The baby boomer generation, of which I'm a member, is a major factor contributing to the graying of America. Since this generation has reached the dawning of their golden years, more people than ever, and a larger percentage of our population than ever, are entering or will soon enter retirement. Consequently, the investment portfolios that have been accumulated over our working lives must now be put to work to maintain and support a comfortable lifestyle over the remainder of our lifetimes.
For many people in retirement, this requires that critical choices must now be made, and these choices may require taking a different approach to portfolio management. Common sense, and conventional wisdom alike, would dictate that retired investors should posture their portfolios more conservatively than they may have in the past. On the other hand, the term "conservative" has many different meanings to different people. In the context of this discussion, this most aptly applies to how investors think about, or have been taught to think about the risk associated with certain asset classes.
In this regard, I contend that many widely-held portfolio construction conventions are being too strictly promoted or adhered to in light of the reality of the existence of extraordinary circumstances and times. In other words, when economic and market conditions are functioning within normal ranges, I would agree that conventional wisdom regarding portfolio construction for retirees is valid. However, I would not agree that these portfolio construction postulates should be mindlessly adhered to.
Human beings are blessed with the capacity to think and the capability to adapt. Therefore, extraordinary times require extraordinary actions and behaviors. In other words, what makes sense when markets and the economy are behaving normally may not make sense when they are not. Personally, I contend that we are currently in extraordinary times regarding the risk profile of the two primary asset classes: equity and debt. As a result, I further contend that we must be willing to adapt and think differently about how we look at the risks typically associated with stocks and bonds.
Stocks versus bonds: Considerations of Risk
Historically bonds have been considered the safer alternative based on the predictability of the returns they offered. Under normal times, the interest rates from bonds were higher, and often significantly higher than the dividends available on dividend paying stocks. Furthermore, the predictability of having all your money returned (in nominal dollars) at maturity reduced volatility risk. Of course, volatility risk was not totally eliminated, but under normal interest rate levels it could be easily managed by constructing the bond portion of a portfolio comprised of laddered (staggered) maturities. However, I believe those traditional advantages of investing in bonds are not evident in today's low interest rate environment. Therefore, temporarily at least, I believe the risk profile of bonds has been turned upside down.
Regarding equities or stocks, conventional wisdom has long held this to be the riskier asset class. In general terms I would agree because owners are not afforded the guarantees that loaners are. As owners, our returns are directly related to the successful operations, or failures, of the enterprise that we own. Less predictability implies greater risk, but simultaneously implies the opportunity for greater return.
Furthermore, in normal times the typical blue-chip dividend paying stock offered less current income than bonds. But that is not necessarily true today. Also, the dividend income available from a common stock can vary. It can grow, it can be eliminated or it can be reduced. No guarantees, but there is at least the possibility of a growing income opportunity if your stocks are carefully selected, sound and prudent.
The Risks Associated with Investing in Blue-Chip Dividend Paying Stocks Is Greatly Exaggerated
This brings me to the primary thesis and point of this article. My goal going forward is to demonstrate and provide supporting evidence behind my belief that the risks associated with investing in stocks is often greatly exaggerated. Not necessarily with all stocks, but specifically with the risk relating to investing in high quality blue-chip dividend paying stocks. For starters, not all stocks are the same; therefore, not all stocks carry the same levels of risk. There's an old adage that states "the devil is in the details." With regards to blue-chip dividend paying stocks, I offer that the "angels" are in the details. Therefore, it is from and through the details that true enlightenment can be found.
Consequently, I believe that the general public has been oversold on the notion that stocks are risky. Some stocks are very risky, some are moderately risky and there are some stocks that are in truth quite conservative to the point of being low risk investments. Therefore, it seems logical and prudent to me that investment decisions on common stocks are best made by analyzing the investment merits and characteristics of the individual stocks that the investor is interested in or considering.
