Blue-Chip Investing vs. Value Investing: An Illustration

I gravitated towards high-quality dividend stocks because you only have to make a decision once and the ownership process is satisfying in the same way that planting an oak tree on the family farm and watching it grow for decades is satisfying.

Imagine if, around 2002, you learned that McCormick controls 40% of the spice market. You checked out the company’s history and saw that it has a conservative balance sheet, double-digit profit margins, and a dividend history that doesn’t miss a beat. You figure that people will continue to put salt and pepper, among so many others, on their food.

So you buy x number of shares. Well, guess what happened from 2002-2018. Profits grew from $1.26 per share to $4.96 per share, and the dividend grew from $0.42 to $2.08 per share. Literally every year, the profits and and dividends have grown. How do you not love that? You did nothing but supply the initial knowledge (i.e. McCormick is a great company) with your initial capital (i.e. surplus from labor, investments, or other sources) and then had the wisdom (i.e. patience) to sit back and watch every dollar you put in the stock grow into five dollars while the dividend payouts you received also quintupled.

You can see why Warren Buffett gravitated towards long-term, buy-and-hold investing. You combine knowledge with capital once, and then the ever-growing proceeds come your way again and again, while you’re out there planting another oak tree that will set this process into motion with a second, then third, and then fourth investment that share these characteristics so that you have ever-growing cash-generating assets supporting your family here, there, and someday, everywhere.

In contrast, there is Benjamin Graham’s famous value investing, in which you look for businesses selling for .4-.6x and capture a high return if the business value increases to x within a few year timeframe.

Look at business like Harley-Davidson stock (HOG). It trades at $40 per share, yields 3.6%, and really trades at about 10x earnings (the P/E ratio in a stock screener might look a little higher around 13x earnings because Harley is consolidating its Kansas City, MO and York, PA manufacturing facilities.

The unusually low valuation for the stock is due to the fact that people under 45 are not buying motorcycles. In the United States, the overall demand is down 9% per year over the past three years, and the international demand is down 4%. Revenues have remained stagnant for the past decade, as Harley has been able to make up for the decline in demand by raising the prices of its motorcycles by 6% per year and increase the interest rates on its secured loans for the motorcycles by 1.5%.

Over a three-year stretch, there is a fair chance that Harley Davidson shareholders will outperform McCormick shareholders. The P/E expansion of Harley as a 10x earnings stock plus earnings per share growth will probably produce greater movement than McCormick’s P/E contraction from its current perch of 27x earnings mixed with its earnings per share growth.

The value investing strategy relies on the magnitude of the jump in the P/E ratio that will come. If there is a year or two in Harley’s future in which motorcycle sales actually increase, this could suddenly become a stock with a P/E ratio of 16 or 17. If earnings rise to $4.75 at the time the stock trades at 16x earnings, the stock should rise to $76, essentially doubling in value once the dividends along the way are counted.

The catch with this approach is that: (1) you have to identify the highish point when to sell, which is notoriously difficult and can be unsatisfying because you have to sell the asset during the period when it is performing well, which goes against one’s nature; and (2) you have to subject yourself to taxes if held in a taxable account at the time of sale, lowering your future compounding base.

Both strategies can and do work. I also think the station of your life, as well as your goals, will dictate which strategy will be the highest and best use of your resources. If you are trying to amass your initial base of capital, leaning towards value investing is an understandable approach. If you are trying to build a self-sustaining infrastructure that will lay the foundation for a lifetime, it is sensible to lean towards the best-in-class companies that have unassailable competitive advantages and a distinguished history of wealth creation.

Originally posted 2018-05-11 21:35:25.

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