I'd like to preface this article by suggesting that I have previously used a similar format in evaluating AT&T (T) - same title and everything. So if you happened to catch that article then it's likely that you will draw similar conclusions from this one. I suppose you should find comfort in my consistency. Let's get to it. If you saw the recent UBS upgrade or perhaps more aptly the strong share price run-up in Walgreen (WAG) over the past few months then you know where this is going: I partnered with Walgreen a short while ago, it has since risen substantially and now I'm faced with the dilemma of a tidy profit or sticking with a wonderful company. Let's move to the particulars.
On July 13, of 2012, I bought shares of Walgreen at a per share cost basis of roughly $30.26. Certainly this wasn't the bottom, but I would like to indicate that is wasn't that far off. Additionally I would like to indicate that I profess no special talent in buying at this time. I was merely searching for a wonderful company, given a limited amount of capital, at a reasonable price. I won't spend much time on the selection process, but I would like to quickly lay out my rationale. First, I'm a dividend-growth investor; so this means looking for companies that 1) pay a dividend, 2) have a propensity to increase the dividend and 3) possess a sustainable "economic moat" such that earnings and payouts can far outpace inflation. At my time of purchase, Walgreen had paid a dividend for 319 straight quarters (that's over 79 years folks), had increased this payment for the last 37 years, grown the payout by an annualized rate of 24% over the past five years and by a rate of over 17% each year for this century. Further, I like to talk about Walgreen in the 75/65 sense. That is, 75% of the U.S. population lives within five miles of a Walgreen and roughly 65% of its he business comes from prescriptions. Given an aging baby boom population, it doesn't seem especially difficult to presume that it will demand more drugs - and hopefully for Walgreen close-by and legal ones. Without even considering relative valuation yet, it appears that WAG is a sensible long-term partnership.
So where am I today? Well, as of March 13, (eight months after my purchase), WAG closed at a per share price of $42.78. Add in three $0.275 dividend payments, and we reach a grand total of $43.61. In other words, a 44.11% return in just two-thirds of a year. Forget annualizing it, at that yearly rate I'd be retired by 30. But again, I would like to indicate that I did nothing altogether special in this circumstance.
My dilemma of the moment is this: Do I take the large short-term paper gain, or do I continue to "stick with the plan" and partner with a wonderful company for the long term?
Much like my AT&T article, the answer is developed in comparing the next best alternative. The alternative not only has to replace the growing income stream, but I also need to find a company that I perceive to be at least as wonderful. Let's address the likelihood of finding a better income stream.
A lot of people like to quote yield on cost (YOC), but that doesn't necessarily apply to this example. (I like to use it as an "income measuring yardstick" but not necessarily as a comparative tool.) So while my YOC is roughly 3.6% on a $30.26 per share basis, the current yield of 2.6% on today's price is more reasonable. Let's imagine that you hold WAG in a taxable account such that any gains would be subject to say a 20% tax. (We'll just throw frictional expenses, opportunity costs for finding another company and short-term holding rates into one to make this simple) Taxing 20% of gains we find a more comparative $40.28 to invest in order to achieve the same $1.10 in dividends, or a 2.73% current yield. Obviously there is an abundance of dividend growth companies to choose from, but let's narrow the field and pick three: Target (TGT), Johnson & Johnson (JNJ) and AT&T. Now I have no idea how fast each company will grow their payouts, but putting my finger into the air let's call it 12% for Target, 10% for WAG, 8% for JNJ and 3% for T over the next decade. Additionally we'll say you invest $1,000 and we ignore frictional expenses. What does this look like?
|Yearly Income||Yr 1||Yr 5||Yr 10|
Notice that the "WAG equivalent" is based on finding a new security with the same characteristics as holding WAG, but after you have sold off your ownership and paid taxes. Think of it like holding 24.81818 shares of WAG (yes I did the math). That's a cost at my basis of $753.48, a current value of $1,061.72 at today's price and you guessed it $1,000 worth of buying power if you sold at the aforementioned tax rate disregarding frictional expenses. I used the current yield of TGT, JNJ and T. We see that WAG trails JNJ and T in the first five years, but eclipses all of the holdings in a decade's time. Clearly time value of money and reinvesting aggregate dividend payouts would have to be considered. However, there is at least a theoretical framework to suggest that moving forward - given that all of the dividend growth rates eventually converge - the WAG payouts would ultimately provide the greatest amount of income. Granted if TGT kept up its hypothetical dividend growth pace it would be the very long-term winner instead. But the point is that a clear "dividend income stream advantage" does not appear to emerge in the intermediate term by selling WAG.
To the point of finding a similarly wonderful company, I would advocate that this would also mean finding a company within the given sector that you find favorable. So for example comparing, say Consolidated Edison (ED) to Walgreen would in effect be comparing apples to a beach chair. Undoubtedly CVS Caremark (CVS) is the go-to rival in this framework, but I would simply suggest that for the long-term dividend growth investor one would be hard pressed to find a more consistent drug store.
The final point of emphasis is current valuation. Using data from Fastgraphs.com one can find that WAG has grown it's earnings by just over 11% a year since 1999 and has grown its dividend by just over 16%. In addition, you would see an average high price to earnings ratio around 32 and an average low price to earnings ratio around 21 over this same time period. Those seem a touch high considering today's forward rate is around 13, so let's look at the past five years: average high PE equals about 17 and the average low PE averages about 11, that's better. Add in a current yield around 2.6% versus an average five-year high dividend yield of 2.29% and a payout ratio around 35% and we're in business. Fastgraphs.com seems to agree with this "reasonable" assumption as well, indicating a potential 16.2% annualized five-year return within a band of possibilities, given rational earnings multiples and consensus earnings projections. (By the way, you can manually adjust this forecast to your liking.) Doing a "back of the envelope calculation," given earnings growth projections in the 12% range and management's commitment to keeping the payout ratio in the 30-35% range, one could logically expect earnings and payouts to grow at the previously mentioned 10% rate over the intermediate term. Even at 6-8% you're beating inflation and likely making a decent amount of money moving forward. In other words, if the dividend keeps growing at an acceptable rate - which in turn necessitates long-term earnings growth - then capital appreciation will come whether you want it to or not.
To me WAG is still quite reasonable, but it can be hard to justify further ownership after a short 40%+ gain. In Ben Graham's ideology, that quick run surely racked up a great deal of the "margin of safety." But just because you wouldn't buy today, doesn't mean you can't hold; in effect Walgreens would have to "make me sell" before I considered removing myself from a long-term partnership. Moving from Graham to Warren Buffett: "I don't look for 7-foot bars to jump over, I look for 1-foot bars that I can step over." Walgreen at $30 was likely pretty close to a one-foot bar, today perhaps it's closer to a three or four-foot bar.
Incidentally, I would have actually preferred a falling price rather than this run-up, as I would have been able to claim a greater ownership in what I perceive to be a reasonable business. Yet in reality whether the price goes up or down in the short term, that likely doesn't tell you much about the underlying business over the long term. Perhaps I'm giving up the thrill of a short-term gain, but for me I'm quite content establishing durable partnerships and waiting for wonderful companies to continue to be successful.