However, and I feel this is one of the most important points behind this article, this is not how most investors approach investing in equities. Instead of focusing on the opportunities or risks associated with specific stocks, it is quite common for investors to focus on generalities such as what the overall stock market may or may not do. In addition to the commonly-held opinion that stocks are a risky asset class, this overly-generalized line of thinking leads people to forming opinions about investing in equities that are often fallacious and not supported by real facts.
Some of the more common myths that I have recently heard about investing in stocks that this line of thinking has currently formed are as follows:
1. Stocks are at an all-time high, therefore, they are sure to soon fall.
2. Buying any stocks at a time when the stock market continues to hit new highs is not the best investment strategy.
3. When the market crashes (or corrects), all stocks will fall with it and accordingly.
4. That recent popularity of dividends portends lower future returns, this should be obvious and a concern.
5. After a market crash, stocks may never recover or take a long time before they do.
All of this brings me to the primary reasons why I have no fear of the next market crash or correction. I readily acknowledge that one or both of those events are in our future. However, I do not know, nor do I believe anyone knows, when either of those events might actually occur. It could be very soon, or it could be years away. Regardless, every individual stock, dividend paying or not, carries its own level of risk. Since I believe in building portfolios one company at a time based on the merits and valuation of each company, I spend no time worrying about the stock market. Instead, as I previously stated, I make my decisions one company at a time based on the merits and valuation of the specific stock in question.
Every Individual Dividend Paying Stock Carries Its Own Level of Risk
With the remainder of this article I will present factual analysis and data that refutes the myths presented above as universal truths. In the spirit of fairness, I will acknowledge that there are modicums of truth in some of those beliefs. However, any truth that is contained in the above myths cannot be universally applied to all stocks, which is why I call them myths. For example, there are many stocks that are at all-time highs and remain fairly valued. Conversely, there also individual stocks at all-time highs that are dangerously overvalued. In order to be successful, these are critical distinctions that investors must make.
The Great Recession: Analyzing Current and Past Dividend Champions
In order to accomplish my goal of providing factual analysis and data, I will as usual turn to F.A.S.T. Graphs™ the fundamentals analyzer research tool. The evidence supporting my thesis will be found through the careful examination of each individual earnings and price correlated graph on the Dividend Champions presented. My focal point for most of the following examples will be on the operating results and the price action that occurred during the Great Recession. Since this timeframe represents the most significant market crash that we've experienced in modern history, it will serve as a most appropriate period for testing the veracity, or lack thereof, of the myths listed above.
Consequently, the reader should note that most, but not all, of the examples that I will present in fact do represent Dividend Champions and/or Aristocrats that are dangerously overvalued today. Therefore, it should be clearly understood that I am not offering them as viable candidates for investment at this time. In my previous article, I did, in fact, present research candidates that I felt were fairly valued or close to it currently. Stated more clearly, these examples are focused on how the prices of these blue-chip dividend paying companies acted during the Great Recession, and why.
The objective is to support why I do not fear market crashes or even recessions. Even the most cynical of all readers should acknowledge that this was the most severe economic crisis we experienced since the Great Depression. Consequently, I contend this timeframe represents a quintessential period of time to examine what I consider to be the biased and erroneous opinions and beliefs referenced above that many hold today about common stocks.
However, there are important qualifiers that I will articulate and apply to my arguments that are sure to raise the ire and consternation of the most cynical among us. The most important of which is the importance of sound fundamental valuation and how it often mitigates the price drop risk to a near immaterial level when investing in the best-of-breed companies. Stated more plainly, I intend to demonstrate that best-of-breed high-quality blue-chips purchased at or below fair value substantially reduce price volatility risk even during a severe economic crisis.
I will forewarn the reader again, that the only way the following exercise can be of true value is through the careful review and analysis of each of the individual earnings and price correlated graphs presented. However, I will be providing brief commentary and qualifying remarks on each example for clarity. Furthermore, for those that believe it's too much work to review individual stocks, I submit that I chose the following examples by reviewing each individual constituent of the 106 current Dividend Champions.
