Great Businesses That Cause Investors Trouble

From 2004 through 2014, BHP Billiton grew its profits from $0.86 per share to $5.18 per share, and raised its dividend from $0.33 per share to $2.36 per share. Over that same ten-year time frame, Aflac grew its profits from $2.30 to $6.20. And Aflac grew its dividend from $0.38 per share to $1.50 per share over that same period of time. And from 2004-2014, John Deere grew its profits from $2.74 to $8.63 per share, raising the dividend from $0.53 to $2.40 over that same stretch of time. These are healthy businesses in the commodity, insurance, and manufacturing sectors that over time grow profits and raise dividends like any long-term owner would hope at the time that he makes an investment.

Yet, it is my speculation that many shareholders in these companies did not experience the type of returns you would expect from this type of long-term business performance because the price of the stock moved around a lot over the past during this ten-year block of time. BHP Billiton saw its stock climb from $16 in 2004 to $47 today, and yet, BHP Billiton probably destroyed a lot of wealth for people because the stock went from $95 to $24 in 2008. At the worst of it, BHP Billiton saw its profits fall from $15 billion to $5 billion, and management raised the dividend by almost 50% (taking the dividend payout ratio up to 78% from 20%) in an effort to remind shareholders that they owned a profitable firm and should have stayed the course.

In the case of Aflac, the price of the stock increased from $33 to $63, and the company actually grew its profits between 2007 and 2009, raising its dividend each year along the way. Yet, the price of the stock fell from $68 to $10 per share. If I had to name an example of the most irrationality ever seen in a specific stock (on the downside), my candidate would be Aflac. It underwrites insurance, and makes 78% of its profits from selling supplemental cancer insurance to Japanese consumers. It was largely unaffected by the financial crisis, but because it is technically a finance firm domiciled in the U.S., it experienced wild swings in 2008 and 2009 even as profits of $1.6 billion in 2007 grew to $1.8 billion in 2009. The difference between perception and reality regarding Aflac was extraordinary during this two-year stretch.

For John Deere, the price of the stock grew from $28 in 2004 to $87 now, and the dividend has grown every year since 2003 (it was frozen at $0.44 per share in the late 1990s through 2003). Yet, the price of the stock went from $94 in 2008 to $24 in 2009. Profits cut in half—from $2 billion to $1.1 billion, yet the stock lost over ¾ of its value (overshooting is common to companies that experience a drop in core profits as the price of the stock falls by more than the actual decline profits because investors extrapolate recent bad news well into the future). When the dividend increased during this time period, the dividend payout ratio never crossed 40%.

I don’t talk about beta much in my writings because I disagree with the conventional teaching in business schools that treat beta as synonymous with risk. Beta refers to the volatility in stock price compared to the volatility of something else (usually the S&P 500 Index). If the price of a stock has a track of moving faster than the volatility of the S&P 500, it is considered a high beta stock. If it moves less, it is considered a low beta stock. The reason why most academics regard this as a measurement of risk is because if the price of a stock is liable to decline from $90 to $50 in the short run, it carries a high risk of loss if you decide to sell.

I do not adopt that viewpoint because a stock price is a representation of what other people are willing to pay to acquire ownership at a given point in time. Coca-Cola makes about $9 billion in profits per year. My idea of risk is the likelihood that the $9 billion profit engine could be threatened—what is the probability it could fall to $5 billion in annual profits? $2.5 billion? $0? Or stay at $9 billion per year while inflation runs at 3.5% annually? That is my idea of risk—I care about threats to a company’s fundamentals, much less so about the daily, weekly, annual fluctuations in what people are willing to pay to get their hands on an ownership stake in those fundamentals.

But still, the real world does intrude sometimes, especially so when a stock experiences very steep declines in price. People who owned a $300,000 portfolio of BHP Billiton, Aflac, and Deere could have seen their paper wealth come down to the $100,000 mark even though the long-term business fundamentals of those companies have been great (and all three remained profitable during the worst of the financial crisis).

The best remedies against running into problems with these great businesses that could cause trouble for people due to short-term volatility probably look something like this:

Practice diversification. If you have 25% of your net worth tied into Aflac, it can be difficult to remain rational when you see so much paper wealth evaporate. Ideally, even someone with a hyper concentrated portfolio could still remain rational under this set of conditions, but it would be difficult. Stick a decimal in there and limit Aflac to something like 2.5% of your overall portfolio, and the price decline is more like a nuisance or irritant (rather than an impending tragedy or disaster). It’s easier to shrug off the paper loss and study the underlying fundamentals and reinvest the growing dividend when your long-term future doesn’t depend on the performance of one company for your family’s long-term financial future.

Avoid negative self-talk. In the investment commentary industry, there is a lot of groupthink where people on message boards, finance sites, or given communities share the same opinion on just about every stock. The opinions of others are useful when you look for additional facts to complete your analysis, but it should not replace your analysis. Barron’s ran a negative blurb two weeks ago arguing that Chevron would be a poor investment because it has poor medium-term profits for growth. I could read that article and proceed completely unaffected because I have run my own studies on what happens when Chevron yields 4% and those dividends get reinvested. It tends to work out very well.

Likewise, cyclicals like BHP Billiton are known to be very volatile, but the long-term studies show that this volatility (mixed with dividend reinvestment) partially explains why BHP Billiton has returned over 12.5% annually since 1987 because there are regular intervals to reinvest the dividends at a price lower than what the business should actually be worth. However, fluctuating annual profits will always be part and parcel of the case with cyclical companies like BHP Billiton and John Deere. That leads to the third important consideration…

Avoid recency bias. Usually, when a dividend gets cut or a cyclical companies reports a decline in profits, people sell the stock and extrapolate the recent troubles indefinitely into the future. This attitude is what will turn someone into a buy high, sell low investor. When there are recessions, people don’t buy new farm equipment. When tomato, sugar, and grain prices rise, agricultural profits rise and new farm equipment gets bought. That is the way it has always been for John Deere, and will likely continue to be the case for many recessions and expansions to come. That is why I prefer to study companies over twenty-year business cycles (or at a minimum, ten years) to get an idea of how varying economic conditions affect the business over the long term. This leads to more informed thinking than assuming years like 2008 and 2009 will repeat themselves over and over.

And lastly, only purchase ownership positions in businesses you understand. This is where Coca-Cola will make sense for people in a way that Zoetis, the company I recently discussed, might not. In troubled times, it is difficult to get a feel for animal vaccines and medicines to get a tangible indication that the business is real and the bad business environment will be overcome. With Coca-Cola, you could sit on a bench at Wal-Mart and see the Dasani, Vitaminwater, Cherry Coke, Diet Coke, Fanta, Powerade, and Sprite pile into people’s carts. Consumer companies make it easier to bridge the gap between computer blips on a screen like KO, PG, JNJ, and NSRGY and the fact that it actually represents real business ownership. Anything that will mentally tie digits moving on a screen to actual business ownership will likely improve your cognition over the long haul.

We are currently in the seventh year since the S&P 500 has brought down the value of someone’s portfolio over the full course of a calendar year. Statistically, we are closer to a down year than an up year. This isn’t a call for market timing, but rather, preparation for the fact that you want to use the time when stocks are high to evaluate your risk tolerance and make sure what you own makes sense, rather than trying to figure that kind of stuff out during a correction. The truth is that there are some absolutely excellent businesses that see their stock prices erode quickly in recessions, and you don’t want to be someone that sells low only to see that company raise its dividend as profits and stock prices increase in the subsequent economic recovery.