After my recent article covering the role of utility stocks in DRIP accounts specifically and income accounts generally, I was happy to hear from a few of you that you have successfully owned various utilities for 15+ years, and been pleasantly surprised by the steady returns (and occasional S&P 500 index outperformance) that has occurred over the years. For me, I found it interesting to hear that Western U.S. utilities have performed on pace with Southeastern U.S. utilities, something I didn’t find intuitively obvious.
I’ll have to add that to my study list over Christmas–first, is the stereotype of coastal regulation accurate? If so, by how much? And how does this affect the investment returns? If the returns are nearly equal, I wonder if there is some type of valuation differential that could explain the parity. Maybe the presumption of intense regulation for electric utilities in states like California lead to lower valuations, and thus more favorable perpetual reinvestment. And maybe the expectations of loose regulations in the American South lead to higher valuations that diminish the effect of dividend reinvestment when stretched out over decades. Those are my questions, and hopefully I’ll have some answers to that in the coming weeks.
Based on my anecdotal experience with readers, it seems that the stocks chosen for perpetual acquisition and reinvestment in DRIP accounts by retail investors come from a cluster of sectors: healthcare, oil, consumer staples, and even utilities. From what I can tell, the stocks with high long-term earnings per share growth rates that fall outside these sectors tend to be disfavored in DRIP accounts.
I have three theories that might explain why this happens: (1) Companies with high earnings per share growth are often new companies, or involve some type of fast-changing technology that deservedly scares off investors from the thought of escalating their commitment to it; (2) the lower present income offered by faster growing companies discourages people that intend to hold an investment for life, as the income is the only spending outcome they will get from the investment; and (3) the P/E ratios of these growth stocks often hovers outside of an investor’s comfort zone, prompting him to turn off the auto-reinvest or auto-contribute feature.
It is this third option that I want to talk about today. Let’s use Nike as an example, as it is one of the few non-tech companies with a well-documented history of superior earnings growth. As some of you already know, it is one of my favorite two or three dozen companies in the world. It has an astonishing large market–everyone in the world could potentially be a Nike customer at some point in their life. It has a very strong brand that translates into the ability to charge strong prices. And because of its lucrative deals with athletes around the world, it has global appeal and is able to easily enter and then thoroughly dominate any market it enters (compare this to another of my favorite companies, Hershey, which knows that branded chocolates have existed for perhaps centuries in every country it enters, and must grow through acquisitions because a Hershey is not guaranteed to ever mean something to somebody in China).
Since 1980, Nike has grown earnings per share at over 20% annualized. The growth has been generally consistent, as I can’t find any year in the past twenty-five in which Nike delivered year-over-year earnings per share declines. And most importantly, the company is achieving strong sales growth (north of 15% annually since 1995). Some companies have to financially engineer to achieve earnings per share growth, like IBM. Others, like Procter & Gamble, deal with volume declines anytime it tries to raise prices. And companies like McDonald’s are tied to specific price points with their customers that make it difficult to hike up prices (although they compensate for this by having strong control over their supply chain).
Nike is immune from much of this. It can raise prices by 8% in a given year, and still see product demand rise 8%. It is actually delivering remarkable growth right now for a blue-chip enterprise, but some of that has been masked by the strength of the U.S. dollar. For instance, in the past 12 months, it has sold 9% more stuff in U.S. dollars. That has translated into earnings per share growth from $2.97 in 2014 to $3.70 in 2015, for a gain of 24.5%. But this is actually understated. The reported sales growth of 9% is really 17% when you hold the currency constant, as that reflects the growing demand for Nike products in countries like Mexico and Brazil (it just has diminished results when the native currencies are translated back to U.S. dollars).
It pretty much has everything you’d want in an investment. It has low debt, as the $1.2 billion debt balance only represents 8% of capital. And it didn’t borrow because it needed the money–it borrowed because the interest costs are so low. Nike is only paying $32 million in cumulative long-term interest over the next five years. The dividend payout, which has gone up by 17.5% annually for the past ten years, is still in the 20% range. That is a wildly successful statistic–earnings are depressed a bit due to the strength of the U.S. dollar, the dividend has been growing wildly fast, and the payout ratio is still quite low.
The athletic apparel firm has grown revenues from $13 billion in 2005 to $30 billion in 2015, and the share count has simultaneously decreased from 1.0 billion to 857 million. It has created an environment in which profits per share have been able to climb from $1.12 in 2005 to $3.70 in 2015. It really is a money machine. And it is sitting on $5 billion in cash, which is over 5x the debt load and could facilitate some bolt-on acquisitions (on the other hand, the cash load has generally stayed between $3.5 billion and $6 billion since the Great Recession, and this might just be the comfort zone for the Nike Board).
