I have previously said that if you purchase a large-cap stock with a history of raising dividends, and then hold on for five years, the odds of you suffering significant harm is quite limited. It is my contention that most investors get into trouble because they consider two to three years to be super long term—it feels like it to them–when really it is not a long enough time for business results to accumulate and tilt the odds in your favor against the vagaries of Mr. Market.
From time to time, I like to revisit investments that meet some of my criteria and don’t work out as initially hoped. It is the only clear way to fairly evaluate a strategy. If I am going to trumpet the success stories, then it is important to include the downside of an investment plan otherwise my partial disclosures would really be a disservice to the people that are trying to make up their minds regarding what to do with the surplus they accumulate from their labor.
A good example to evaluate is IBM (IBM). If you could go back to 2011, you would find that IBM displays many of the characteristics that I like in a stock. It had 16% net profit margins. It had an almost twenty-year streak of raising dividends. It had previous ten-year earnings growth of 12%. The P/E ratio was 12.5. The dividend payout ratio was only 23%. It had a large cash position and was repurchasing large amounts of stock. Warren Buffett was investing in it. These are the prime indicia of a successful investment.
And yet, these past five years have been hard on IBM. Although it has been achieving nearly 20% annual revenue growth in the fields of cloud computing and data analytics, the profit margins in those fields is slim and the starting base was low.
Meanwhile, the attrition in IBM’s cash-cow hardware businesses have occurred much quicker than anticipated. If I had to guess what caused IBM executives to make this appraisal, I would speculate that they assumed Fortune 1000 companies would be zealous about protecting their data in the surefire old-fashioned way and would be hesitant to create risks of proprietary and otherwise confidential information in the pursuit of lower costs.
The “cloud” is one of the greatest euphemisms of our generation. It makes people think that data is off in sky, out of reach of those who would steal. All cloud storage means is that the databases and servers are in remote rather than on-site locations–there is no physical premise in your work building storing data like the olden days, but instead, there might be some mega-database in Michigan that transmits your information to you online once credentialed. Despite the hacking risk of this method–which recently affected my local grocery store!–companies can’t run to it fast enough because it grants convenience and lower cost.
I think IBM executives believed that security certainty would trump convenience and cost in the trade-off calculations made by their executive clientele, and this miscalculation is a big part of the reason why earnings have fallen from $13.06 per share to $12.25 per share over the past five years.
So let’s calculate the damages over the past 5+ years.
The stock traded at an average price of $170.36 in 2011.
In the meantime, investors have collected dividends as follows: $2.90 per share in 2011, $3.30 per share in 2012, $3.70 per share in 2013, $4.25 per share in 2014, $5.00 per share in 2015, and $5.50 per share in 2016 (pending the final $1.40 payment.) That is $24.65 per share in cumulative dividend payments.
As of yesterday’s close, IBM was trading at $154.45. When you count the $24.65 in dividends, we are talking about an economic value of $179.10. It’s not much–only 1% annual compounding, which is a net loss of purchasing power when you account for the 3.5% annual loss in purchasing power that is characteristic of advanced economies with fiat currencies.
But all told, it’s not bad. While deep value investing tolerates some instances of complete failure so because it is expected that the magnitude of the gains will eclipse the losses along the way, dividend growth investing with large caps relies on the regular accumulation of singles and doubles with very few permanent capital losses along the way.
That is what you see with IBM. The past five years have been on the “realistic worst case scenario” side of the spectrum. But you know what? It is still bringing in $11 billion in annual profits, and the shareholder returns have been improved by the dividend payouts along the way. If you’ve been reinvesting, your returns have achieved an additional boost.
This is yet another example of the difference between headline risk and actual reality. When you read the regular criticisms of IBM related to sluggish revenues and difficulties with income replacement, you might think that the shareholder experience is pure misery. The reality is that you’ve basically broken even if you’ve been reinvesting, and you’re down compared to inflation if you’ve been letting the dividends stockpile.
Most individual investors own somewhere between 15 and 50 stocks. Some spot has to occupy your worst investment on the list. If IBM is your worst stock, it means that you’ve made an investment that has failed to make money over the past five years (rather than an investment that has lost you lots.) When viewed as one of the worst performers in a diversified portfolio executing a dividend growth strategy, you can see why this limited downside is a vindication rather than repudiation of generally conservative investment principles.
Originally posted 2016-10-15 22:35:43.