I have spent the past month reading critical editorials of my favorite investors. I wanted to see if there were any holes in my thinking that I could address by segregating the best philosophical contributions of my favorite investors from their editorial asides that do not hold up well to scrutiny.
One of Peter Lynch’s famous ideas, expressed in his book “One Up on Wall Street” and subsequent public appearances, is that you should “buy what you know.” It is a notion that drew considerable criticism from Stephen Taub in his April 18, 1989 review of the book in Financial World titled “Peter Lynch’s ‘10-Bagger’ of Wind.”
Taub’s review included the following: “C’mon, Peter, you know it’s not that easy. Otherwise, in 1984 I would have bought and taken a beating on Pizza Time Theatre after visiting a crowded, noisy franchise in the D.C. suburbs several weeks before Pizza Time filed for bankruptcy.”
This is fair criticism. It is not true that every company which appears to be successful at first glance, measured by a high visibility of customers, would make a good investment.
If you visited a bakery in 1930, you would have seen cake products sold by The National Biscuit Company and Interstate Bakeries. The products appeared indistinguishable–cupcakes, cakes, chocolates, candies, sweets. You could have decided to purchase either under the Lynch “buy what you know” theory.
And yet, the fates of each investor would have been radically different. If you purchased shares in The National Biscuit Company, you would have seen the company turn into Nabisco, and then become Kraft, and then join Philip Morris, and then get spun-off from Philip Morris in such a way that you would also own shares of Altria and Philip Morris International, and then you would have seen Kraft chop itself into both Kraft Foods and Mondelez, and then you would have seen the Kraft shares get purchased by Warren Buffett and 3G in a mega-merger with Heinz.
You would have spent the past 85 years compounding at a rate of 18.5% because of the premiums associated with the buyouts and the success of the combined snack-tobacco entity. A $1,000 investment over the past 85 years in the original National Biscuit Company would have compounded into $5.9 billion today. You’d own Kraft-Heinz, Mondelez, Altria, and Philip Morris International.
The lollapalooza compounding was a result of the unique circumstances surrounding this cash generator: Usually, fast-growing stable cash flows trade at a healthy valuation like Hershey where you only get a 2% dividend yield or so. That high valuation does limit some of the beneficial effects of dividend reinvestment.
National Biscuit Company had the opposite issue–the tobacco and snack brands were growing profits per share at 11% per year, but the stock was also trading at a cheap valuation so that the dividend yield was typically in the 5% to 8% range throughout its history. A modest investment in the tobacco or snack giant, made at any point in the past couple decades, would have turned into a life-changing investment (and this is another psychological benefit of practicing buy-and-hold investing; you never have to deal with watching something you once owned go on to produce millions of dollars in foregone wealth.)
And yet, long-term owners of Interstate Bakeries did not enjoy a similar success story. It owned Wonder Bread. It owned Nature’s Pride. It owned Dolly Madison. It owned Butternut Bread. It owned Drake’s. It owned Twinkies. It owned Ho Hos. Even if you had a critical eye, it would not be easy to detect that Interstate Bakeries was dramatically inferior to Kraft Products like A-1 steak sauce, Oscar Mayer hot dogs, Maxwell House coffee, and Planter’s Peanuts. Sure, if you dug into the statements, you would seen that Kraft made about 18% on every product sold while Hostess made 12% on each product sold, but a naked eye observation of the business would have made you think that both were blue-chip stocks.
Interstate Bakeries renamed itself Hostess as it began through deep labor and union problems. The distrust between management and rank-and-file employees ran deep. In 1975, Hostess truck drivers were promised pension benefits at 120% replacement value of their salary with a projected retirement age of 52. Hostess borrowed money at a 12% interest rate from the predecessor to GE Capital to make payments to employees. The company closed down 44 bakeries in five years during 1985-1994 to make payments to employees.
Eventually, the company get the pension payments by 80% based on its own decision, prompting litigation that would last over twenty years. Eventually, the pension payments of $4,000-$6,000 per month turned into trifling $300 monthly pension payments to former truck drivers. After clearing a large chunk of the pension obligations off the books, Hostess management gave itself 80% raises without telling the union leaders, and this information did not become known until Hostess executives sought debt financing from Silver Point Financing and an auditor tipped off a union rep about the hidden executive payments.
The union response was to have Hostess products “go missing” and truck drivers were frequently late delivering products to grocery stores. Shareholders of the original Interstate Bakeries got wiped out in 2004, and then got wiped out in 2012 under separate bankruptcy filings.
The products seemed the same, yet a $1,000 investment in The National Biscuit Company grew to $5.9 billion by 2015 while a $1,000 investment in Interstate Bakeries grew to $0. How can the lay investor modify the Peter Lynch “buy what you know” principle to tilt the odds in favor of receiving National Biscuit Company results instead of Interstate Bakeries results?
With non-cyclical companies, you can learn a lot from the dividend. The original Philip Morris has never cut its dividend since The Great Depression. For a long time, Kraft was a part of that history. Even after being spun out in its own, the Kraft didn’t never get cut. Sure, there were years of dividend freezes and 1% to 2% dividend hikes that didn’t cover inflation, but the shareholders never had to take a step backwards.
The same is not true for Interstate Bakeries. Interstate never grew its dividend for more than 16 years annually in its existence. Throughout the 1980s, 1990s, and 2000s, there were frequent dividend suspensions and cuts (eight years of no dividend growth, and four dividend cuts between 1982 and 2004). The inability to create free cash flow at Interstate Bakeries showed up in the dividend.
It is an obvious principle, but it bears repeating: To pay a dividend, you need the cash to do it. When AT&T pays out $11.7 billion in cash to shareholders, it needs to have that actual cash amount withdrawn from the bank. You can’t “fake” dividend payments. It can either be withdrawn from the company treasury, or it can’t. Companies with skittish dividend records can sometimes tell you something about the quality at the business. The labor strife may not have been immediately apparent to a prospective Interstate Bakeries shareholder, but the absence of any dividend growth while a peer is growing its dividend every year should have been a tip off.
You could turn Peter Lynch’s “buy what you know” advocacy into an effective stock screener if you combined businesses you understand with a stock screener based on a set minimum years of dividend growth. You can make the filter as strong as you like–10 years of dividend hikes, 15, 20, 25, it’s up to you.
The famous English jurist Sir William Blackstone wrote in 1769 that it is better for ten guilty men to walk free than it is for one innocent man to suffer. The stringency of your dividend growth requirement applies in a similar manner. If you insist on 25+ years of annual dividend growth, you will reduce the likelihood of making a bad investment but you will also foreclose the opportunity to make a good investment.
If you only insist on five years of dividend growth, you will open yourself to better opportunities like Visa, Hershey, Wells Fargo, General Electric, Dr. Pepper, and Philip Morris International, but you will also increase the likelihood of picking a poor company because a five year dividend history won’t even incorporate The Great Recession.
The lesson is that you get to modify the wisdom of others to suit your own purposes. Lynch’s adage that you should “buy what you know” is incomplete as a basis for making decisions. But if you combine it with some other principle, like a minimum number of dividend hikes, then you can purge many of the losers necessarily incorporated in Lynch’s original dictum.
Originally posted 2015-07-12 23:30:11.