The old Philip Morris is such an important case study that offers so many lessons for investors into the nature of successful compounding because the company went over fifty years of delivering 17% annual returns while only growing the business at a rate of 11% annually. This spread is something I think about quite often because it lasted for so long. It wasn’t simply a case of a stock changing its P/E ratio from 5 to 10 during a short-term measuring period, doubling an investor’s returns. No, this was an example of some permanent condition existing in the equity markets that turbo-charged the company’s returns on a sustained basis over what can be expected from just reading the annual reports and monitoring the annual growth of the tobacco company.
Some of it can be explained by the dividend, in the way that AT&T only grows at 2% annually, but when combined with a dividend over 5%, tends to give total returns in the 8% range over time. But Altria had a long period in the ‘70s and ‘80s when it was heavily diversifying into food companies, and offered a dividend yield in the 3-4% range. Except for recently during the recession, and during the (justified) fear surrounding the heavy tobacco litigation of the 1990s, there haven’t been many sustained periods when Altria yielded 6% or more. In other words, another percentage point or two needed to be explained beyond simply adding up the growth rate of a company and the dividend payments to explain Altria’s returns: In this case, the added wealth came from dividends that got reinvested when the stock was trading for a price below what it was worth.
Professor Jeremy Siegel, from Wharton’s Business School, refers to this effect as “the bear protector” and the “total return accelerator” aspect of dividend investing. Siegel said, “There are two important ways that dividends help investors in bear markets. The greater number of shares accumulated through reinvested dividends cushions the decline in the value of the investor’s portfolio. It is because of additional shares purchased in down markets that I call dividends the ‘bear market protector.’ These extra shares do even more than cushion the decline when the market recovers. Those extra shares will greatly enhance future returns. So in addition to being a bear market protector, reinvesting dividends turns into a ‘return accelerator’ once stock prices turn up. This is why dividend-paying stocks provide the highest returns over stock market cycles.”
Most people are conditioned to treat companies that have low volatility as expressing a desirable holdings, particularly for the retirement investor. I understand that sentiment. In the past twelve months, Southern Company has traded between $40 and $47 per share, and the tightness of that volatility is in a form that most investors would like—the price of the stock marches up! It’s not volatile because expectations are pretty clear with the holding: you can calculate earnings per share for electric companies pretty easily (unless they’re on an acquisition binge or have significant outstanding rate increases that will be resolved in a tight timeframe). You get your $0.525 quarterly dividend that goes up a bit each year. It’s very…bondlike, but with the rising income. I understand why that’s highly appealing—if you’re in your 70s, you don’t really want to see your paper wealth—your economic life’s work, go from $450,000 to $320,000 in short order.
The problem though, is that firms like The Southern Company rarely trade at less than fair value, and you rarely get a chance to turbo-charge your returns with dividends reinvested significantly below intrinsic value. Conoco, meanwhile, has swung between $62 and $87 this year, which is a 40% price swing. This is somewhat of a typical year for Conoco and other oil firms, which constantly experience great fluctuations in stock price. Because oil firms tend to err on the side of undervaluation over the course of most business cycles (look up Jeremy Siegel’s IBM vs. Exxon comparisons to see why, but in short: people tend to overreact to bad oil news more than they overreact to good oil news), you get regular chances to buy up extra shares. And if you’re truly enterprising, you may keep some cash on hand to add to your oil stock investments when those price declines come by, so not only do you get reinvested dividends but also fresh cash to boost your future compounding.
On a personal level, I get that people reach a stage in their lives where cyclical investing loses its appeal, to the extent that escalating commitments to the oil industry on the eve of retirement or during retirement may not be desirable. If I were crafting a grand estate-building strategy, it would be something like this: Establish meaningful positions in the oil majors, and spend the 10+ years before retirement using price declines as opportunities to add to shares of BP, Total SA, Royal Dutch Shell, Conoco, Exxon, and Chevron. As retirement approaches within a five to ten-year window, you can take those fat oil stock dividends and use them to independently fund purchases in things like Nestle or Johnson & Johnson which have high internal rates of compounding but don’t experience those profit fluctuations. It corresponds to your stage of life a bit, but if you’re enterprising and seeking to maximize wealth, being aware of reinvested dividends + fresh cash deposits during times of oil stock undervaluation seems to be a useful thing to always keep at the back of your mind.
Originally posted 2014-12-28 08:00:18.