You want to know what you could have bought back in 1989 that would have gone on to perform better than Wells Fargo? The world’s largest sodium bicarbonate producer, Church & Dwight. While Wells Fargo compounded at 14.75% annually since 1989–turning $25,000 into $973,000–Church & Dwight has managed to compound at a rate of 15.95% annually since 1989 to turn the same hypothetical $25,000 investment into $1.284 million today. I could find no year-over-year measuring period in which the profits at Church & Dwight have failed to grow (I reviewed data back to 1995).
I had been slow to cover Church & Dwight much on the site for two reasons. The first is that, by the time I really discovered the company, it was trading at a strong premium. I think I really recognized the strength of the business back in 2014. The problem is that it was trading at $81 per share while reporting trailing earnings of $2.79. That’s a P/E ratio of 29. One of the hard parts of investing is trying to figure out what ought to be the highest price you should be willing to pay for a superior business, but it didn’t make sense to go nuts over Church & Dwight at the time because it was literally trading at its highest P/E ratio in the past thirty years. This was before the dollar really took off, and there was no meaningful distortion in the numbers–Church & Dwight was a classic example of investors overpaying for a high-quality company with strong growth characteristics.
The other reason why I had been slow to cover it is because I have been unsure of how to properly measure Church & Dwight’s moat. When I read Washington & Lee graduate Andrew Kilpatrick’s biography “Of Permanent Value”, I vividly remember Kilpatrick’s remark that Buffett was surprised at how many seemingly legendary American consumer brands lost market share or didn’t have as much pricing power as expected in the early 1990s.
Recognizing that something is a brand is a distinctly different endeavor from recognizing that a company has a strong moat. They are connected, as a strong brand often translates into a strong moat, but there are other variables. Sears is a strong brand–you know what I’m talking about when I mention it–but it in no way possesses a strong moat. Popeyes Chicken is a brand, but it never translates into a strong moat. Yet, Hershey’s is a strong brand that does have a strong moat. This conversation is difficult to have because it involves subjective analysis, but it is absolutely crucial to successful long-term buy and hold investing so it cannot be ignored.
The signature brand at Church & Dwight is, of course, Arm & Hammer. It has been difficult for me to measure the strength of the brand beyond the baking soda division–how strong is Arm & Hammer toothpaste, deodorizer, and so on? I can easily imagine a world in which Colgate-Palmolive or Kimberly-Clark outcompetes Church & Dwight in some of the consumer divisions in which Arm & Hammer operates, and I can also imagine consumers switching to generics during a recession and never coming back.
Yet, I eventually concluded that Arm & Hammer does have a strong moat because it is able to produce sodium bicarbonate at the cheapest cost in the industry. It is Wells Fargo. It is Wal-Mart. It is Southwest Airlines. Whereas Macy’s and Popeyes have weak moats because the brands aren’t terribly strong, they also have weak moats because the fixed costs are on the high side (the gap between operating costs and brand strength isn’t all that wide). And yet Arm & Hammer is the low cost producer with a strong brand, and together, this is what creates a strong moat.
This is why Church & Dwight has delivered 12% annual revenue growth and 16% annual earnings per share growth over the past twenty years. Over the past ten years, annual revenue growth has been 9% and annual earnings per share growth has been 16.5%. The secret is that the business sells products that are repurchased on a recurring basis, has moderate brand-pricing power, and has a substantial advantage in terms of possessing the lowest cost in the industry. When you spend $2 on that box of baking soda, $0.50 of it goes straight to shareholders as residual profits. That’s the secret.
This recent market decline has brought Church & Dwight down into hailing distance of what I would consider the high end of the “zone of reasonableness.” After crossing the $80s in 2014 and the $90s in 2015, the earnings at the business needed to catch up a bit to the lofty valuation. Now, we have a situation where Church & Dwight is trading at $81 per share while being expected to earn $3.70 over the course of 2016. That’s a P/E ratio of 22x earnings–the stock is not on sale, but I can’t think of any time where it has been bad to buy a household goods company with 13% to 16% annual earnings growth at a P/E ratio in the low 20s where it went on to be a source of regret.
Church & Dwight has spent 11 of the past 17 years with a P/E ratio in the low 20s, and during the worst of the recession in 2009, the valuation on the stock only went down to 15x earnings. People know how good this company is, and it doesn’t go on sale much. If I had to guess the ten-year returns for someone who bought Church & Dwight at $81 in 2016 and held through 2026, I’d guess investors are destined for returns of around 11.5% assuming the stock is fairly valued ten years from now.
The joy of value investing is getting stocks on sale and knowing that you can get great returns even with only moderate subsequent business performance. But one of the frustrations of value investing is that you are often dealing with companies that have something wrong and demand patience before seeing eventual earnings growth (and the good case scenario only calls for high-single digit earnings growth in the best case scenario).
Church & Dwight is the kind of stock for people who want to have a part of their portfolio that gets away from that–it is a “growth at a reasonable price” type of stock that can add some balance to a value-focused portfolio.
Companies that deliver strong earnings growth while also having a substantial moat–think Brown Forman, Nike, and Google—also trade at valuations that already incorporate much of that projected growth. The two year stalling of Church & Dwight’s stock price, coupled with the recent broad market decline, has given investors looking for that strong growth kick a chance to catch Church & Dwight trading at the high end of fair value. I have no idea whether the stock will come down to the low end of fair value or tread back towards overvaluation territory from here, but I can guess that $81 is now a price at which prospective Church & Dwight shareholders ought to outperform the S&P 500 index by a percentage point or two over the coming ten years.
Originally posted 2016-01-25 01:01:03.
