Passive Income Built During Recessions

On Monday, March 9th, 2009, at approximately 4 PM, someone out there successfully placed a buy order for 10,000 common stock shares out of Starbuck’s then existing 1,460,000,000 ownership pie. This amount of overall ownership was a drop in the bucket. It only gave some guy an ownership claim on 0.00000684931% of the Seattle-based coffee empire. This wasn’t even a large enough investment position for the management to have any idea who you are if you were to show up at the annual shareholder meeting.

But yet, there was something quite special about making an investment in Starbucks on that day. The price of the stock was only $4.15 per share.

I really have no idea what people were thinking as they discarded a company with 15% annual growth for two decades as though the stock certificates were a parasitic piece of trash. The profits of $500 million were actually increasing throughout the last recession–and the five-year earnings growth record was almost 20%. The balance sheet was very strong, with only about $700 million in debt against $1 billion in cash.

The common narrative held that people would give up their lattes and morning routine when discretionary income dwindled. But this intuitive notion didn’t show up in the numbers.

Economists and financial prognosticators often draw up this hypothetical rational man when projecting future decisionmaking. People who overweigh logic in their analyses often underweigh or completely miss the behavioral component.

It reminds of when politicians trotted out economists to curry favor for tobacco tax increases, using rhetorical like: “What are they going to choose, a pack of cigs or feeding their kids?” The cigs won out more than contemplated. The general bromides you hear such as “people will choose their kids if the cigarette taxes are higher,” “people won’t take their families to Disneyland during a recession”, and “People will give up their morning coffee routine when they’re feeling the pinch” deserve more scrutiny. This is my polite way of saying that these arguments are intuitively appealing but ultimately wrong in light of the results during past recessions and regulatory changes.

And the story now?

That guy’s Starbucks shares have paid out $3.10 per share in dividends, a gift that had to be at least someone unexpected considering that Starbucks didn’t pay out a dividend at the time the shares were purchased.

As for the business itself, the earnings that climbed during the recession have continued to climb and the $0.40 per share profits in 2009 are now at $1.85. Over this time period in which earnings more than quadrupled, the valuation nearly tripled as the stock shifted from 10x earnings to 28x earnings.

As a result, the investor that made a $41,500 in Starbucks is now sitting on 10,000 shares worth $530,000 and $31,000 in cumulative dividends that have been paid out over the past seven years. Better yet, he is now collecting $8,000 annually for a 20% yield on cost. Those dividend payments ought to be double within the next four years. This is one of the most extreme examples of creating life-changing wealth within the context of large-cap American businesses.

People say, “Yeah, yeah, that’s hard to do.”

Of course it is. But it is not impossible, and the payoff is so extreme that it is worth figuring out the circumstances that can make it your reality rather than just a story about what could have been.

It comes down to two things.

First, you need to have the available cash. That is one of the reasons why you see the wealthy keep 10% to 30% of their wealth as liquid cash equivalents. When great opportunities arise, you need for there to be a benefit from your insight. Often, you will want this figure to be worth more than a paycheck or two, and that is where a build-up of cash comes in handy.

Second, you need just one insight. There are 15,000 publicly traded corporations you get to choose from. You only need to be right about one of them. I cite the metaphor about there being no called strikes in investing as illustrative of this concept.

The difficult areas are cyclicals and financially distressed companies. The nice thing about Starbucks is that it did not require a leap of faith insight about a return to normalcy. It was excelling even as the stock price plummeted. Profits were growing, the brand was strong, and so was the balance sheet. The stock came down to 10x earnings. On a fundamental basis, what was there to complain about? Nothing. It was just the stock price that caused distress.

Shifting gears, I have noticed in the past two or three years that many dividend growth investors over at Seeking Alpha have written about adding Starbucks to their portfolios. Given its valuation of 28x earnings, but also high growth, I am agnostic on the wisdom of this purchase decision. But I do think people should be aware that a stock that traded at 10x earnings in the past decade is capable of doing so again under adverse economic conditions. The fall from 28x earnings to 10x earnings is a long one, and late entrants better be equipped to deal with the possibility of such volatility otherwise they will lose a lot of money by selling low.

I think Baron Rothschild was right about most great fortunes being built during times of distress. Buying Starbucks while it was dirt cheap allowed you to do in seven years what it would have otherwise taken twenty five years to accomplish. There are definitely undervalued stocks out there right now, but with the S&P 500 at 24x earnings, I see wisdom in setting aside 10% to 30% of investable income as cash and deploying the rest into securities that are undervalued.