Investing On The Eve Of Crisis

Lately, I’ve been doing some back-testing to try and find good answers to the following: (1) What if someone invested a lump sum in 2007 right before the financial crisis, and (2) what if that investor paid an unusually high premium for the stock even during a period of high valuations? It’s been my way of challenging the Benjamin Graham thesis that investors should focus on getting the price above all else. I wanted to test scenarios to see what happens if treated quality as your primary concern, and regarded price as a secondary matter (you can never truly get past “price matters” because paying something like 50x earnings for Coca-Cola in 1998 will take 25 years to burn off, but you can test what happens when you pay 25x earnings for a high-quality stock instead of 20x earnings.)

My testing gave me renewed appreciation for the likes of Hershey, Colgate-Palmolive, and Brown Forman. Those companies aren’t featured nearly as often as they should be because their dividend yields are low and their valuations always look a little bit higher than you’d be comfortable paying on a P/E basis.

But still, let’s take a walk through the merits. These are the types of companies that are distinguished from other blue-chip stocks because you have the combination of 50+ years of profitability mixed with high revenue growth right now.

Imagine, though, taking a look at Hershey in the summer of 2007. It would not have been especially cheap. The P/E ratio for Hershey was almost 24x earnings, and the valuation of the S&P 500 in general was 19.5x earnings. And, although you would not have known it at the time, the world was about to plunge into the worst economic catastrophe since the 1930s.

And here is what happened—Hershey saw its profits go from $480 million to $430 million during the worst of the financial crisis while Hershey’s management raised the dividend payout from $260 million to $280 million. On a per share basis, earnings per share went from $2.08 to $1.88 and the dividend went from $1.14 to $1.19. There were some high-quality companies that actually grew their profits during the financial crisis, but still, Hershey stock fell squarely into the category of businesses that are a delight to own during adversity. The company has been the embodiment of safety—profits remained intact, and the dividend remained strong.

Now, here is where things get interesting: In the years coming out of the recession, Hershey grew revenues by 7%. That is very impressive for a blue-chip consumer stock. Usually, mature brands like Coca-Cola, PepsiCo, Kraft, and Nestle investors look for 3-5% annual revenue growth. And they are the best of the best. Clearly, there is something special about the Hershey brand that gives it such a strong foundation for revenue growth (hint: Reese’s is one of the most profitable per unit consumer products that are purchased on a daily basis throughout the United States.)

The 7% revenue growth is something that Hershey has been able to turn into 10.5% annual earnings per share growth. The calendar year 2015 may be the first year in Hershey’s history that the company makes $1 billion in annual profits, although the analyst consensus calls for $980 million in 2015 profits so we might have to wait another year. But still, the ride is fun for Hershey’s long-term investors: The profit engine grew from $480 million in 2007 to the $1 billion range in 2015, plus you got an extra earnings per share boost as Hershey repurchased 10 million shares between 2007 and 2015. And you got to collect dividend payments each year.

Hershey has come down 15% in recent months and now trades at $93 per share for a valuation of 21x earnings. That is a nice price point for a company that is going to raise the dividend payout significantly each decade and deliver strong capital gains as the earnings per share advance at a rate of nearly 10% annually.

The appeal of something like Hershey is that each dollar deployed converts to a significant amount of wealth. Let’s say it makes $980 million in profit this year. It is expected to generate those profits from revenues of $7.8 billion. That means for every dollar of Hershey’s candy sold, over 13% trickles to shareholders as profits free and clear. That is the hallmark of an excellent long-term business.

And if you buy Hershey, there is a low risk of the company ever being bought out. The company is owned by the Milton Hershey Trust, which administers orphanage and schooling for Pennsylvania children. The Trust relies on Hershey dividends to fund operations. If you merely looked at the common stock, you would see that the Hershey Trust owns 7.9% of the common stock.

But that does not tell you the full story. The common stock is split into two-voting classes, the A shares and the B shares. If you are put in an order through your brokerage to buy Hershey, you are buying the A shares. With the A shares, you get “1 vote” for each share you own, and you are entitled to elect 1/6 of the Directors. With the B shares, you are entitled to “10 votes” for each share you own, and you get to collect 5/6 of the Board of Directors. The B shares collect a 10% lower dividend payment, and the B shares are 99.9% owned by the Hershey Trust. This makes Hershey practically immune from a takeover.

Furthermore, the Attorney General of Pennsylvania would have to approve a takeover (it was part of Milton Hershey’s deal back in the day to receive government land at a discounted price to build chocolate factories, and in turn, he pledged Hershey’s allegiance to Pennsylvania by giving the Attorney General the authority to veto any takeover deal that the Hershey Trust agreed to enter.)

