In 1923, a lawyer from Columbia University named Robert Lee Hale wrote the charmingly titled “Coercion and Distribution in a Supposedly Non-Coercive State” to argue that there is a significant gap between the theory of a how is supposed to work and how it actually gets applied in practice. It was Hale’s work, along with the Supreme Court opinions written by justice Oliver Wendell Holmes, that helped give rise to a school of philosophy called legal realism in which you focus on the real-world effects of laws rather than regarding laws as self-executing principles that get properly applied as intended.
A similar shift is taking place in the field of investing as The Dalbar Institute has led studies showing that investors actually reap returns of 3-4% over 20+ year measuring periods in which the stock market delivers 9-10% annual returns, providing data ammunition that confirms behavior economics and knowing yourself well are just as important (and probably more important) than what a particular company can deliver over a long period of time.
Take something like Union Pacific. It is a true throwback, which hearkens back to the days when you bought the leading railroad, Standard Oil, AT&T, General Electric, Philip Morris, Procter & Gamble, Coca-Cola, and called it a diversified income portfolio, collecting your roughly bi-weekly dividend checks that would arrive in your mailbox 28 times per year.
Even though it is often disregarded as a boring old economy company, it truly does deliver excellent returns to those who buy-and-hold for the long term. Since 1980, Union Pacific has compounded at 13.3% annually. Since 1990, it has compounded at 15.2% annually. And since 2000, the Union Pacific Railroad has returned 20.6% annually compared to the S&P 500’s 4.3% annual returns. The dividend also is nice, occasionally freezing but not getting cut in the past generation. In the past ten years, the dividend has been especially nice, growing at a rate of 19.5% per year. When you own 31,868 miles of railroad tracks across the Western United States and collect nearly equal revenue streams from coal transport, intermodal transport, agricultural transport, industrial transport, chemical transport, and automotive transport, you are dealing with the kind of business model that will likely be in place for many years to come.
And yet, even though Union Pacific has been an absolutely excellent company for the past century that delivers market-beating wealth for those that hold on for the ride, there is also a reason to believe that this is precisely the kind of investment that would be disastrous to own if you can’t think and act in terms of decades-long boom and bust cycles. The company was highly profitable in the mid-1990s, then suddenly lost $0.05 per share in 1998 and froze the dividend at $0.20. The price of the stock collapsed nearly 60%. Could you deal with that bottom of the cycle?
The dividend offered little reassurance—freezing at $0.20 until 2003 when the annual dividend increased to $0.23 per share—but the profits offered little predictability. Profits of $2.07 in 2000 quickly fell to $0.72 in 2004, taking a $28 stock down to a low of $13.70. When profits went down from $2.3 billion to $1.8 billion during the financial crisis (the reason why profits didn’t go down substantially is because Union Pacific usually operates with multi-year contracts, so the goods with lower market value to consumers didn’t affect the fact that they were still getting shipped), the price of the stock fell harder: from $42.90 to $16.60. Being a long-term holder of Union Pacific necessarily required seeing 1,000 shares go from a market value of $42,900 to $16,600. Although the 2008-2009 financial crisis was deep, there was also a bit of luck that the general economy recovered each year from 2009 onward—an extended bear market could have sent the stock down into the single digits given that you’d have to factor in weaker reporting results as well as the fact that investors tend to overreact to the bad news.
The behavioral side of investing is something that goes totally neglected when you run a stock screener—you can look up Union Pacific’s excellent ten, twenty, and thirty year record. You can see the 15% annual earnings growth of the past decade. The 19.5% annual dividend growth. The low 30% dividend payout ratio. The six straight years of significant profit growth. A stock hitting significantly new highs six years running. All of those things are true, and play into why someone might want to own Union Pacific for the long haul. But it is incomplete: You also have to calculate the occasional dividend freezes, the eventual (temporary but real) profit declines, and the reality of a stock price that can fall quickly when sizing up a company like this as an investment.
Obviously, the principles of this article isn’t something that only applies to Union Pacific. It is about cyclical investing in general. When you are six years into an expanding economy and a stock market that has increased even more than the gains in the economy, it is easy to become cozy with the concept of cyclical investing. Believing that cyclical stocks are right for you when, in fact, they exceed your comfort zone is one of the biggest investment mistakes you can make because you have to deal with the double whammy of (1) selling at a low, treating the stock market as a tool for wealth destruction rather than wealth creation, and (2) seeing that same stock rapidly rise in price and increase its dividends when the economy recovers. Knowing how you respond to deep stock price declines accompanied by lower profits (or no profits altogether) is the first step of analysis that should precede any contemplation to buy ownership stakes in companies that regularly experience profit drops.