This entire exercise took me precisely 27 minutes to accomplish. Researching stocks does not have to be hard and time-consuming if you possess the proper tools. Thanks to technology, primarily the Internet, investors today have many tools at their disposal. Remember, my purpose is to prove that all common stocks are not the same, and all common stocks do not carry the same level of risk. Consequently, I contend that investing success is best accomplished by analyzing the specific and unique merits of each investment under consideration.
A Graphical Review of Dividend Champions with Different Fundamentals
The remainder of this article will be primarily based on analyzing the fundamentals (earnings and dividends) of several Dividend Champions, and how stock price action reacted. For the reader's enlightenment, I have broken each constituent down into several categories in order to illustrate the distinct differences that exist within the universe.
Little to No Operating Stress During The Great Recession
Perhaps the strongest reason for why I don't fear a market crash or correction is because I consider operating results (fundamentals) more important than price action. The stock market is an auction, and as such, emotions can overrule reason in the short run. However, since I believe in positioning myself as a long-term owner of a strong, healthy and growing business, my main focus is on how the business is doing. As long as the business remains strong, I trust and know that stock price will take care of itself over the longer run. This empowers me with the capacity to ignore irrational price action, because I recognize it for what it is.
McDonald's Corp. (NYSE:MCD)
The first Dividend Champion I will review is McDonald's Corporation. For the convenience and clarification of those not oriented to the F.A.S.T. Graphs™ research tool, I will build this first example one component at a time starting with plotting earnings per share (the orange line with triangles) since 2001. As previously stated, with any common stock I consider for investment, this is where my primary focus rests.
The important take-away from this first graph is that McDonald's earnings remained strong and growing prior to, during and after the Great Recession. Clearly, McDonald's suffered little to no operating stress during this economic crisis (see yellow and green highlights at the bottom of the graph).
With my second graph on McDonald's I will add a plotting of the company's dividends (the pink line) prior to being paid out of earnings (the green shaded area). This reveals a couple of important facts. First we discover that McDonald's dividend payout ratio (the green shaded area below the pink line) began increasing in 2005, and since 2006 the company has paid out approximately half of their earnings to shareholders in the form of dividends. If we look closely, we will notice that in 2008 the company did pay out a slightly smaller portion of earnings during the recession. This might indicate that the company was being conservative during hard economic times; nevertheless, their dividend was increased by a healthy 8% over 2007's dividend.
With my next graph I add two additional components. The first is the black line on the graph representing a plotting of monthly closing stock prices. When the stock price is touching the orange fair valuation reference line, this indicates a fair value P/E ratio of 15. When the stock price is above the orange line, overvaluation is indicated.
The important lesson to be gleaned from the McDonald's example is the importance of fair valuation as it pertains to this recession-resistant blue-chip. As long as investors exercised the discipline to only invest at fair value (P/E ratio of 15 or less in this example) there was little to fear (note the yellow arrows on the graph). Moreover, although McDonald's was moderately overvalued entering the Great Recession the price drop was benign and held at fair valuation (the orange line). In this case at least, overvaluation was more relevant than economic conditions.
Fair Value Reference Line
With my final and complete graph on McDonald's, I add the calculation of the company's historical normal P/E ratio (the dark blue line) over this timeframe. This simply illustrates that Mr. Market had a tendency to apply a premium valuation to the company's share price since 2001. The interesting take-away that the normal P/E ratio offers is that investors willing to pay a premium valuation to own this blue-chip still fared rather well through the Great Recession.
The magnitude of the price drop from premium valuation was a little higher, but hardly severe. Importantly, the price drop was only temporary, as price quickly recovered from both valuation reference lines (the blue normal P/E ratio and the orange fair value P/E ratio). But most importantly, shareholders were generously paid to wait for price to return above prior levels because McDonald's raised their dividend each and every year. The good news is they didn't have to wait long as the graph illustrates.