I should clarify that I can think of scenarios in which Hershey might be subject to a takeover. Warren Buffett could very well offer the Hershey Trust a 50% premium to take control of Hershey, and he could get the Attorney General of Pennsylvania to agree to the deal by engineering it similar to the Kraft-Heinz deal in which Buffett/3G would take 51% ownership of the company and the other 49% would remain publicly traded and owned by existing Hershey shareholders (including the Hershey Trust B Shares.)

If there was a pledge to keep the headquarters in Pennsylvania, I could see something like this potentially happening. The Pennsylvania public, though, has been sensitive in the past to any suggestions that the Hershey Trust diversify its assets or dilute its ownership of the company, and past history would indicate strong public resistance to such a move. On the other hand, no one would have thought 3G capable of Anheuser-Busch in 2008, so who knows. The politics of this situation is foggy enough that I can’t offer a prediction, although I can note that buying out Hershey is significantly more difficult than other S&P 500 firms.

The point, though, is this: Since the summer of 2007, shares of Hershey have compounded at 10.7% annually. Shares of Colgate-Palmolive have compounded at 11.9% annually. Shares of Brown Forman have compounded at 15% annually. A small portion of that is illusory—for instance, Brown Forman is probably due for a 20% price haircut that would take the compounding rate down to 13%–but the merits that these companies were great investments even at high valuations on the eve of crisis is still pretty sound.

In financial commentary, there are a lot of people who argue that you need to guess the directions of markets in the short term correctly in order to make money and find financial security. That is not the case. While it is always going to be true that buying during years like 2009 will yield better returns than years like 2007, you can still choose investments that provide satisfactory returns even if you make your initial purchase at a high peak.

Graham is right that finding stocks with attractive valuations will always ensure success, no matter the general market conditions. Do you really think someone buying Exxon at $85 per share right now is going to have any regrets 20 years from now? But Graham’s argument does deserve elaboration and acknowledgement of other circumstances that can lead to success. With blue-chip stocks, paying a slightly higher price than you’re comfortable with can also work out if the company has strong revenue growth.

I know there are people reading this who can rationally appreciate the appeal of paying over 20x earnings for something like Hershey or Brown Forman but have trouble actually doing it in practice. If you are wired to get deals, some of the stimulation is lost when you know you are paying full price for a stock.

If this is you, the best way to modify your general temperament is to do a one-time paired purchase and see how it works. Say you do something like buy Hershey at $93 and buy Chevron at $103. You’ll get the high yield and value from the Chevron purchase, scratching your itch to get a bargain. Simultaneously purchasing Hershey will give you the opportunity to see what it is like to own a best-in-breed stock with high revenue growth.

About 80% of Hershey’s sales occur in the United States, and it is much newer to the international growth ballgame than many of its peers (especially Nestle). Someone who bought Hershey in 2012 saw profits per share grow from $3.24 then to $4.35 today. The dividend also grew from $1.56 to $2.24. The stock price went from $60 to $90. Even in just three years, you get to see the effects of Hershey’s high quality at work in your portfolio.

Someone who paid $60 in 2012 for Hershey stock now has a P/E ratio of 13.8x earnings on the initial purchase of the stock. You wouldn’t want to get in the habit of making decisions based on low future P/E ratios because it can be used as an excuse to overpay for things, but it can be useful to demonstrate how quickly today’s higher-than-comfortable price can turn into tomorrow’s bargain of nostalgia that makes you think, “I wish I would’ve bought Hershey at $60 in 2012.” Well, most people in 2012 were commenting on the 21x earnings valuation as being expensive.

The advantage of owning a company like Hershey—which hasn’t had more than two years in a row of profit declines during the past generation—is that constantly growing profits per share drags the intrinsic value of the firm forward and constantly raises the justified valuation for the stock. There is no guarantee that a stock will trade at its fair valuation, but regularly growing profits at least mitigate the risk of a falling stock price in the event something happens in your personal life and you have to sell the stock. It’s a nice hedge against the unpredictable.

A similar story exists for Colgate-Palmolive, Brown Forman, Visa, and a few others. The blue-chips with high revenue growth are very easy to ignore because of their low initial dividend yields and the appearance that they are never on sale. It’s when you model what happens to these companies before, through, and after a crisis that you develop a respect for their role in portfolio construction and realize there may be more value in paying a full price for some things rather than getting bargains on others.