Approaching The Fiscal Cliff 'Thelma & Louise' Style

Includes: JNJ, KO, MCD, PEP, PG
by: Eli Inkrot

I'm not sure if you've heard or not, but there's this thing called the "mystical whiff" that's coming up… wait, that's not right. Maybe it was the "sea side bluff," or the "fiscal bluff" -- yeah, that's closer. Ah, I've got it: it's the "fiscal cliff" that is forthcoming! You can tell that I haven't been watching much CNBC lately. All of this short-term buzz word bingo would normally be enough for me to reread the Berkshire Hathaway (NYSE:BRK.A) annual letters or perhaps more opportunistically, take a stroll down the aisles of Target (NYSE:TGT) or Wal-Mart (NYSE:WMT), observing hoards of consumers reliably grabbing for their favorite brands in good times or bad. However, there is a compelling aspect of the "fiscal cliff" that persuades me to pay a hint of attention -- that is: a potential short-term market folly. Allow me to explain.

If it were mathematically up to me, I would treat the approaching "fiscal cliff" the same way as the ending of the movie, "Thelma & Louise". Incidentally, I have never seen the movie, but I am aware of the conclusion. Basically, I would allow us to cruise over the proverbial cliff and never look back. Now, I would presume that I lost some of my audience instantaneously right there. Surely, various scoffs would all be to the tune of: "Don't you understand the massive impact that this would have on spending, personal consumption, unemployment and GDP?!?" To be perfectly frank, I don't have a complete understanding of the ramifications; but I would contend that no one has a perfect understanding until after the facts.

Here's where I'm coming from. Imagine you have a friend that has been spending lavishly for the last decade or so: big house, new car every couple of years, weekends at the beach, summers in France, the whole deal. Then you find out that while they did indeed have an impressive income -- call it $500 a day -- they have been spending say $1,000 a day. To make up for this excessive deficit, they went straight to credit cards, of which they ultimately will not be able to fulfill the payments. Eventually, lenders are starting to notice and have begun to doubt your friend's ability to pay the mounting debt. Perhaps they should have noticed earlier, but that's neither here nor there. In the real world, a bank would foreclose on your friend's house and lenders would take the cars. As well they should -- your friend made an agreement that they couldn't carry out. But the "fiscal cliff" world doesn't work quite the same way. Instead of cutting up the credit cards, telling the government to spend less and/or make more money, we've decided to talk things out for a bit. If we were parents disciplining a child, we would be suggesting "hey, we don't approve of this attitude or behavior, but let's still let the kid have a little bit of fun."

Before I get to the message of the article, I would like to indicate an additional reasonable point with regard to the potential increase in investment taxes. As stated by Warren Buffett:

"I have worked with investors for 60 years and I have yet to see anyone -- not even when capital gains rates were 39.9 percent in 1976-77 -- shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off."


Now I want to be perfectly clear that I understand the unpinning argument for the potentially grievous nature of increased taxes and decreased spending for many people. I make no arguments that, especially in the short term, the consequences aren't likely more than unwanted. But I would still maintain that a person or entity that becomes accustomed to living above their means will face consequences sooner or later anyway.

I think the point that Buffett made is especially practical in developing a thought process about the "fiscal cliff." Just like investors don't shy away from making money because of higher taxes, people shouldn't shy away from profitable business opportunities because something outside of the firm's control might or might not have a widespread effect. A business isn't valued based solely on what it makes this year. Rather, a business is valued as an ongoing concern and should be thought of accordingly. Does the McDonald's (NYSE:MCD) franchisee or neighborhood dentist get up each morning thinking about selling their business on the latest news? Of course not. Yet so many "investors" consider selling their wonderful partnerships on an everyday basis.

Now hopefully, I didn't spend too much time sparking a conversation that truthfully, I have little interest in reaffirming. But what I do want to converse about is the sensibility and the math of the situation. Let's even forget that it's the "fiscal cliff" and just make up an event, say "Event X." With this Event X, we will see a massive decline in the price of securities, less spending in the near future, and a resultant flat or even lower amount of earnings in the short term for even the best companies in the world. Sounds pretty unfortunate, doesn't it? Now consider that you have $10,000 to invest each year for the next 10 years, and I come to you with the option of "Event X" or a constant 5% annual increase in security prices. Which do you choose? It seems like an obvious decision: "Event X" sounds awful and 5% yearly price increases seem okay. But let's see if the applicable math agrees. For this example, we're going to need a plethora of qualifying assumptions. For starters, let's assume that you subscribe to a long-term dividend growth strategy such that you own a basket of stocks similar to Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), PepsiCo (NYSE:PEP) and McDonald's:

$66.35 $36.43 $69.07 $68.19 $84.05
Dividends $2.25 $1.02 $2.44 $2.15 $3.08
Earnings TTM $3.59 $1.91 $3.05 $3.76 $5.31

