The Difference Between Building Wealth And Inventorying Wealth

Today, I saw the wire come through announcing that Campbell Soup will pay a $0.312 quarterly dividend. If someone were to buy shares of Campbell Soup today, he would get a yield of 2.75%. This is the kind of company that is useful if you want to inventory wealth and modestly improve your purchasing power over time, but it is much less useful if your goal is to build wealth. This may not be immediately obvious if you study Campbell Soup’s long-term history of delivering 10.5% dating back to 1985. It appears to be roughly equal to what you would get by investing through an S&P 500 Index Fund.

And yet, over the past fourteen years, Campbell Soup has only compounded at a rate of 6.5% per year. And it is not as if 2001 was an era of dotcom mania overvaluation for the soup giant—it was trading at 18x earnings that year. The reason why Campbell Soup has experienced this structural decline is because long-term revenues only increase at 3.0% per year. Soup is a steady business, but it is not a growth business because it is hard to get people to purchase more and more soup in a given year. The last time Campbell Soup significantly grew revenues involved the Pepperidge Farm, and Campbell Soup has not done anything game-changing of recent note.

Since 2001, a $10,000 investment in Campbell Soup would have grown to $23,700. Adjusted for inflation, the purchasing power gain has taken you from $10,000 to $17,600 over the past fourteen years. That is the kind of investment that is nice if you are in the preservation stage—after all, the company is stable and you did get wealthier over time by your decision to invest in it—but is somewhat inadequate if you lean harder on your investments to change your lifestyle than, say, your salary or income generated by your primary way of receiving cash.

If you are looking for your passive investments in stocks to build meaningful wealth, you want to look for companies that are growing revenues in the 10% neighborhood, operate in an industry you consider essential, and you want to buy the stock as close to 20x earnings as possible. It is difficult to satisfy those three conditions simultaneously, and you can still do well for yourself if you deviate modestly from those conditions.

Still, you want to look for companies that share the business characteristics of companies like Visa, Disney, and Becton Dickinson. Becton Dickinson has been delivering 14.7% annual returns since 1983 (and that number is arbitrary because it’s the furthest back data I could find. The company’s investor relations department says that the dividend has been raised every year since 1965, so the odds are likely that the total returns have been quite good for almost half-a-century (though getting finance data from the 1960s and 1970s can be difficult in some instances because much of that data hasn’t been translated online and you have to pay a fee for access to the original source materials).

Over the past ten years, Becton Dickinson has increased its revenues by 9.5% and the earnings per share by 11.5%. That is a 12.3% compounding rate. Someone that bought and held Becton Dickinson for only the past ten years saw every dollar turn into $3.13. A $10,000 investment turned into $31,300. A $100,000 investment turned into $313,000. A $1 million investment turned into $3.13 million. And so on. And that is just with ten years of holding the stock.

The reason why this approach is preferable is because there is more permanence when wealth is created through business growth successes rather than valuation. If a company doubles in price because the P/E ratio goes from 20 to 40, that is something that can easily be taken away by a change in investor sentiment. Becton Dickinson, meanwhile, went from making $700 million to $1.2 billion over the past ten years (and also reduced the share count from 249 million to 192 million, enhancing the results). When profits per share increase from $2.88 to $6.30, your foundation is sturdier compared to someone who relies primarily on valuation changes to make money. A stock losing 25% of its value from changes in P/E ratios is not unusual. A midsized healthcare stock losing 25% of its profits would be much more unlikely.

The reason why I attach the condition that it helps to buy the stock at 20x earnings or better is because you want to make sure that P/E compression won’t suck away some of your growth. That is why Visa’s current valuation puts me in a hard spot from analysis perspective. Most people who study Visa can plainly see that the company is delivering 15% annual growth in a sustainable way while enjoying a position of strength in its industry and a balance sheet without any debt. But the problem right now is that other people realize this as well. And the stock currently trades at 30x earnings. It’s starting to leave that zone of reasonableness which Warren Buffett talks about when slight overvaluation for blue-chip stocks is not a big deal.

The concern is that Visa will continue delivering double-digit growth and then, at some point between 2020 and 2025, the P/E ratio of the stock would come down towards 20x earnings. If that happens, you will lose about a third of the stock’s valuation from P/E compression. If you get some years of 15% growth thrown in there, it’s not an issue. But it’s the reverse margin of safety principle at work—the increasing guarantee that your investing results will trail the business results of the firm because the valuation seems likely to come down a bit over time.

But as a business, Visa has the kind of business characteristics that are conducive to building wealth. Every $1 invested into Visa’s IPO in 2008 is now $5. It would a $20,000 investment into $100,000 within seven years. You want to stuff your portfolio with companies like that if your goal is to see your passive stock market investments lead to important changes in your overall wealth picture.

Companies like Visa and Becton Dickinson are great for building wealth, and companies like Campbell Soup are great if your primary focus is to preserve or inventory wealth from a primary occupation. The distinction is import because, if you are someone starting up scraping to save $350 per month, putting it all into Campbell Soup doesn’t have that outsized chance of changing your life. But if you did that with Visa, Becton Dickinson, and Disney for ten years, the results would give you a level of wealth disproportionate to the amount of money that you were able to set aside. That distinction matters most when you have grand ambitions and a modest savings rate.

Originally posted 2015-03-25 19:55:26.

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