People with over $500,000 in investable assets know that it is a common practice to receive heaps of unsolicited mail from financial advisors, planners, and managers that seek to take investment control over your investment accounts. Between 2004 and 2014, the top quintile of hedge fund managers delivered returns of 10.23% to their clients after charging a 2% override on total assets and then taking a 20% fee on gains over an agreed-upon threshold. This is the realistic best-case scenario, and it involves turning every $500,000 invested into $1.3 million ten years later. Most people that outsource their asset management would be satisfied with these results.
Yet, what catches my attention is the everyday opportunities that present themselves to those who go through life with their eyes open to good business deals–particularly those that do not require you to find the right manager that would put you in the top 20% of overall category performance.
One opportunity that continues to catch my attention is the cheapness of Hershey stock. It doesn’t get nearly as much attention as other blue chips, usually because the initial dividend yield on the stock is so low. Between 1990 and 2005, the average yield on Hershey shares was 1.9%. Given that this coincided with a period in which U.S. bonds, tobacco stocks, telecom stocks, and energy stocks offered triple the yield at various points in the past fifteen years, it is understandable why income investors would ignore something that only paid $190 initially for every $10,000 invested.
But sometimes the prospect of earnings growth is predictable, and the capital gains that accompany such growth is so substantial, that it is worth finding a place for the occasional stock that offers a lower yield than what most income investors would otherwise consider the low end of their comfort zone.
This January, Hershey traded at $111 per share. Now, it’s trading at $84 per share. That’s a stunning 24% drop in less than a year. Hershey didn’t do anything exceptionally bad–it raised prices on its confectionary portfolio by over 8%, and volumes only increased by a point or so. And its acquisition of Golden Shanghai Monkey in China turned out to be an embarrassment, as it projected over $200 million in sales that only amounted to $90 million in sales after Hershey learned that the commercial buyers of the chocolate were not providing as much recurring business as anticipated at the time of the deal.
As a result, prospective investors have the chance to be an exceptional company right at fair value–Hershey trades at $84 against $4.15 in annual profits for a P/E ratio right at 20. People often agree with the Warren Buffett quote that “it’s better to be a wonderful business at a fair price than a fair business at a wonderful price” and then use it to justify something pricey. This isn’t that.
Hershey is trading at a valuation where the earnings per share growth will fully translate into corresponding capital gains, and plus you get the historically high 2.74% starting yield.
Returning to my hedge fund example, Hershey’s earnings have marched straight upward since 1999 (and for the decades previous as well.) If we extended our hedge fund comparison to sixteen years, an investor would get 255% total appreciation. The earnings at Hershey, meanwhile, have increased from $1.05 to $4.15 for cumulative earnings growth of 295%.
The reason why I am focusing on the earnings growth at Hershey, rather than the performance of its stock price since 1999, is because the stock was trading at nearly 29x earnings back then so there has been some downward movement of the P/E ratio that has obfuscated the true growth. Plus, you got sixteen years worth of growing dividends that have combined to nearly quadruple the starting investment amount.
The amazing thing about Hershey is that the business is extraordinarily low cost to produce compared to the retail cost of what customers are actually willing to pay for a Reese’s (to get an idea for the overall cheapness, consider this: Hershey spends a third as much advertising Reese’s through TV ads, online ads, and March Madness sponsorship as it costs to actually produce a Reese’s cup.)
The other company worthy of equal attention among conservative long-term investments is the British distiller Diageo. It made $1.93 in profits back in 1999, selling things like Captain Morgan, Johnnie Walker, Smirnoff, Jose Cuervo, and Guinness (fun fact: back when the company was called Guinness, Warren Buffett owned a huge block of the stock through Berkshire Hathaway and sold it after a quick gain, later calling his short-termism with Guinness one of his top investing regrets in a speech at Stanford.)
Like Hershey, Diageo has a tremendously successful ability to combine three things that I love to see in a long-term investment: (1) it earns high profits per item sold; (2) it can habitually raise prices; and (3) it can keep volumes growing at a strong mid single digit clip over the long haul.
You should note I’m not claiming this all happens concurrently. Sometimes, Hershey and Diageo will raise prices by a good amount, and volumes will just trickle forward. Other years, the prices will remain stagnant, and volume will do most of the increasing. But over most rolling ten-year periods, the growth profile at both firms looks something like this: you get 5-6% sales growth, 8-10% earnings growth, and a dividend around 2%. It is worth noting that the current valuation has the dividend for both firms tilting towards 3%, which is a bit better than you get in most circumstances.
Most of the companies that I have profiled as being attractive–IBM and BP immediately come to mind–are attractive because of their discount to intrinsic value. Once those firms start growing a bit, the excess capital appreciation will come. Hershey and Diageo are different firms–they don’t have much of a discount–but you get a fair price and higher earnings growth. It’s a very high-quality way to make money. Buffett is famous for making his bet that the S&P 500 will outperform the collection of hedge funds in America. I’d like to offer my own version: From November 23rd, 2015 through November 23, 2025, the performance of Hershey and Diageo will outperform the top quintile of hedge funds in America net of all fees.