Yet, when the actual practice of dripping into a stock like Nike comes up, I imagine that many retail investors turn off the DRIP and stop adding to their position or reinvesting the dividends. My basis for this comment is that, frequently on Seeking Alpha, board member participants will disclose that they stop adding to their DRIP accounts when the P/E ratio for a stock starts to drift beyond 20x earnings.
I understand the value in staying disciplined. There is a point at which the P/E ratio for a stock gets so high that it harms returns. If you did something like pay 60x earnings for Coca-Cola in 1998, your annual returns are in the 3% range and you have basically kept your purchasing power intact to match inflation (while earnings no actual real-life gains for your 17 years of patience).
But it is an art to figure out when this moment arrives. For the companies that are growing quite fast in your portfolio–I’m talking the 15% to 20% annual earnings per share growth range–I don’t think the DRIP should be shut off until the P/E ratio hits 30x earnings on a normalized, constant-currency basis.
Why? Because even at this point, the rewards of owning a firm like Nike, Visa, or Brown Forman while they traverse through their golden ages deliver so much earnings per share that it offsets the elevated P/E ratio in such a way that you still end up beating the S&P 500.
Imagine this. You were dripping your Nike account dutifully in 1995, when the price of the stock was a bit over 20x earnings. You knew the enterprise thoroughly, happened to be aware of the excellent long-term returns, and forecast great things in the future. The potential decision? In 1999, when America was partying and drinking the eggnog from the dotcom bubble, the valuation of Nike crosses 30x earnings.
It was paying out $0.12 in dividends, earning $0.42 per share, and trading at a split-adjusted $12.60 per share (when I say split-adjusted, I mean that I am adjusting all the figures to account for the 2-for-1 stock split in April 2008 and the 2-for-1 stock split in December 2012). If you were at a Bloomberg terminal in 1999, you would seen Nike trading at $50.40 per share and earning $1.68.
It would not have been stupid to stop adding to the Nike position at this point, as it had been engaged in international commerce for two decades and had already seemed to saturate the American market. If you put yourself back in the position that existed then, it wouldn’t have seemed like a dumb thing to do.
But the thing to remember is this: The subsequent earnings growth was so extreme that you would have been wise to keep adding even through the periods where the valuation seemed to get high. Take the 1999-2012 measurement period. This marked a moment when earnings per share grew from $0.42 to $2.37, and the P/E ratio of the stock decreased from 30x earnings to 20x earnings. You had 33% valuation compression, but the earnings growth continued to be quite strong.
What were the results? Someone that bought Nike in 1999 ended up with 11.1% annual returns, turning a $10,000 investment into $41,500. If you would have dumped your money into an S&P 500 index fund instead? You would have gotten 2.5% annual returns, turning $10,000 into $13,900. Nike was expensive, and it increased wealth fourfold while the S&P 500 index investor didn’t even eke out a 50% gain yet. If you are going to participate by adding fresh funds in an elevated market, it makes sense to stick with the companies that you perceive as having the highest long-term earnings per share growth rates.
Now, of course, if you measure Nike from 1999 through this day, you would have 15.6% annual returns and that $10,000 investment in 1999 would be worth $109,000 today. The same amount put into the S&P 500 would be worth $20,800, for a 4.5% annual gain and a doubling of your money over sixteen years.
Valuation is important. But when you own a fast-growing company, you will see the P/E ratio of the stock get a bit higher than you’d like during good economic conditions, as the earnings per share climbs and the outlook becomes rosy. If you’re capable of holding cash and buying back during a recession, of course that creates superior results (Nike has delivered 31% annual returns since the worst of 2009, turning $10,000 into $61,000 in just six years).
But continuing to put a couple hundred bucks into a firm like Nike each month, even when the P/E ratio is a bit higher than you’d like, isn’t a decision that you should rule out. Even when the measuring period was bad, such as the 1999-2012 comparison period that saw Nike’s valuation compress 33%, the total returns were still 11.1% annualized. If the S&P 500 is expected to deliver 10% annual returns over the long term, paying a price a bit outside the comfort zone for a company with truly great prospects isn’t a decision you should write off. Munger was right when he said that you should focus on finding the firms with the greatest earnings per share growth characteristics, and holding on for the ride for a long time. But it will come with periods in which the valuation gets elevated, and this is something you should probably be willing to tolerate provided you have a high certainty of the firm’s earnings per share growth prospects. Buying Nike at a high valuation will still go on to outperform many slower growing companies that appear reasonably valued today.