If you read the book "Buffettology" about Berkshire Hathaway (NYSE:BRK.B) CEO Warren Buffett by Mary Buffett (no relation) and David Clark, you will come across many comparisons between Coca-Cola (NYSE:KO) and General Motors (NYSE:GM). The authors juxtapose these companies effectively to demonstrate the difference between what the finances of "a good business" look like in comparison to "a bad business."
In particular, I'd like to share with you a passage from page 250 that gives a pretty biting example of the woes facing long-term General Motors shareholders:
Let's look at a company like General Motors, which had total per share earnings of $37.67 between 1983 and 1993, of which $22.18 was paid out in dividends and $15.49 was retained by the company. Per share earnings for General Motors, however, decreased from $5.92 in 1983 to $2.13 in 1993. General Motors' management kept $15.49 per share of shareholders' earnings and allocated it in such a manner that per share earnings actually dropped. This makes you wonder about the underlying economics of the auto business.
If we ran General Motors' numbers forward to 1995, when it earned $7.28 a share, we would see that from 1983 through 1995 General Motors retained approximately $26.27 in shareholder's earnings and increased its per share earnings from $5.92 in 1983 to $7.28 in 1995. This means that General Motors kept $26.27 in shareholders' earnings and in the process managed to increase per share earnings by $1.36 ($7.28-$5.92=$1.36). Thus we can argue that the $26.27 a share that was retained between 1983 through 1995 produced $1.36 in additional income for 1995. We can argue that the $26.27 in retained earnings earned $1.36 in 1995, for a rate of return of 5.1% ($1.36/$26.27-5.1%).
Considering that inflation has typically run at levels of 3-4%, GM's management team effectively created 1.1-2.1% worth of purchasing power increases (a backtest later revealed that GM management could have generated 6% worth of purchasing power increases had they mindlessly bought back stock without regard to price). This is the difficult part about dealing with cyclical companies or companies that operate in industries with unpredictable earnings: it is not immediately apparent whether management is deploying the retained profits in a way that will fuel satisfactory future earnings growth. In the case of GM, investors experienced a decade-long stretch from 1983 to 1993 when retained earnings were deployed in such a manner that value got destroyed.
This is a sharp contrast to the performance of the no-nonsense blue chips that are the backbones of many conservative investors' portfolios. When you're dealing with an excellent company in a non-cyclical industry, you often see meaningful earnings growth every year. From the perspective of a business, this provides you with some instant gratification that the earnings are being deployed in an intelligent manner. Every year, you can see the increased profitability. For someone entrusting their hard-earned dollars to others, this can be an enormous source of relief and comfort.
If you look at an earnings chart of PepsiCo since 1997, you will see that the earnings per share increased every single year except from 2007 to 2008 and from 2011 to 2012. On average, the earnings have grown by 9.0% over the past decade. And, of course, the dividend went up every single year during this period, on average by 13.5% over the past decade. When you see the earnings going up by high single digit rates every year, you can have the confidence that the management team is redeploying your profits effectively.
Now let's take a look at Colgate-Palmolive. Since 1997, there have only been two periods when earnings did not increase: they went down $0.04 per share from 2003 to 2004, and they fell $0.06 per share from 2009 to 2010 as the United States recovered from the financial crisis. For the past ten years, the earnings have grown by 9.5% and the dividends have grown by 12.5%. Heck, the company has been paying dividends since the 1800s. When you know that (1) the company has been paying out dividends since the second Grover Cleveland presidency, and (2) earnings are growing every single year, you can sleep well at night with the knowledge that your dividend is probably pretty safe.
Coca-Cola, better known as Exhibit A for dividend growth investing, also has an impressive earnings chart. Looking at the period from 1997 to the present, the 1997-1998 period and 2008-2009 period represent the only times that Coca-Cola did not increase earnings. Both of those declines were by less than a nickel per share. On average, Coca-Cola has grown earnings by 9.0% over the past decade and grown dividends by 10.0% over the past decade. There's a reason why Warren Buffett owns 400,000,000 shares of this masterpiece. You can see an almost parallel journey between the growth of the firm each year and the dividend increase that the shareholder receives.
Like all the others, my data for Procter & Gamble goes back to 1997. Since then, P&G saw earnings slip $0.06 per share from 2008 to 2009, fall $0.05 to 2010, and then fall $0.08 from 2011 to 2012. And by the way, this is what happened during a time of extreme turmoil for P&G: the company was losing market share to Colgate-Palmolive, Kimberly-Clark (NYSE:KMB), and generic brands across the board in the household goods segment, and the company also had to address some headwinds in the form of unfavorable currency translations. The past five years have witnessed the worst financial crisis and economic catastrophe since the Great Depression, and P&G management did not respond to the crisis particularly well, and the consequence has been this: a nickel per share loss here and there. That's not bad.
And lastly, let's take a look at Johnson & Johnson. This company, without exception, has increased its normalized earnings per share every year since 1997. Despite the string of recalls that have plagued the company, a look at the company's financials indicate that the earnings power of the firm has continued to march upward. There has been no permanent capital impairment. Earnings have grown by 11% and dividends have grown by 13% the past ten years. When it comes to clockwork earnings growth and dividend growth, Johnson & Johnson is about as good as it gets.
This is what I mean when I say that blue-chip dividend growth investors receive instant gratification. While the dividend growth of these firms is in fact linear, the earnings growth is near linear. You can usually only find a year or two each decade when the earnings per share stagnates. Otherwise, you can actually see, in a very real and demonstrable way, the fact that the retained earnings are being used in a manner that fuels future earnings growth.
By the way, I am not saying that this is the "right" way to invest. A portfolio stuffed with more cyclical companies like ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), Emerson Electric (NYSE:EMR), and General Electric (NYSE:GE) could very well deliver total returns over the next decade that match the company's above. But the four companies that I just mentioned will most likely have much more volatile earnings over the next decade than the blue-chips I mentioned. Some investors are not bothered by the fact that earnings fluctuate, while others may want to see smooth upward growth so they can know that their ownership stakes are producing more and more profit each year. Like anything else, it comes down to knowing yourself.
The funny thing is that most blue-chip stocks have a reputation for being stodgy and are generally associated with the "get rich slowly" approach to building wealth. We're often told that "patience" is the key virtue with these types of stocks. But in some ways, this strategy is a constant series of instant gratifications. You receive a dividend check every three months. Heck, the dividends of the companies I've mentioned go up each and every year. More importantly, these companies also allow you to see right away that the retained earnings are fueling future earnings growth. For investors that want to avoid the GM situation where you have to take on faith the fact that management will do something in intelligent in the future, it can be a welcome relief to own these types of blue chips that offer the immediate annual earnings growth that allow you to see the fact that your dividend continues to be well supported.
Disclosure: I am long GE, PG, XOM, EMR. 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.