Peter Lynch once said that the most important decision that someone makes when constructing a portfolio is deciding what percentage of the portfolio should be put in stocks, and what percentage of the portfolio should be in bonds.
For those of you who have spent some time studying Peter Lynch’s life, it’s no surprise that he is much more of a stock guy than a bond guy. As he writes on page 49 of his book “Beating The Street”:
“The reason that stocks do better than bonds is not hard to fathom. As companies grow larger and more profitable, their stockholders share in the increased profits. The dividends are raised. The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 or 20 years in a row.”
What I like about Peter Lynch’s explanation of stocks vs. bonds is that he does a good job of explaining the benefits of thinking into the future five to ten years in order to realize what you are gaining by selecting a well-chosen dividend growth stock over a bond.
Right now, ten year-treasury bonds yield around 3%. Over the next ten years, that’s all you get: your 3% of investment each year, and then you will collect your $10,000 back (or whatever the amount may be), which will be eroded by inflation.
Meanwhile, there are excellent companies out there that yield less than 3%, but have a habit of growing their dividends in such a regular fashion that, with a little bit of time, will enable you to (1) have more annual income, and (2) have a larger net worth.
If you want to get really get at investing, you need to get in the instant habit of thinking about what dividends and share prices will look five to ten years from now. There is a small subset of companies where this is somewhat doable. Take Colgate-Palmolive stock, for example. Some people might just look at the stock price of $64 or 2.10% dividend and stop there.
Once you adopt a truly long-term investing orientation, you will look and think: for $64, I can get my hands on $2.41 in profit right now, of which $1.36 will be paid to me as a cash dividend and $1.05 will be retained by Colgate’s management to grow profits into the future. Five years from now, that share that you bought for $64 could very well be generating $4.50 in profits and paying out dividends of $2.20 per share, if the company’s past growth and current operational plans are any indication of what is to come.
In other words, the earnings yield of 3.76% right now may be 7.03% five years from now, and the current dividend yield of 2.10% may be 3.43% five years from now. Likewise, those $64 shares should be worth something close to $90 per share five years from now, assuming that Colgate’s price experiences a reversion to the mean in terms of share price.
Personally, those figures would not be enough for me to decide that Colgate is a “buy” right now, compared to some of the other opportunities that I could potentially find in the stock market. However, if I had to choose between Colgate-Palmolive at $64 per share today and a ten-year treasury that is yielding a 3% static yield, I would take Colgate-Palmolive in a heartbeat.
To use an example of a company at fair value, let’s look at Johnson & Johnson. It trades for $92 per share and pumps out $5.48 in profit while paying a dividend of $2.64. Over the past ten years, profits grew by 102% at Johnson & Johnson. The dividend grew by 186%. And, of course, this is a period that took into account the greatest recession in the past century as well as some self-inflicted management wounds in the form of Johnson & Johnson’s safety controls at its factories.
But what if Johnson & Johnson grows its earnings by 102% over the next ten years, and grows dividends by the same amount? As an aside, I’m limiting the dividend growth as it doesn’t seem reasonable for Johnson & Johnson’s dividend to grow twice as fast over the next ten years relative to its profits.
That means, in 2023, Johnson & Johnson will be generating $11.06 in profits and paying $5.33 in dividends. If that holds true, then the current price of a share for $92 will give you an earnings yield of 12.02% and a dividend yield of 5.79% in terms of the initial investment that you make.
This is why wealth-builders tend to prefer stocks to bonds: a ten-year Treasury will only give you your $10,000 back at the end of the ten-year period, and you will only collect $300 each year along the way. The Johnson & Johnson stockowners, meanwhile, will see their annual income slide upward from 2.84% today to 5.79% ten years from now, and instead of only being worth $10,000, you ought to get back a little over $20,000 if the profits of $11.06 per share trade at 17x earnings.
When it comes to income investing, you need to remember that the current yield and current valuation are just two ingredients in the stewing pot. You also need to think about where your dividends will be five to ten years from now, and where the valuation might be five to ten years from now, so you can get a good handle on whether it is a risk worth taking or not. I’m not trying to persuade you necessarily to buy Johnson & Johnson stock—the important thing is to get in the habit of looking at where profits will be five to ten years from now, the likelihood of that prediction coming true, and then making a decision that takes into consideration the role that growth will be play in affecting the current dividends you see available to you today.
Originally posted 2014-01-31 08:06:46.