Besides my own personal preferences, there are a few other reasons why I choose to devote this site to the selection of individual stocks for long-term ownership positions rather than long-term index investing. One of them is this: There are times when the collection of stocks that make up a particular index are overvalued, but you can find individual companies within the index that are not too expensive.
For instance, the historical median range for the S&P 500 is a valuation of 14.57x earnings. The historical mean range is 15.52x earnings. Even if you accept the premise that technological and individual productivity gains can justify slightly higher P/E ratios over time due to the implication that more cash can be extracted from the business (thus meriting the high valuations), we are still only talking about a justified shift towards a permanent 16-17x earnings range. Right now, the S&P trades at 19.64x profits. At a minimum, the average stock in the S&P 500 is 13% overvalued. At a maximum, using the historical median range, the average S&P 500 stock is currently 25% overpriced.
In short, at the moment of initiating a long-term investment, we want to avoid overpaying so we don’t inherit a 1966-1981 type of situation in which the average Dow Jones component returned -0.4% annually. It wasn’t that American businesses didn’t grow during that 15+ year stretch, but rather, the growth was soft in the low single digits and the average American stock was overpriced in 1966. Combine soft growth plus valuations with a negative margin of safety, and you end up going fifteen to sixteen years without realizing a gain on an investment. The wise selection of fairly valued or on sale blue-chip stocks can help you sidestep the fate of spending a third (or more) of your investing life without gaining anything.
What is interesting though is that there were some stocks during that stretch that an individual investor could have chosen that didn’t doom you to mediocre returns—heck, the old Philip Morris returned over 21% annually from 1966 through 1981. Johnson & Johnson got you 8% annual returns over that time frame, Coca-Cola got you 7%, Procter & Gamble and Pepsi delivered around 6.5% over that time. The point? Even during times when the stock market is overvalued, there are still obvious blue-chip companies out there that can give you solid returns even if the rest of the market is expensive and companies in general are due for a slow-down in earnings (I say this with high S&P 500 P/Es in mind, and the fact that we have gone five years now without an economic recession in the business cycle).
So what can you buy today that is extraordinarily high quality, boasting a dividend yield above that of the S&P 500, and is not overvalued? To me, a lot of signals point towards Chevron, the second largest oil giant in the country based on San Ramon that currently has a $220 billion market capitalization.
The vastness of this oil giant is truly staggering. It produces 1.81 million barrels of oil and oil equivalents per day. It owns 7.1 billion barrels of oil in proven reserves, and has over 24 trillion cubic feet of natural gas in proven reserves as well. The most recent estimated value of its reserves is $176 billion. It pumps out about $20 billion in annual profits per year. To get a handle on its vastness, you could own the entire Clorox company for $13 billion. Every seven or eight months, Chevron pumps out enough profit to buy out The Clorox Company in its entirety.
It has $16 billion in cash on hand. During the absolute low of the financial crisis, this is a company that generated $10 billion in profit. It’s going to be around for a very, very long time. It has a AA credit rating, meaning there are only three companies in the United States that currently can boast better credit worthiness (Microsoft, Johnson & Johnson, and competitor ExxonMobil).
Viewed independently, the price of the stock has declined 13% since its July highs to currently sit at $117 per share. The current valuation is 10x earnings during a time of slightly weak oil prices. That catches my attention—this doesn’t mean Chevron is on sale, but it does mean that someone buying Chevron today will be buying one of the top twenty firms in the world at a fair price. From my vantage point, there’s nothing wrong with that, particularly when most other stocks are overvalued (for instance, in 2009, I would be more insistent that the stocks I’d purchase would be on sale, for 2014 I’d settle for buying something at fair price as long as the company was of extraordinarily high quality).
We’ve all heard that Warren Buffett quote about the preference for buying a wonderful company at a fair price rather than buying a fair company at a wonderful price. That’s one of those biblical investing quotes that deserves mulling over, again and again. Why would Buffett say something like that? It’s because of this: When you buy a company that is of decent quality at a wonderful price, your advantage is gone once the price rises to fair value. You then have the responsibility to get out of the stock at the right time, and if not, you will be setting yourself up for mediocre returns from the point the fair company reaches fair value onward. The wonderful company, meanwhile, constantly grows and grows. Profits in 2019 will be substantially higher than profits in 2014, and profits in 2024 will be much higher than profits in 2019. Fair value estimates are constantly being revised upward in light of new growth that gets reported. In other words, there is no obligation to leave your position: the longer you hang on to the stock, the more you get rewarded. This is especially true with a company that grows its dividend every year, like Chevron does.