You can pick whatever basket you would like, but this one is reasonable for our purposes. Additionally, I simply pulled Yahoo Finance's trailing twelve month earnings numbers without verifying them, but as you will see shortly, this does not affect our illustration. Let's make some assumptions about "Event X:"

Present After Event X 1 Year Later 10 Years Later
Price of Basket $324 $162 $173.67 $324
Dividends $10.94 $10.94 $11.60 $19.59
Earnings $17.62 $17.62 $14.10 $25.91

Here, I simply aggregated the five individual stocks and suggested them as a proxy for a larger set of holdings. The current yield is equal to 3.38% with a payout ratio around 62%. As you can see, Event X was truly catastrophic to the share prices, as half of the market capitalization was wiped away. I further assume that it will take 10 full years just to get back to today's level at a flat compound annual growth rate of 7.17%. Given that all of these companies have increased their dividend for at least 36 years and collectively, they have a reasonable payout ratio, I assumed dividend growth of 6% a year. In the first year, I also assumed that the companies will make 20% less than they did in the last 12 months, and then grew earnings by 7% a year; thereby increasing the payout ratio to 75% rather than 62%. Surely, every single one of these numbers could be debated, but realize that it's a hypothetical one-time "disastrous" shock. But was it as catastrophic as one might think? Let's see:

Price Shares Total Shares Div / Sh Total Div
Today $324 30.86 30.86 $10.94 $ 337.65
Year 1 $173.67 57.58 88.44 $11.60 $1,025.64
Year 2 $186.13 53.72 142.17 $12.29 $1,747.57
Year 3 $199.49 50.13 192.30 $13.03 $2,505.57
Year 4 $213.81 46.77 239.07 $13.81 $3,301.87
Year 5 $229.16 43.64 282.71 $14.64 $4,138.86
Year 6 $245.60 40.72 323.42 $15.52 $5,019.05
Year 7 $263.23 37.99 361.41 $16.45 $5,945.11
Year 8 $282.12 35.45 396.86 $17.44 $6,919.87
Year 9 $302.37 33.07 429.93 $18.48 $7,946.33
Year 10 $324.00 30.86 460.79 $19.59 $9,027.80

Here we see that at the end of 10th year, you would have amassed 460.79 shares, which would be valued at $324 each, or a total price value of just over $149,000 as compared to the $110,000 contributed. That is, in a decade of price stagnation, you were still able to gain $39,000 in potential value through essentially dollar cost averaging. Moreover, you also collected nearly $48,000 in dividends along the way, for a total return of about 79%, or a yearly average rate of 6%. I see no disaster here. But what happens if we selected option number two of consistent 5% price appreciation instead?

Price Shares Total Shares Div / Sh Total Div
Today $324 30.86 30.86 $10.94 $ 337.65
Year 1 $340.20 29.39 60.26 $11.60 $ 698.78
Year 2 $357.21 27.99 88.25 $12.29 $ 1,084.83
Year 3 $375.07 26.66 114.92 $13.03 $ 1,497.31
Year 4 $393.82 25.39 140.31 $13.81 $ 1,937.85
Year 5 $413.52 24.18 164.49 $14.64 $ 2,408.16
Year 6 $434.19 23.03 187.52 $15.52 $ 2,910.07
Year 7 $455.90 21.93 209.46 $16.45 $ 3,445.49
Year 8 $478.70 20.89 230.35 $17.44 $ 4,016.47
Year 9 $502.63 19.90 250.24 $18.48 $ 4,625.19
Year 10 $527.76 18.95 269.19 $19.59 $ 5,273.92

Here, we obviously also see an increase in value. But an interesting thing happens. While it is true that your initial $324 is now worth substantially more than the initial investment in the Event X scenario, the total value is just $142,000. If you add in dividends of approximately $28,000, we find a 54% total gain, or approximately a 4.5% annual growth rate.

A few things should be noted. Time value of money calculations, frictional expenditures and opportunity costs would have to be considered. Additionally, I made the example up such that it would work in the favor of Event X. (Although to be sure, it wasn't difficult to do so.) But it remains that even if the ending price values happen to be comparable, as a dividend growth investor, I would much rather have $9,000 in yearly income moving forward than I would a $5,000 yearly income stream.

My point is that the math dictates that a short-term negative event is actually a better proposition for the long-term investor than a consistent upward market swing. This was the potential short-term market folly that I was originally referring to and the ideology of Thelma & Louise sailing over the fiscal cliff. Given that I am effectively "rooting" for prices to decrease in the near term, I must be careful about two things. First, I have no idea what will happen in two months, two years or even two decades. In this way, I want to make certain that I am only investing in the best of companies and doing so regularly. Second, I must understand that if such an ideology is come to fruition, I must be prepared to consider investing as decades, not months or years.

Finally, if I haven't yet satisfactorily and succinctly stated my argument, perhaps this bit from Buffett's 2011 Berkshire Hathaway letter will move the ever teetering totter towards rationality:

"The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply."

Disclosure: I am long PEP, JNJ, PG, KO, MCD, TGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.