Don't Let 'Shiny Objects' Distract You From Your Blue-Chip Dividend Strategy

by: Tim McAleenan Jr.

Judging by the current prices that are prevailing in the stock market, we are in a place that may be somewhat uncomfortable for some blue-chip investors: most of the companies that we usually identify as "buy-and-hold forever" stocks are trading at valuations that leave very little margin of safety. Meanwhile, certain banks, energy companies, and tech companies appear to be trading at cheap valuations, as measured by book values (when relevant) and P/E metrics, assuming we are not at the precipice of a commodities bust or widespread recession.

This can complicate life for buy-and-hold investors because it calls into question whether conservative investors should continue to hold those blue-chips that have low starting yields but have likelihoods sustainable 8-10% dividend increases on a reliable basis going forward.

The appeal of loading up on excellent businesses no matter what is how easy it is. It does not take particular cleverness to identify some of the most profitable companies in the country. We all know General Mills (NYSE:GIS) is an excellent company. We all know Coca-Cola (NYSE:KO) is an excellent company. We all know Johnson & Johnson (NYSE:JNJ) is an excellent company. We all know Nestle (OTCPK:NSRGY) is an excellent company. We all know Colgate-Palmolive (NYSE:CL) is an excellent company. We all know Procter & Gamble (NYSE:PG) is an excellent company. How can you not admire companies that are more or less doing the same that they have been profitably doing for most of the 20th century while showing meaningful earnings growth and dividend growth over almost all five year rolling periods?

If you set aside $100 each month to put into each of those six companies for the next 20+ years, it is really hard to envision how that does not work out well for you. I'm talking both in terms of dividend growth and capital appreciation. It's all in the nature of these companies' underlying business models. Johnson & Johnson and Coca-Cola have been generating fantastic returns on equity for decades (Johnson & Johnson's return on equity figures typically fluctuates between 20-30%, while Coca-Cola's is almost always in the more narrow 25-30% band), despite the fact that both companies were led by less-than-ideal management teams at different points in the last fifteen years. That tells you something about permanent business quality. In the case of Nestle, the company quietly grows earnings 8-11% almost every year, decade after decade, while no one seems to care. Colgate-Palmolive has had returns on capital of over 30% almost every year over the past decades, and that explains how a toothpaste and dish soap company has been able to compound shareholder returns at over 14% since 1993.

The funny thing of it all is that these companies are sitting in plain sight. Does anyone seriously doubt that a company like Coca-Cola has a very, very high likelihood of growing earnings per share by at least 7% over the next 5-10 years, with a reasonable chance that the earnings growth could be over 10% annually? With the exception of the fact that the company has been taking advantage of the low interest to add debt to the balance sheet to fund some buybacks, the company's earnings growth and balance sheet looks remarkably consistent year over year.

Then why don't people load up on these stocks? I call it "shiny object" syndrome. There's always another company out there that seems to glitter a bit more than these blue chips: maybe the yield is much higher, maybe the perceived potential for capital appreciation is much higher, or maybe investors are so caught up in trying to find "the next Coca-Cola" that they discount the possibility that, well, Coca-Cola itself could be the next Coca-Cola (kind of like how investors have spent the past twenty years looking for the "next Warren Buffett", while Warren Buffett himself managed to deliver 12.36% annual returns to shareholders since June 15th, 1993).

You could always find a reason not to buy an excellent company like Coca-Cola. You might look at it and see that the company doesn't "seem to move all that much", with its price trading in the range of $36-$42 for the most part. You might see the 2.67% starting yield and think, "Ehhh, I can do better." Going back twenty years, Coca-Cola has always had a low starting dividend yield that grew by 8-10% on average every year. A $10,000 investment that would have paid out $129 annually in 1993 would be paying out $1,036 annually today. Oh, and it would be worth over $53,000. For twenty years, you got 8x your starting income and 5x your initial investment. And it would have been a smooth ride, too: the lowest annual dividend increase that investors would have experienced in that time frame would be the two 6% increases that happened in 2000 and 2001. These kinds of returns are what you can get when you refuse to compromise on quality.

There is one catch though: even with the best-in-class companies, price still matters. None of us can get past the inescapable fact that the future dividend streams and total returns that we experience are a function of the price that we pay for each security. And when you overpay for a stock, you get a "negative margin of safety", meaning that your total returns will not match the growth of the company due to something known as price-to-earnings compression (this is when investors decide that they only want to, say, pay $17 for each dollar of the company's profits instead of $20).

The effects of overpaying for a security can be very real: over the past eleven years, Coca-Cola has grown by about 9% annually. Yet, we can identify moments in 2002-2003 when investors could have only achieved returns of 7% on their Coca-Cola stock because the company was overvalued. It can be frustrating to watch a company experience growth that is greater than the returns you generate, and you could be particularly hurt if the company has a rough patch where earnings growth is weak and you get hit by P/E compression at the same time (this is why Benjamin Graham dedicated most of his life's work to encouraging investors to buy companies with a "margin of safety" provided by the price).

With interest rates so low, some investors are buying into the alphabet soup of REITs, BDCs, and MLPs instead of the traditional old-guard blue chip stocks. There is nothing wrong with this, per se, if you know what you are doing (i.e. can you readily identify which MLPs in the refining industry are generating record profits due to very favorable hedges that will expire in two to three years, causing the current yield of 8-10% to possibly shrink in 2016 when that happens?).

The fun thing about owning Coke and Pepsi (NYSE:PEP) is that those companies likely fall within every investor's circle of competence. While you may not have a margin of safety in terms of price with either company right now, you gain a margin of safety by owning an excellent business with reliable cash flows. This fact is easy to discount when there are other "shiny objects" out there that have much higher current yields (and this possibly tempts the investor to stray beyond his circle of competence).

Would I encourage investors to make a big lump sum investment into consumer staples, utilities, and blue-chip healthcare companies right now? Probably not. Personally, I think the current investing environment is a good time for investors to have a blended strategy. Let's say you have $600 per month to invest. I'd DRIP $200-$300 per month into companies with free DRIPs like Procter & Gamble and Johnson & Johnson (note: JNJ's DRIP is only free if you pay by check), and spend the other $300-$400 each month looking for attractively valued energy supermajors, banks like Wells Fargo (NYSE:WFC) and US Bancorp (NYSE:USB), and tech companies like IBM (NYSE:IBM). That way, you're balancing high quality with attractive valuation.

Disclosure: I am long PG, JNJ, IBM. 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.