There are two things you really pay attention to when looking for an attractive long-term business: the earnings quality and the growth of those earnings. If you find a corporation that is attractive on both those two counts, plus valuation, you’ve really hit the jackpot in your search for a life-long holding.
Depending on what you’re trying to do in life–preserve wealth or create wealth–the way you prioritize those first two variables will be different. If your goal is to take some capital and make a little something with it but you have a strong loss aversion tendency with that pile of cash, then “earnings quality” is going to be your top consideration. Earnings quality is a jargon-y way of asking the question “How durable are these profits in times of economic distress?” If the current profits keep coming in at more or less the same rate during a recession, the business is said to have high earnings quality. If the profits are more sporadic, or turn into losses during a recession, then the business is said to have a low earnings quality.
If you have a “build” rather than “preserve” mindset, then you will be all about the earnings per share growth rate of your investment. You’ll be willing to tolerate some greater fluctuations in earnings and market price, if, over the full course of a business cycle or two, you get a higher earnings per share growth rate propelling your account to higher values as a perfectly fine form of compensation for the volatility that you chose to absorb.
I bifurcate the difference between earnings quality and earnings growth because it can provide clarity to how you approach your study of a business like Procter & Gamble. As of 2016, Procter & Gamble had nineteen brands that generate at least $1 billion in annual sales: Always (women’s hygiene); Ariel (detergent); Bounty (paper towels); Charmin (toilet paper); Crest (toothpaste); Dawn (dishwashing liquid); Downy (fabric softener, dryer sheets); Febreze (odor spray); Gain (detergent, dishwashing liquid); Gillette (razors); Head & Shoulders (shampoo); Olay (beauty products); Oral-B (dental); Pampers (diapers); Pantene (hair care); SK-II (beauty); Tide (detergent); Vicks (cough medicine); and Wella (hair care).
In terms of earnings quality, that is one of the top ten businesses in the world. It stands up right there with PepsiCo, Nestle, Johnson & Johnson, Colgate-Palmolive, General Electric, Coca-Cola, ExxonMobil, Berkshire Hathaway, and Kraft-Heinz. It would take an extraordinarily poor global economy for Procter & Gamble to see its profits fall by 50%. And heck, even during the last recession of 2008-2009, Procter & Gamble only saw its earnings decline from $3.64 to $3.58. THe profit engine itself is remarkably durable.
On the other hand, the growth aspect for Procter & Gamble has been much less impressive this decade. After trading at $75 per share in 2007, Procter & Gamble only trades at $82 per share today. It’s been almost ten years, and all you’ve gotten is capital appreciation of 1.00% annually plus a dividend. Valuation changes and the strength of the dollar have played a part, but the central issue is that earnings have only grown by 3.10% annually over the past nine years.
The dividend, meanwhile, grew much faster than it should have these past nine years. Procter & Gamble was paying out $1.28 in dividends back in 2007, and by the end of 2015, was paying out $2.65 in dividends (technically shareholders only collected $2.59 because the dividend hike doesn’t come until the second quarter at P&G).
You can see how this is a problem. Unless you are actively trying to boost your dividend payout ratio as part of a corporation’s transition from being a growth company to a mature one, you don’t want to see dividend growth outstrip earnings growth.
At Procter & Gamble, the dividend grew at a rate of 8.15% annually from 2007 through 2015 while the earnings have only been growing at 3.10%. That gap can only last for so long, as the dividend payments went from consuming 41% of profits back in 2007 to nearly 70% of profits today.
Two days ago, the Procter & Gamble Board of Directors decided that 2016 would be the year to start remedying this disparity. They announced that the quarterly dividend would only grow from $0.6629 to $0.6695, a dividend increase of only 1%.
The last Procter & Gamble found itself in a similar predicament was the late 1980s, when the shareholders received a 4% hike in 1985, 2.9% hike in 1986, 0.9% in 1987, and then a 3.7% hike in 1988. These lean years were followed by high dividend growth of 17% in 1989 and 12% in 1990, before beginning an extended 15+ year streak where shareholders reaped dividend growth increases between 9% and 10% annually.
So the corporation has been here before, and it’s prudent of the Board to try and get the dividend payout ratio down to the 50% to 55% of earnings range. Why? Because that permits you to repurchase stock of 2% to 3% per year, try and grow revenues by 3.5% over the long haul, and then turn that into profit growth in the 5-6%. Combined with the repurchases, that can keep Procter & Gamble’s earnings moving at a 7% to 8% pace, and it’s hard to ask for much more than that from a $220 billion conglomerate.
