One of the most important pieces of wisdom that I have ever picked up from Peter Lynch is the notion that we should separate a company's reputational risk that is the result of financial headlines from the underlying business performance of the company. If you acquire that skill set, you will be able to do things like buy McDonald's (MCD) stock in 2002 and 2003 when it was being lambasted for its unhealthy food options, while the profits and dividends continued to grow. You will be able to do things like buy Johnson & Johnson (JNJ) in the $60s during the string of product recalls, because the dividends and profits were actively increasing while these problems were occurring. For a more modern example, a focus on underlying business performance will lead you to buy something like BP (BP) oil stock, realizing that a worst-case court scenario could still ensure reasonable returns going forward (and excellent returns going forward if a worst scenario does not, in fact, materialize).
It is the spirit of Peter Lynch's advice to focus on underlying quality rather than reputational risk that leads me to a discussion of General Electric (GE) today. GE is probably the most dominant company in the United States that is not universally regarded as such. The backlog of work to be done well exceeds $200 billion. The company is probably going to be generate somewhere between $146 billion and $147 billion this year. The company enjoys operating margins of nearly 30%, despite a drastic reduction in its financial operations.
The company now generates over half of its revenue overseas; it's a shame that the word "global" has become such an overused word to the point where it has become devoid of meaning, because global is the right word to describe the nature of GE's profits: there are now over 100 countries that are contributing to the $16.7 billion that GE will be creating for shareholders by the end of 2013.
What's interesting, though, is that some people can't get past the dividend cut in the third quarter of 2009, when GE went from paying out $0.31 quarterly to $0.10 quarterly. That moment deserves a spot on the list of worst moments for blue-chip investors in American history. GE broke its informal contract with shareholders by allowing the financial arm of the company to grow unwieldy-when you have credit divisions loaning out large sums of money to people that don't have the earnings power to pay you back, or to real estate divisions that are buying assets at inflated prices, then you will lose a lot of money when economic distress comes knocking.
And that's exactly what happened in 2009. When the company's credit divisions proved to be of much lower quality than had been advertised, profits fell from $18 billion to $11 billion (as an aside, that's an interesting trivia fact: as GE cut its dividend and fell to $6 per share, it still made $11 billion in profit in 2009). My guess as to why some income-focused investors might shun GE is because of the unfortunate timing of Immelt declaring the dividend to be safe and then cutting it very shortly thereafter.
Plenty of financial commentary has been dedicated to interpreting that moment to conclude that Immelt was a liar, deceiver, or something to that effect. However, the lesson I walked away with was this: A dividend can only be as strong and reliable as the underlying profits of the company that pays it.
And that is why I believe GE's dividend is in a much safer place today than it was during the Financial Crisis. If the current General Electric had to go through a 2009 scenario again today, my belief is that not only would the dividend be maintained through the recession, but it would grow through it as well. My basis for this belief is the reduced exposure to the financial elements, and higher-quality industrial earnings. GE has reduced its financial exposure 75% over the past five years. The low-quality assets have been spun off and sold, as GE is even shedding much of its lower quality credit-card operations that have been cash cows in normal times and good times.
Right now, GE is a company that is performing like an orchestra where all the members are performing together in harmony. First, you have share buybacks that are actually reducing the share count from a high of 10.6 billion in 2009 to a total that should be lower than 10.0 billion in the next year or so.
Secondly, you have a company that is cutting costs ruthlessly, increasing the amount of profits that can end up in the pockets of shareholders over the coming years. The company, specifically through Jeff Bornstein, indicated a desire to cut $2.0-$2.5 billion in costs over the next twelve to eighteen months, and that should be something that allows shareholders to experience a higher dividend.
The industrial side, which consists of operations like aircraft engines, water processing, medical imaging, and household appliances, is growing a little over 7% annually at its core, when you strip out the currency fluctuations. When you combine this with the $2 billion decrease in costs and a buyback that is reducing share count, it is easy to see how General Electric could be one of the few behemoths in the world to deliver 10% or more annual shareholder growth.
Some of you may have just seen that GE has raised its quarterly dividend 16%, from $0.19 per share to $0.22 per share. My guess is that 8-12% dividend increases is what GE shareholders can reasonably attain over the course of the next five years. The theory is that the industrial divisions have a $200 billion backlog that ought to enable the company to grow 7-8% annually from the industrial side over the next five or so years, and when you add in the cost-cutting and buybacks, you get growth around 10%. And as the company slowly rises the payout ratio from 48-50% of profits to 60% or so of profits, the dividend growth right might gently increase faster than the earnings per share growth rate at the company.
In terms of valuation, GE shares give you a fair share right about now. You're not going to get whacked by P/E compression, nor are you going to be engaging in Graham-style value investing paying 15x earnings for a large industrial. Instead, you're going to be engaging in growth at a reasonable price investing, in which the growth rate of the high-quality company itself will reflect the total returns that you experience as an investor. But with a company buying back stock, cutting costs, growing at 7% organically on the industrial side with a $200+ billion backlog, you are going to put yourself in a position to experience GE's golden age of dividend growth as you find yourself getting 8-12% annual dividend increases. The 16% dividend increase this morning was on the high end of good things to come.