It is my expectation that two things will have a high probability of occurring sometime between now and 2026-2031: The taxes on dividends and capital gains will increase, and interest rates will be at a higher rate than they are right now. Although I echo and agree with the general frustration that any capital gains or dividend tax is essentially a “double tax” on the shareholder who already paid a ~35% tax on the same earnings at the corporate level, I also recognize that this view does not represent the pulse of the republic.
From a historical perspective, dividend taxes tend to settle somewhere in the 30% range, and I would plan accordingly (this prediction will intensify as Peter Drucker’s prediction of an hourglass America due to technology advancements becomes more realized.) I also expect thirty-year Treasury bonds to settle somewhere in the 5% to 6% historical range, compared to the 2.98% prevailing rate.
Both of these elements act as disincentives against the type of slow-growth dividend investing that has performed well over the previous five and ten years. If a company has slow growth, and returning most of its profits to shareholders, it benefitted over the past ten years from declining interest rates and lower dividend taxes that gave shareholders higher returns than they’d otherwise expect due to an expanding P/E ratio. When stodgy companies are 15% or 20% overvalued, that is a much bigger deal than when fast-growth stocks experience a similar type of overvaluation because the former stocks don’t deliver the earnings per share growth that can offset the period when the overvaluation is burned off.
A combination of higher dividend cuts, higher interest rates, and moderate P/E compression may mean that the performance of some healthcare firms, utilities, tobacco companies, telecom stocks, and slow-growing consumer corporations might deliver worse performance from the 2016 onward period than we saw from the 2005-2015 stretch.
This should call to mind the famous Warren Buffett quote in which he stated that he doesn’t pay attention to macroeconomic factors or invest according to interest rate projections because his goal is to buy the greatest amount of risk-adjusted future profits possible. The implicit aspect of Buffett’s argument is that the expanding profits of a well-selected stock will still yield superior results compared to selecting a bond alternative. There is a time when this is not always true–in the late 1970s and early 1980s interest rates crossed 10% and you could very briefly get a U.S. bond yielding 15.2% that would have paid you from 1981 through 2001, but this is something that happens four or five years out of a hundred. At the back of your mind, you should recognize that there is a point at which the interest rates would become so high that bonds would be the most attractive investment you could make, but this is an event that might only happen in two clusters over a lifetime.
But looking ahead for the long term from the current investment point, there are five investment opportunities that immediately come to mind: ExxonMobil, Berkshire Hathaway, Hershey, Diageo, and Tiffany. Each of those companies have very strong balance sheets, great earnings even at low points in the business cycle, and trade at favorable valuations today.
Hershey has its famous 16% return on assets. Berkshire has expected 12% annual near-term earnings growth, plus Warren Buffett sitting on $50 billion waiting to allocate. Exxon has delivered 13% annual returns since 1970, is earning $17 billion at the low point of the business cycle, and is trading at a good price while oil is low. Tiffany and Diageo pay out a decent dividend attached to 10-12% annual earnings growth. If you are investing in a taxable account, Berkshire may be the most advantageous; if you’re in a tax-free account, the starting yield at Exxon probably makes the oil giant the best one to consider.
The moral of the story is simple: You should continue focusing on the blue chips with high earnings per share–that’s what you do regardless of interest rates (except when you reach the crossover point where US bond yields become the most attractive asset class which is so historically unusual it is often neglected entirely from analysis.) But the past ten years have some slow growers with high dividend yields seem more competitive with the faster growing blue chips than would ordinarily be the case. In the future, the amount of foregone wealth from taking the slow growers may be more substantial (with the notable exception being the slow growers that, for whatever reason, trade at a substantial discount).
I mean, Campbell Soup shareholders have received almost 9% annual returns over the past decade. That has outperformed Hershey’s 5% annual returns over the same time span! From 2016 onward, that pattern won’t help. The past decade marked a period in which Campbell Soup grew around 5% per year, paid out a dividend of around 2.5%, and then picked up about 1.5% annualized due to an expanding multiple. That won’t exist going forward–you’ll get that 7.5% earnings growth + dividend in conjunction with mild P/E compression. You’ll be looking at something in the neighborhood of 5-6% annual returns.
Ten years ago, Hershey was trading at 27x earnings. The price has come down to 20x earnings, meaning that the inferior returns at Hershey were the result of 25.9% valuation compression. Otherwise, the business grew by 8%, which is nice considering that the ending period included a $250 million write-off from the Shanghai Golden Monkey acquisition. Hershey won’t be facing P/E compression from this point forward, while Campbell Soup will. And Hershey has superior earnings per share growth by anywhere from three to five percentage points annualized.
This is a good example of why the “past performance does not guarantee future returns” is plastered over the financial industry’s literature; the conditions that enabled Campbell Soup to outperform Hershey since 2005 no longer exist, as the firms have traded places from a P/E perspective (Hershey started the last comparison period expensive while Campbell Soup started it cheap, and now Hershey’s starting point is cheap compared to Campbell Soup).
Oil. Alcohol. Conglomerate. Chocolate. Jewelry. Whichever industry you prefer, you can find something right now that offers you a fair deal. The only thing they require is patience, which is the greatest competitive advantage that a self-directed investor possesses. If you can wait five or more years to see an investment thesis come to fruition, you are investing on more favorable terms than just about everyone else industry. Just about anyone can look at Exxon right now and figure out that the investors of today will do quite well over the next ten to fifteen years. But if you’re running a fund, if you to try and ask yourself the question: Will it do well in the quarter? Year? Two years? That’s a much harder question to answer. At this point, it would shock me if a portfolio of Berkshire, Exxon, Tiffany, Diageo, and Hershey failed to outperform the S&P 500 over the 2016-2026 or 2016-2031 investment periods.