Right now, you can get the stock for a yield between 3.50-3.75%, depending on the price fluctuation. You get double the initial yield of the S&P 500, plus an earnings per share growth and a dividend growth rate that is superior to the average S&P 500 company. Right now, it pays out a quarterly dividend of $1.07 per share. By my estimates, the quarterly dividend will rise to $1.15 per share next year. Imagine putting in a limit buy order for Chevron at $115 per share. If/when it gets executed, you would have an immediate dividend yield of 3.72%. If next year’s quarterly dividend hike is to $1.15 like I anticipate, you will be collecting 4% of your initial investment throughout the 2015 year.
What’s so great about that is you won’t be sacrificing future capital gains for yield. Imagine someone buying Altria right now. For most of its history, it’s been a deeply undervalued stock. Right now is one of the few times when the company is expensive. Yeah, you get a 4.19% yield from Altria right now, but you are losing something as well: The current P/E ratio of the stock is 22x earnings, and over the long-term, it will likely drift towards 15-17x earnings to reflect the risk inherent in volumes declining by 4% and the common-sensical observation that you don’t see people around smoking as much. That risk is not currently priced into the tobacco maker’s stock.
Chevron, meanwhile, has a historically high dividend yield right now. For comparison, during 2008 and 2009, Chevron average a dividend yield of 3.8%. The current yield of 3.6% or so isn’t much below the Recession-era price you could get on the stock. The year 2003 was the only time Chevron ever went a whole year yielding 4.0%. Otherwise, ever year from 1998 through 2014, the average yield was 2.7-3.5% (except for a brief period in 2010 when the stock yielded 3.6%). The current decline in the price of oil and other liquid chemicals has provided a fair value entry point for the stock.
Also, Chevron has the stated objective in its annual report of growing production by 20% between 2014 and 2017, with heavy projects in Australia and the Gulf of Mexico expecting to come on line in 2016 and start affecting bottom-line profits in 2017. To the extent that I can put on my Gretzky helmet and skate to where the puck will be rather than where it is now, I would anticipate significantly higher earnings and dividend payouts three to four years from now when the prices of commodities recover and Chevron’s heavy capital investments start coming to fruition.
The dividends have been growing at 9.5% annually for the past ten years. The payout has been increasing annually for three decades, making it one of only two energy firms in the world (the other being Exxon) that have the vastness of resources and the disciplined capital allocation strategies to keep giving owners more and more money each year, despite operating in an industry (commodities) that must endure significant fluctuations in the products being sold. The long-run total returns are impressive for this company, regardless of the long-term measuring period that you use: the ten-year returns for the stock are 13.13% annually, the twenty-year returns for the stock are 12.08% annually, the thirty-year returns for the stock are 13.27% annually, and the forty-year returns for the stock are 12.86% annually.
In the super short term (next few months to two years), I have no idea what Chevron stock will do. Oil prices could fall to $50 and the stock could fall to the $80s, or oil prices could mark a swift recovery and the price of the stock will be in the $150s before you know it. I offer no prediction for those interested in a short term trade. But, for those looking for safety, growing dividends, and possibly great total returns over the next five to twenty years, Chevron fits the bill.
If you’re in a position to reinvest, those high dividends that are growing have a sneaky way of boosting your income and total returns in a way that is not readily apparent from looking at a stock chart. From 1994 to 2004, investors in Chevron could have gotten a starting yield of 4.0% that grew at 8% annually for the next twenty years. That’s close enough to the conditions that exist today to be analogous. During the intervening twenty years, the price of the stock went up from $22 to $116. Nice. But if you reinvested, you also got 274% of your invested amount in the form of dividends. If you invested $100, you received $274 in dividends over those twenty years. If you invested $1,000, you collected $2,700 in dividends over the next twenty years. If you invested $10,000, you collected $27,000. You get it.
This means that, for those that reinvested, you doubled your share count over that period. Not only did you see each share increase in price from $22 to $116 over the twenty year period, but you doubled the amount of shares to your name that now trade for $116 each. That’s a heck of a boost to keep in mind. Your yield-on-cost would now be 36%, giving you $360 in annual dividend income on every $1,000 invested in Chevron twenty years ago.
A lot of times, the quote about buying a wonderful company at a fair price is used as a justification to buy an expensive stock when an investor lacks patience. Actually, that isn’t the worst strategy in the world, but you’re still forfeiting some of your potential capital gains to the extent that the stock is overvalued. In the case of Chevron, you are getting a fair deal when you buy today. You won’t have a margin of safety in terms of price, but you won’t be forfeiting anything either. You’ll be achieving total returns that mirror the growth of the business plus the dividends paid out. Given the high-quality of Chevron’s business, and given the expensiveness of everything else, that catches my attention. For someone looking to deploy a large sum of capital in something that is safe, has a yield twice the S&P 500, is slated to grow, and isn’t overpriced, Chevron seems like a very attractive candidate for “buy it and forget it” investing right now.
Originally posted 2014-11-06 12:28:21.