I’ve been covering stocks for five years, and there are very few excellent long-term businesses that I have neglected to mention at least once. After noting how Cisco investors need to make peace with a management team that feeds at the trough due to the detriment of shareholders, I want to talk about a company that is very good at keeping compensation reasonable while also delivering exceptional value to shareholders: Sherwin-Williams (SHW).
Even though Sherwin Williams has been raising its dividend for 38 years, and sells paints and automotive coatings that are well known to consumers, you rarely hear it mentioned in discussions of ideal long-term investments. I suspect this is because the starting dividend yield frequently hovers around the 1% mark. A lot of people who get interested in owning large, established firms want to see at least 3% of their investment come right back at them as a share of the profits distributed to them in the first year from their investment.
It’s an understandable impulse, but one I consider ultimately detrimental to long-term wealth building. On the forums I read among investors trying to figure out what to do with a nest egg that is not quite enough to generate enough passive income to live on during retirement, the almost universal wisdom involves either (1) a suggestion to work longer, which I regard as evasive because it disregards the premise, or (2) suggestions on how to turn a 3% dividend portfolio into a 5% or 6% yielding portfolio.
I don’t think reaching for yield is ever the answer, as it almost always involves moving towards companies that give you lower capital appreciation and often have a higher yield for a reason (either because of that lower capital appreciation or because there is some sort of business obstacle that puts the sustainability of the dividend at risk). It is a fool’s gold option because your dividend might not be safe, and your capital returns will suffer.
It’s an underreported fact that, although Jeremy Siegel’s research points out that the top quintile of dividend stocks outperformed all others from 1956 through 2003, you must have owned the old Philip Morris and its 20% annual returns for half-a-century to earn returns similar to the data set. It’s similar to how you needed to own Wal-Mart in order for the Nifty Fifty outperformance to hold true–data sets often include an unbelievable winner or two that single or double-handedly alter the results from the data set. That’s why economists often obsess over median, rather than mean, data points.
I mention all of this context to say that, if I were trying to stretch a nest egg a bit out of necessity, my inquiry would be: (1) Which companies have the best business models in the world?; (2) Which of those have reasonable or better balance sheet?; (3) Which of those have the highest earnings per share growth rates?; and (4) Which of those are trading at the best valuations today? That’s what my process would look like–I’d prefer the risk of “dead money” with a Johnson & Johnson during the late 2000s to the risk of lower capital appreciation and threats to the dividend payout.
Specifically, my search would take me towards companies like Sherwin-Williams. Even though the starting dividend yield is only 1%, you get something nice in exchange: a remarkably consistently high earnings growth and dividend growth rate. Sherwin Williams has a ten-year earnings growth rate of 12.5%; a twenty-year growth rate of 13.5%; and a thirty-year growth rate of 15.0%. People paint things, they pay a lot more for paint than it costs to produce, and there are a lot of bolt-on acquisitions that can get neatly tucked into the core business (brushes, waxes, other paint brands, and so on).
The company has been buying back stock non-stop for twenty years. That’s not necessarily a blessing in its own right–buybacks are value-destructive if the price is too high–but the paint industry doesn’t get the talking heads on CNBC hot and bothered so there are rarely periods where the stock gets overpriced.
The share count has come down from 165 million to 92 million over the past eighteen years, meaning the company retires about 3% of its total stock each year. Basically, the profits from the business have been returned to shareholders at a 4% rate each year for the past eighteen years–you get a point from the dividend, and three from the share repurchases. I don’t think I could name more than a dozen businesses that have a better 15+ year track record of actually boosting an investor’s ownership stake in the firm by buying out the sellers and wiping their equity existence off the books.
Consider this: Even without considering the organic growth of Sherwin-Williams itself, shareholders have already turned $1 in 1998 earnings into $1.44 in 2016 earnings just through the act of increasing the ownership claim that each share represents. Because the dividend only takes up about 25% of earnings historically, the buyback has been able to coexist with retained earnings that also go towards future acquisitions and growth-of-existing paint lines.
