If you have ever subscribed to the popular Ibottson Data booklet, you will know that the Dow Jones gave investors returns slightly in excess of 10% from 1926 through 2006. That's where the oft-referenced "10% annual returns" achieved its statistical legitimacy. For a modern look at large-cap stocks in general, you can click here to see that the big American stocks achieved general returns of 9.8% annually from 1926 through the end of 2012.
But if you are seeking to beat a major benchmark index such as the S&P 500 over an extended period (~10 years), then the reasonable implication is that you would want to acquire ownership stakes in companies that have a plausible likelihood of achieving returns in excess of 9.8% or so during the coming decade.
There are a lot of ways that you could do that, but if you have the intent to do it with: (1) companies you do not sell over that ten-year time frame, and (2) companies that will pay dividends over the entirety of that ten-year time frame, then you should be focused on finding stocks that meet these two criteria:
(1) The companies will have earnings per share growth rates above 10% annually for the next decade, and
(2) At the time you make your purchase, the stocks should be trading at fair valuation (or better) so that you can capture the full benefits of the earnings per share growth rate.
If I wanted to construct such a portfolio, here's where I would start.
I would take a good, hard look at Visa (NYSE:V) stock.
With a company like Visa, it is easy to find a lot of superficial reasons to avoid buying any shares of the company. Firstly, and perhaps most importantly, it appears to be trading at a steep valuation.
If you look at a popular stock screener for Visa, you will see that the company is trading at $202 while seemingly earning $5.80 per share for a P/E ratio apparently in excess of 34x earnings. Considering that I have gone on the record criticizing investors for paying more than 30x earnings during the tech bubble, and considering that I have expressed admiration for Benjamin Graham's advice to avoid trouble by never paying more than 20x earnings for a company, I should explain why Visa qualifies as a common-sense exception.
The $5.80 figure that you see in stock screeners may tell you Visa's current earnings, but it does not tell you Visa's current earnings power. Visa management is aggressive in its accounting of impairments in its financial reports, but once you strip them out, you will see that Visa is about to earn $7.60 per share this year (with each share generating over $8 per share in cash flow). From an earnings power perspective, Visa is valued more reasonably at 26x earnings rather than 34x earnings.
But still, that may seem high, and I think you need to be sympathetic to the Charlie Munger playbook of investing to find Visa an attractive investment at current prices. What I mean by that is this: Charlie Munger once said that the most common way for an intelligent man to make an investment mistake is to buy shares in a steel company. That's because even though steel companies seemed to be trading at 6-7x earnings, they were actually value traps because they required heavy new capital expenditures that ate up all the profits. "Steel mill investing" is metonymic jargon that points out the general truism that P/E ratios are meaningless if not interpreted within the context of capital expenditures.
In the case of Visa, everything is clean-the company has no pension plan, no preferred stock, and not even a dollar of debt on the balance sheet (Visa is one of the few companies that conducts its buyback program by taking cash profits to retire shares, and then destroying them so that you get an ownership claim on a larger slice of the enterprise).
And the company is only spending $0.50 per share in capital expenditures, while having over $7.60 in earnings power. Unlike the steel mill that has to constantly reinvest its profits to maintain the status quo, Visa retains giant sums of cash to give investors honest-to-god topline earnings growth that also manifests itself in the form of a high dividend growth rate (namely, a dividend that has sextupled since 2008) over the long term because the low reinvestment needs allow chunks of profits to be extracted from company coffers and transferred to the pockets of you, the owner.
Visa's current international growth story is one of the best among large-cap companies domiciled in America. It's hard to find an international market where Visa is not growing by double-digits. It's growing by almost 14% in Asia, just shy of 20% in Latin America, and almost 30% in Central Europe. Companywide, revenues are currently growing over 15% annually. That's what happens when you are expanding Visa, Visa Electron, Plus, and Interlink brands in over 200 countries simultaneously while achieving 20.5% returns on shareholder equity and a 63.5% operating margin that is superior to almost every company I currently own.
On a more personal note, there are two factors that entice me towards a Visa investment. The first is that the company is resilient during periods of economic hardship. In 2008-2009, the annual dividend doubled from $0.21 to $0.44, earnings per share increased from $2.25 to $2.92, and cash flow per share increased from $2.50 to $3.22. While I never insist upon annual profit growth, I do find investment judgment calls easier to make when profits and dividends are actually increasing during exceptionally difficult economic environments. Because of that economic resilience, Visa passed the economic catastrophe stress test in my book.
And secondly, I find Visa well-positioned to survive (and even thrive) during periods of high inflation, both here and abroad. That is because Visa operates on the Gross Dollar Volume business model. The company's business is partially set up to receive compensation based on the amount of money spent, and when inflation causes increases in total spending, Visa continues to take in a percentage of that. It's a natural, built-in hedge.
The type of person least likely to be interested in Visa would be an investor that needs to see material amounts of dividend income generated right now, perhaps to meet living expenses or to meet a pre-defined objective of total dividend income generated. The dividend yield is currently 0.65%. If you own a modest amount of Visa stock, an aggressive day of scouring the couches for loose change might produce more money than what you'd get from the Visa dividend.
Given that I have spoken so glowingly about Visa's business model, I should explain why I do not currently own the stock. For most of this year, I had spent my time buying shares of Microsoft (NASDAQ:MSFT), IBM (NYSE:IBM), and Becton Dickinson (NYSE:BDX). Together, they have a blended dividend yield of 2.4%, and that is including Microsoft's recent sizable dividend increase.
Those three purchases brought my portfolio's overall dividend yield below what I desired. A first-world problem, to be sure, but a circumstance I wanted to change regardless. That means I spent most of my summer and early autumn buying shares of yield-rich energy giants, namely BP (NYSE:BP) and Royal Dutch Shell (NYSE:RDS.B) to raise my overall yield. In the context of buying Becton Dickinson and IBM, a purchase of Visa needed to wait (you can only draft so many speedy wide receivers in a row before you need to pay attention to adding big offensive linemen that churn out immediate profits so you can give the speedsters the necessary time to grow).
Given its low reinvestment needs and double-digit international growth, it seems reasonable that Visa will continue its path of double-digit growth. And when a company is growing by 13-17%, it is unlikely that the overall valuation that marks "fair value" will decline, absent the emergence of a new economic impediment that is not a presently known risk factor. When valuation holds steady, and when you own something poised to clear the 10% annual earnings per share growth mark, then you have found fertile ground for making an investment that will outstrip the S&P 500 over the long haul, and more importantly, give you the growth necessary to create substantial personal wealth.
Disclosure: I am long RDS.B, MSFT, BDX, BP, 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.