“This is a very bad, incoherent piece.” I received this feedback from a reader concerning my most recent article for Institutional Investor . I don’t expect everyone to agree with me, and I welcome negative feedback because it provides an opportunity to learn. But this stung. If this comment had been about almost any other article I’ve written this year, I’d probably have filed it under “let’s agree to disagree.” Looking back, however, I’m not sure this reader was wrong. While I stand by my original thesis, I think I could have made my case more clearly. So here is what I meant to say:
We are in the freakiest investment environment ever. Investors are buying bonds because they are looking for capital appreciation — essentially gambling that the price of an asset delivering negative (if you are in certain parts of Europe or Japan) or almost no (if you are in the U.S.) current income will go up. And investors are buying stocks solely for income. Dear reader, this is an upside-down world.
In my original article I addressed a group of stocks I call bond substitutes: stocks bought solely for their dividend yield. They are a special group of companies that have been around forever and that are usually perceived to be high-quality companies — think Coca-Cola, Kimberly-Clark Corp. and Campbell Soup Co., among others. I picked on Coke just because it is one of the most quintessentially American companies. I figured I’d just use Coke as an example to make a much broader point about the dangers of focusing solely on yield.
Equity returns come from two sources: stock appreciation and dividends. Stock appreciation is mathematically driven by two variables: earnings growth and price-earnings change. In other words, take any stock in your portfolio, go back five years, and you can deconstruct the return you received from it by looking at the sum of three variables: earnings growth, P/E change and dividends.
Let’s return to the example of Coke. Five years ago its stock price was $27 (today it’s $42), earnings were $1.50 (today $1.69), and investors collected about $5.90 of cumulative dividends, or about a 4 percent annualized return on the $27 purchase price. If you’d bought Coke’s stock five years ago, your annual total return (price appreciation and dividends) would have been about 13 percent a year — 4 percent from dividends and 9 percent from stock appreciation. The stock appreciated for two reasons: earnings grew 2 percent a year and P/E increased 7 percent a year (from 18 to 25). In other words, a 13 percent total return = 4 percent dividends + 2 percent earnings growth + 7 percent P/E expansion. (It took me two whole minutes to come up with these rough calculations; I am trying to be vaguely right here, not precisely wrong). Anyone who bought the already fully valued Coke stock five years ago made a great total return of 13 percent, not because the business did well — the fundamental return from earnings growth and dividends was only 6 percent — but because its P/E ratio went from high (18) to very high (25).
Today investors look at Coke, admire the return it has delivered over the last five years, mull over its 3 percent dividend, and say to themselves, “Three percent is better than the 1.4 percent I get from Treasuries.” When they do this, however, they focus on one shiny object (the dividend yield) but ignore the other parts of the aforementioned stock market math formula that are less shiny (earnings growth and P/E) and are barely positive in this example and will likely turn negative.
Article by Vitaliy Katsenelson, Investment Management Associates