To get an idea of how important buybacks have become to Procter & Gamble’s strategy of growing per share earnings, consider this: Procter & Gamble made $12 billion in profits in 2008, and will make $10.7 billion in profits this year. The reported profits have actually declined over the past seven years, but Procter & Gamble has retired over 300 million shares of stock over the past seven years to bring the share count down from 3.0 billion down to just under 2.7 billion.
This has enabled the earnings to grow from $3.64 in 2008 to around $4 per share this year. The entirety of Procter & Gamble’s growth the past seven years has come from buybacks. You’d add a dime and a nickel if you made the results currency neutral, but the conclusion wouldn’t change: Shareholders have seen earnings per share entirely due to share repurchases over the past seven years.
In my view, investors that regularly contribute a little bit each month to the Procter & Gamble direct share purchase program and have a long view that stretches out decades will be rewarded for their patience. Procter & Gamble is sitting on $14 billion in cash, and a meaningful acquisition that tacks on $500 million to $1 billion in annual profits may be in the offing. Also, Procter & Gamble has been aggressively raising prices in the past year, and the volume growth has cooled in response to the price hikes of things like Tide detergent which is now 30% more expensive than it was four years ago. Once those price gains get normalized a bit, you might see volume growth pick up (especially in developing nations).
Also, for what it’s worth, these concerns have always been worth us. Check out this Warren Buffett talk at Florida in 1998. Move to the 1 hour and 7 minute mark. Buffett is talking about Procter & Gamble as a buy-and-hold forever investment. He is remarking that Procter & Gamble has difficulties growing volumes and sells products that are more subject to product substitution than something like Coca-Cola.
[su_youtube url=”https://www.youtube.com/watch?v=2MHIcabnjrA” width=”980″ height=”640″]
Buffett, I think, nails it when he says: “I wouldn’t be unhappy if someone told me I had to own Procter & Gamble during the twenty-year period. That would be in my top 5% because they’re not going to get killed…I would not be unhappy if you told me that I had to put my family’s net worth i P&G…I might prefer some other name, but there are not another 100 names that I would prefer.”
Since Buffett made those comments in 1998, Procter & Gamble has returned 6.41% annually. But it’s also seen its P/E ratio shrink from a dotcom era high of 29.7x earnings to the current valuation of 20x earnings. The valuation change has taken 2.17% annually off the amount of capital appreciation of the stock. In other words, if the P/E ratio of P&G held steady the past eighteen years, P&G shareholders would have achieved 8.58% annual returns. Many of the same concerns that exist today, and yet P&G shareholders did all right. I also don’t anticipate that the shareholders of today would experience anything like the P&G stock buyers in 1998 had to endure.
The earnings quality at Procter & Gamble is one of the best in the world. I’d put it in the top ten among publicly traded businesses. It’s absolutely something you want to own during a recession or capital that you invest with an exceptionally low tolerance to potential losses. The profits keep rolling in, and the risk of a dividend cut is extremely remote. Collecting things like that as you go through life is great. The share count keeps growing through dividend reinvestment, and as you effectively escalate your commitment to P&G through these dividend reinvestments, you can have high confidence that you’re on sturdy ground.
You don’t have that “poof, it might be all gone some day” risk that faced a Wachovia investor that was happily reinvesting their dividends throughout the 2000s only to see it all disappear. That’s because P&G doesn’t have that kind of leverage, and sells products that are intertwined with the human experience in such a way and with such pricing power that the risk of substantial profit declines is minimal (note: I distinguish my use of pricing power from Buffett’s use in this way: In his speech, he was talking about P&G’s difficulty in raising prices and getting volume growth. When I talk about pricing power in this paragraph, I am referring to the unlikelihood that P&G would ever have to substantially cut its prices during a recession to compete.)
If I were investing a chunk of money where building wealth was the top priority, I would look to Tiffany, Hershey, and Diageo. Their valuations are nice, and their earnings growth is almost certain to be superior to Procter & Gamble. Heck, I think I’d rather overpay by a good amount for Nike and Brown Forman and accept the P/E compression on the theory that the earnings growth from those firms would be superior enough to still deliver better returns than Procter & Gamble at 20x earnings right now.
But Procter & Gamble has also been here before. This happened in the late 1980s. The concerns about volume growth have been ever-present since then. The dividend grows every year, the earnings quality is rock solid, and over the very long term, you ought to get earnings per share growth in the 7-8% range. It’s not going to be a rapid wealth builder, but it’s a great way to inventory cash surpluses that you acquire in life and desire to allocate towards something with a de minimis chance of capital loss.
Originally posted 2016-04-16 14:50:08.