great companies companies that will deliver disappointing returns because of valuations that had to come down.