I
received this question recently from one of my readers:
Hi Manoj. When we make investments, one of the best weapons we have in our arsenal is the ability to make each investment one at a time. The fact that the Dow Jones is trading above 15,000 (or whatever figure might be dominating the headlines) says little about the valuation specifics of each company. For instance, Aflac typically traded at 250-400% of book value, and 15-25x earnings, before the financial crisis hit. Nowadays, the company trades at 100-170% of book value and only trades at 7-9x earnings, despite the fact that Aflac’s portfolio is now of higher quality than it was before The Great Recession hit.
On
the other side of the equation, we have a company like Hershey Chocolate that
is trading at 29-30x earnings, and the chocolate maker hasn’t traded at that
kind of valuation level since the dotcom bubble burst in the late 1990s. That
is why I do not get caught up with what the Dow Jones, S&P 500, or whatever
index you might be using as a reference point is doing. Since I invest in
individual companies, that is what is important to me. If 400 companies in the
S&P 500 are “overvalued” at a given point in time, then it is my job as an
investor to find at least one of the 100 other companies that are not
overvalued at the time I intend to make my investment.
In
your question, you pointed out three companies in particular: ExxonMobil,
Procter & Gamble, and Johnson & Johnson. Here is how I would approach
answering that question:
(1)
First, I would determine my expectations for the company over the next decade,
both in terms of total returns and total dividends produced.
(2)
Secondly, I would ask myself whether that likely result would be satisfactory
to me, on a risk-adjusted basis.
Take
something like Exxon. The company is currently playing a game of see-saw with
Apple to see which one can be the largest company in the world. With Apple
currently worth $417 billion and Exxon currently worth $409 billion, it looks
like Exxon is in second place right now. With a non-tech company as big as
Exxon, it is unlikely that the company is going to be either excessively
overvalued or excessively undervalued.
There
are four or five dozen analysts that cover the company. Just about every trust
fund, pension fund, and large-cap index fund in the country owns shares of
Irving-based oil giant. When a company is that big, and when its earnings are
that predictable (the catch, of course, is when an unexpected commodities bust
cycle strikes), then it is likely that a company of Exxon’s size and
predictability will typically trade within hailing distance of its intrinsic
value.
Historically
speaking, Exxon’s fair value is between 8-10x earnings. Right now, it is
generating $9.80 per share. At the current price of $92 per share, that works
out to a little above 9x earnings. I’m guessing that most reasonable people
would peg Exxon as being in a range from 10-15% undervalued to 5% overvalued.
That would lead me to this conclusion about Exxon: the total returns
experienced by investors over the next ten or so years will likely correspond
to the earnings per share growth rate of the firm, and income investors that
buy Exxon may experience the treat of receiving a dividend growth rate that
exceeds the growth of the company.
Some
people might look at something like Exxon and think, “Ehh, I’m not
interested—it only yields 2.75%.” But what that ignores is the fact that Exxon
is possibly in the process of raising its dividend by 10% over the medium-term.
Today’s $2.52 payout may be next year’s $2.77 payout, which may turn into
2015’s $3.04 payout, which may turn into 2016’s $3.34 payout, which may turn
into 2017’s $3.67 payout. But people don’t think like this. They only look at
the $2.52 annual payout and think that Exxon is unimpressive. But it is
entirely possible that, if you wait four years, you could be earning $3.67 per
share in dividends. All of a sudden, that 2.75% yield has turned into a 4.07%
dividend yield on your initial investment, and that is not even assuming
reinvested dividends (by the way, that is the best secret of blue-chip
investing: combining an 8-12% dividend growth rate for 10 years with the
reinvestment of dividends. You can get some pretty sweet yield-on-costs down
the road if you follow that metric).
Similar
stories exist for Procter & Gamble and Johnson & Johnson, although I’d
guess that Procter & Gamble is a little bit more overvalued than the other
two.
As
you can see, I answered your question in a roundabout way. The truth is that I
do not know:
(1)
what the stock prices of any of these companies will be in the next six months,
one year, twenty months, etc. (i.e. would you be ticked off if you purchased
Exxon at $90 today and saw that you could buy it at $80 per share a year from
now, or would you be content knowing that at $90 per share, you should still be
able to capture total returns that mirror the growth rate of the firm?)
(2)
What stocks would you pick otherwise? When I first started dividend investing,
one of the things that surprised me was that many high-quality companies
(Coca-Cola, Pepsi, Nestle) tended to outperform the S&P 500 over most 15+
year periods. That didn’t make sense to me. I intuitively thought that, in
exchange for buying higher quality, you had to accept lower total returns. But
the truth is that, when you own a high-quality company that is gushing out
growing profits across dozens of countries, and is able to sustain that
business model for decades, you will do quite well over long periods of time.
We have all these excellent companies sitting right in front of us, and it is
easier to ignore them because there is always a “more glittery” company out
there somewhere.
With
that said, I don’t think that Procter & Gamble, Johnson & Johnson, and
ExxonMobil are on the discount rack right now. Dollar cost averaging (i.e.
putting $100 per month into each company eachT month) is a wonderful tool for a
blue-chip investor, and now may be a good time to do something like that.
Considering
Procter & Gamble and Exxon charge $0 to have money taken out of your
checking account monthly, and considering that Johnson & Johnson charges $0
if you mail in a check, they can be a free way to get some high quality assets
under your belt over time. There’s about a dozen or so companies on my
“buy-and-hold forever list”, and each of those three companies would occupy one
of the three slots. If you put $100 (or whatever amount you’re working with)
into each of these three companies each month for the next ten to fifteen
years, I cannot imagine that working out poorly. Best of luck with everything,
Manoj.
This article was written by Tim McAleenan at www.theconservativeincomeinvestor.com .