Companies firing on all cylinders often share these characteristics: (1) a business that creates a lot of shareholder “residue” profit from each item sold; (2) solid top-line growth from the growth of the main business and foreseeable acquisitions; (3) disciplined management that grows earnings per share, including using buybacks as necessary; (4) and a low dividend payout ratio that presages future growth while also leaving substantial retained earnings to increase the owner earnings that flow through to corporate headquarters.
The existence of these four factors explain why Sherwin-Williams has been able to grow its earnings from $1.68 to $12.60 (2016 estimated) over the past fifteen years and dividends from $0.58 to $3.36 (2016 estimated) during the 2001-2016 examination period. That’s a fifteen-year annual earnings growth rate of 14.38% and dividend growth rate of 12.42%, respectively.
The nutshell of the business is this. Say you buy a $25 gallon of paint. After paying off all the employees, landlords at the manufacturing plant, and costs of shipping the paint, Sherwin-Williams generates 14.3% or $3.57. If you’re buying the paint at Lowe’s instead of a Sherwin-Williams store, then the measurement would be the gap between Sherwin-William’s costs and what it sells it to Home Depot for before the markups. Then, Sherwin-Williams pays the taxes on that $3.57, and the shareholders are left with a net profit margin of 10.0% even, or $2.50. When all the costs are apportioned, that’s what you the shareholder are left with on each can of paint: about two and a half bucks.
That may not sound like a lot, but when you have 4,068 stores and a distributorship relationship with Lowe’s among others, each can of paint and other objects start to add up. The business is also resilient to most technological changes–people are always going to try and make their foundations look nicer without a total replacement (and even if people do go the throwaway route, there is still the need to paint cars and houses in the first instance).
These high profits permit Sherwin Williams to add about 100 stores to its existing 4,000+ count each year, or about 2.46% new locations per year. This mixes well with 4% foot traffic gains at existing stores, and 5% annual price hikes on existing items. You also have those shares getting retired at a 3% rate each year. With the $1.9 billion debt being reasonable compared to $1.1 billion in annual profits, you can see how Sherwin-Williams seems to have the inherent nature to deliver double-digit annual returns.
The $288 price tag is a bit higher than I’d aim to pay for it. The stock has traded at over 20x earnings since 2012, but before that, you could regularly pick up shares under the 20x earnings mark. Compared to my estimates of $12.60 per share in earnings this year, we are talking a price range of 22.85x earnings. I’d characterize the stock as about 14% higher than the top end of what I’d consider a fair deal for the stock. Given Sherwin-Williams’ impressive track record, the practical implication is that buyers at $288 will “tread water for a year” either with a stagnating share price, stock price growth that lags earnings by a bit, or just an outright price decline. Though I’d also wager that, by 2018 or 2019, investors will look back longingly at the opportunity to buy the stock at $288 in 2016 (absent a recession in the interim.)
I would regard Sherwin-Williams as one of my biggest omissions on the “Master List of Stocks” tab on the side of my site. It was an oversight on my part. People overlook it all the time because of the low 1% starting yield, but it is something that eventually compensates you well over time–both with significant capital appreciation and a double digit dividend growth rate. At the absolute low of the last recession, it only came down to 14x earnings. People know this is a great business, and treat it as much.
The alternative to view to my Cisco post is that Sherwin-Williams gives you commensurate growth with better resistance to technological changes over time and also doesn’t offer management equity options that leave you feeling your brokerage account statement is giving you a number lower than it ought to be. Watching paint dry is the proverb for boring, but boring is profitable. A 1986 investment of $10,000 in Sherwin-Williams stock would make you a paper millionaire today, providing another entry into the cannon that selling everyday items at a nice profit over and over again is the surest path to creating real long-term wealth in a passive way.
Originally posted 2016-05-22 06:00:07.