The Choppiness of Blue-Chip Stock Market Returns

Because I have previously argued that Hershey is one of the best stocks to buy at today’s valuation, I want to discuss the psychological side of what owning this company for the long-term looks like. Ten years is the shortest period of time that I would regard as a qualifier for a long-term investment, so let’s put ourselves in the shoes of someone that bought Hershey stock back in 2005.

Back in 2005, shares of Hershey were available for $52.50 per share. It was earning $2.28, and someone that bought the stock would have locked in an earnings yield of 4.34% as the P/E ratio was 23. The valuation was little bit high–the kind of thing that might knock a point or two off your returns in the medium term but would eventually be burned off as confectionery brands got acquired, existing chocolate production facilities got expanded, stock got repurchased, and the price of the candies increased.

If you purchased the stock in 2005, you would have seen the price come down a bit to the upper $40s in 2006. Then you would have seen it go to the low $40s in 2007. When the financial crisis hit in 2008, the price of the stock would have come down to the mid $30s. At the worst of the recession in March 2009, you would have seen Hershey stock trade at a low of $30.30.

If you are someone that doesn’t pay attention to the underlying quality of an enterprise, and instead judges quality based on the price other people are willing to pay for your assets at a given time, you would have seen the paper price of your stock decline from $52.50 to $30.30 over four years. The capital loss would have appeared to be 42%. So much for the conservatism of blue-chip investing!

Yet, the enterprise was doing what it always did: sell gobs and gobs of chocolate at such a high price that the stable of Hershey brands generate a combined 16% return on assets. During the worst of the crisis, profits were $2.17 per share. In other words, the world saw the world financial calamity in the past fifty years–the second worst in the past century–and profits were only down 4%.

The dividend, meanwhile, had increased over those four years as Hershey chose to increase its dividend payout ratio from 40% to 50% to encourage its owners to maintain steady hands and remember that the company is an exceptional enterprise despite what the price of the stock was indicating at a given moment. The dividend grew from $0.93 to $1.19 during this period. An investor would have collected $5.50 in total dividends between 2005 and 2009, so the 42% price plummet was really a decline of 31.8% once you consider the cash shipped from Hershey, PA headquarters to shareholders around the globe.

And then, the recovery of 2010-2013 happened. After keeping prices of chocolate steady between the summer of 2007 and the middle of 2010, Hershey began to test the pricing power of its brands by increasing the price of the chocolates 5% here, 6% there. Volumes still grew 4.5% despite these price hikes. As a result, earnings went on a tear: profits of $2.55 in 2010, $2.82 in 2011, $3.24 in 2012, and $3.72 in 2013. The price came quickly–the stock almost double in 2010, and then doubled again between 2011 and 2013.

The business itself has performed in line with expectations over the past ten years–you bought something that was of obviously high quality and saw the profits grow from $2.28 to $4.15 while the dividend grew from $0.93 to $2.332 over the same decade span. While the type of earnings growth was predictable, you should always remember that the delivery of capital gains is wildly unpredictable. Between 2005 and 2009, Hershey stock compounded at -5% annually. You saw a third of your money disappear. Between 2005 and 2013, the same Hershey stock compounded at 9.3% and more than doubled your money. Over a full business cycle, you can predict what will happen, but the method of delivering those gains follows no obvious pattern.

And the crazy thing? Hershey is one of the most predictable businesses in the world. It is easy to understand, it is easy to predict, and it never deals with cyclical swings. As I mentioned, investors only saw a 4% decline in earnings between 2005 and 2009. And yet, even for a company of this caliber, the gains themselves were unpredictable.

People need to divorce themselves from the notion that the stock market delivers gains in a neat and tidy fashion. Somewhere along the line, a good number of people got the idea in their head that each investment is supposed to go up tidily 10% annually, or in a neat 8-12% band. No, that’s not how it works. You will have years of losses, some of the sharp in magnitude or moderately dull but lasting years, and then it will be overcompensated for during the good years.

That’s why I recommend things like Royal Dutch Shell at $50 or BHP Billiton at $30. It’s not based on a prediction that oil will rise in the next year or so—I have no idea. Instead, it’s based on the fact that commodities will be materially higher over the long haul, and this is a heck of a price to absorb that volatility if you can wait things out. From 1926 onward, small-cap value stocks have returned 12.2% annually. If you missed the best six years in the past 89 years? Then your returns were only a little over 8% (hat tip to Jeremy Siegel’s “Stocks for the Long Run” for this data point.)

Diversification across healthcare, energy, consumer staples, and so on is important because industry returns are choppy, and you want to arrange your affairs so that you can benefit from the growth in something like Visa and Nike while IBM and Royal Dutch Shell are trading cheaply (I’ve written before about how Exxon and Coca-Cola are great twin stocks to own in a portfolio as they delivered the bulk of their gains at different points in the past forty years.)

It’s uncommon, but not incredibly rare, for investors to get their hands on something like Hershey for 20x earnings or better. The good news is that the investors of today don’t have to burn off 15% or so overvaluation, so any subsequent price declines would be the result of the stock going from fairly valued to undervalued (the 2005-2009 period marked Hershey going from overvalued to undervalued.) But that does not mean the returns won’t be choppy. Even with a company that has remarkable earnings consistency, the returns at Hershey have been uneven as the bulk of investor returns between 2005 and 2013 happened between 2010 and 2013. You should embrace this choppiness–using the low points as opportunities to add more–rather than giving in to the naivete that volatility among the best companies in the world is something worthy of worry.