Go dig up an old S&P Capital IQ from 2013 and look up the earnings expectations for Coca-Cola in 2018. You will see that analysts predicted the company would make $3.00 per share in 2018. At the time, the stock traded at $43 per share. Afterwards, as volume gains struggled to take foot, and as currency headwinds affected the company because only 22% of profits are made in the U.S., the figure got revised to $2.80 per share. This was a downward revision of 6.67%.
Once these revised downward forecasts began to take hold, the price of the stock seemingly got stock at around $40 for awhile. This marked a downward shift of 6.98% in the price of the stock. It is not a coincidence that the price of the stock corresponded to changes in the five-year growth expectations of growth for the company. Because there haven’t been extrinsic factors affecting valuations in the past three years–no deep changes in the economy, declarations of war, rapid increases in interest rates, or changes in world geopolitics that will still be mentioned fifteen years from now–there has been a clear relationship between the changing expectations of the company’s five year projections and the stock price.
It has something that I have yet to cover in depth in any of my articles, but it is the heart of the difference between medium-term investing and super long-term investing. If I am to make an investment that will outperform the S&P 500 over the next five years, I am going to look for companies that have a high probability not just of delivering the highest earnings per share growth possible, but rather, I am going to look for companies where I have a high probability of being right that actual earnings results will exceed consensus earnings estimates over the next five years.
That is why I tend to like oil stocks as they become disfavored, like they are now. I’ve been gone from writing here at the site for a bit, but I could have just as easily taken the Bart at the chalkboard approach and written Chevron Chevron Chevron while I have been gone. It is, without a doubt, the second most powerful energy company in the world behind Exxon Mobil (Royal Dutch Shell would be #2 but currently has too leveraged of a balance sheet to hold that title, and Total SA has to deal with obscenely high 55% French income taxes, and BP is currently recuperating from asset sales and a historically high debt amount).
Analysts estimates are calling for anywhere from $7 to $9 per share in profits five years from now. Please. The price of oil was $71 per barrel in 2010, and the company still managed to generate $9.48 per share in profits that year. In other words, Chevron can exceed expectations just by a sustained increase in the price of oil from the $50s to low $70s. Plus, the company is making heavy investments in liquified natural gas in Australia that will come to market in 2017-2018, and the added production plus a general expectation that oil will be more expensive should be a recipe for five-year outperformance.
There is also the 5% dividend yield, which is above anything that Chevron has been able to offer in the past twenty years. I’m not as worried about the frozen dividend as others. Between the first quarter of 1998 and the third quarter of 2001, there was only one dividend hike from $0.61 to $0.65 (for full historical appreciation, keep in mind that Chevron split its stock in 2004 so it is more analogous to say the dividend hike was from $.305 to $.325). And yet, the 2001-2015 dividend growth was 345%. Analyzing oil stocks year-to-year, rather than decade to decade, is a great way to sell low and miss great income-generating opportunities.
Chevron is like Fayez Sarofim meets Jeremy Siegel. You have the type of high yield and high quality that Sarofim built a Texas fortune on, and you have the Siegel factors of low valuation mixed with low expectations that set the stage for future outperformance (the rudiments of this philosophy could be seen in Benjamin Graham’s arguments that stocks trading at low book values lead to long-term outperformance because the expectations are so low).
That is why Chevron is a great five year stock, and all things considered, probably a great lifelong holding. But when I analyze a stock for 25+ year estimated holding periods, the type of analysis is different. The primary consideration is not about finding stocks with better five year expectations than general reality, but rather, finding companies that have higher terminal growth rates than expected.
When investors run models that estimate the present value of the stock, they tend to make estimates like the following: “I assume the stock will grow earnings at 8% for the next five years, then 6% for the next five, and then will have a terminal growth rate of 4% after that.” The specific formulas change according to each investor’s preferences and the styles of the investment firms they work at, but the general principle holds: You assume a certain rate for five years or so, a lower rate for the next five or so years, and then an even lower finishing rate.
The secret to super long-term buy-and-hold investing success, then, is finding those companies that have a core engine destined to generate higher earnings than that terminal estimate. Hershey is one of my favorite examples of this. It has earned 16% returns on retained profits that were not paid out as dividends for over a century. At some point, it stops being a coincidence and instead becomes an indication that Hershey is one of the fifty best investments in the world, a perfect candidate to buy and never look back.
The reason why Hershey doesn’t usually get valued at points where it generates returns in line with market averages as a whole is that people still assume the terminal growth rate will come down. They assume that 2020 Hershey won’t be deploying earnings as profitably as 2015 Hershey, and is valued accordingly. That’s where the outperformance happens–holding the stock through those terminal growth expectations well into the point where expectations get readjusted upward.
That’s why Hershey, through almost every decade, has a stable earnings per share growth rate somewhere between 8% and 12%, no matter what else is going on in the rest of the world. Keep in mind that is truly exquisite–Hershey ships out almost half of its earnings to shareholders, and is only able to use half its annual profits to grow the entire profit pie by 8% to 12%. This is different than the advantage Warren Buffett has–he gets to keep the entire $16 billion in profits generated per year to grow Berkshire Hathaway.
That’s why buy-and-hold investing for 20+ years boils down to something like “buy Johnson & Johnson, Nestle, Coca-Cola, Colgate-Palmolive, Hershey, and Coca-Cola and never think about it thereafter.” It’s the best bang for your buck in terms of effort expended. The only strategy that beats is deep value investing or finding small-cap companies riding strong five to fifteen year growth periods. But the amount of work required to executive the latter strategy is substantially larger than the “buy Hershey and forget it” strategy.
If you are looking out to 2020, your focus should be on companies that will outperform consensus expectations as far as earnings growth is concerned (the dividend component of the analysis is moot except to the extent shareholders benefit from cheap reinvestment at low prices because dividend growth is ultimately driven by earnings growth). But if you are looking out to 2040, you should be focused on incorrect terminal growth rates. You should be looking for the truly superior companies that will be pounding out more and more cash at the same rate it is now.
Brands, economies of scale, an extraordinary management team that will be around for a long time, and barriers to entry or particularized market niches are usually the signals of super long-term investments. Brands are the hardest competitive advantages to topple, economies of scale and barriers to entry are somewhere in the middle, and the loss of an exceptional CEO is the quickest way to surrender a long-term competitive growth advantage. You should tailor your search accordingly.
Source: Chevron Dividend History