To round out this review of McDonald's, I include the company's performance from December 29, 2000 to June 12, 2014 -- the timeframe that the graphs were drawn over. Here we discover that this blue-chip Dividend Champion outperformed the S&P 500 on all counts. Cumulative dividend income was more than double the index, and capital appreciation of 8.3% per annum almost triple the 2.9% per annum of the S&P 500.
To complete this review of McDonald's and to support why I don't fear recessions if I own great companies purchased at sound valuation, I include McDonald's performance since December 31, 2007 to its close on June 12, 2014. Once again, McDonald's performance was excellent, providing a solid annualized total return of 10.9% coupled with a growing dividend income stream that was never cut.
Colgate-Palmolive Co. (NYSE:CL): Legacy of Premium Valuation
With my next example I offer a review of the blue-chip Dividend Champion Colgate-Palmolive. This example is in many ways similar to McDonald's. Once again, we see a recession-resistant blue-chip that continued to grow earnings and dividends through the Great Recession. However, with this example we see a company with a long legacy of being afforded a premium valuation by Mr. Market.
This Colgate-Palmolive example supports the case that paying a premium to invest in this company might be warranted. However, I am a stickler for fair valuation and my discipline demands that it exists before I will invest. Nevertheless, for those willing to pay a premium, this example also validates the notion that operating results, to include earnings and increasing dividends, support my thesis of not fearing a recession.
In this case, the price drop from its premium valuation during the Great Recession was more severe as price fell from $40.04 on November 30, 2007 to $30.09 by February 27, 2009 during the throes of the Great Recession. However, by November 30, 2009 stock price had recovered to $42.10, or slightly higher than its pre-recession monthly closing peak. Price drops are nothing to fear when fundamentals remain strong. Strong fundamentals can even overcome paying too much. But I feel this example offers an even more important message. If you have the patience and discipline to only invest in high quality blue chips when fair value is manifest, there is even less to fear.
Additional Examples Similar to Colgate-Palmolive
I offer the following additional examples of recession-resistant blue-chip Dividend Champions that like Colgate-Palmolive have a legacy of Mr. Market awarding a premium valuation. In each of these examples we see evidence that operating results are more important than price action in the long run. Furthermore, with each of these examples, and all of the previous examples, we discover that from a business perspective there was no Great Recession for any of them.
It is true that stock price temporarily reacted badly, but it is also true that it soon recovered thanks to growing earnings and a steadily-increasing dividend income stream. I remind the reader of the warning I expressed earlier, none of these represent attractive investments at today's levels. The purpose of their inclusion is to review their records of price action, earnings and dividend growth during the worst recession we had in modern times.
Remember, the true value of this exercise is through the careful analysis of each graph with a focus on earnings, dividends and price action. Therefore, I will let these next graphs speak for themselves and ask that the reader examines each of them closely from the perspective and instructions offered with the McDonald's example.
McCormick & Company, Inc. (NYSE:MKC)
Sigma-Aldrich Corporation (NASDAQ:SIAL)
Johnson & Johnson (NYSE:JNJ)
Ecolab Inc. (NYSE:ECL)
Becton, Dickinson and Company (NYSE:BDX)
Moderate Operating Stress During The Great Recession
With this next set of graphs I present examples of Dividend Champions that maintained their champion status but did experience moderate operating stress during the recession. Consequently, short-term to intermediate-term price action was moderately more severe as price tended to follow earnings as expected. However, each company in the following examples was financially healthy and strong enough to continue to raise their dividends each year. Moreover, each example was also strong enough to recover from the moderate earnings stress they experienced.
I also remind the reader to focus on each company's valuation and its impact on price action as they entered the Great Recession. Additionally, there are a few cases within this group where the prudent dividend growth investor that was closely monitoring their companies might have elected to exit their positions. In many cases, weakening quarterly earnings reports could have alerted them. Conversely, those prudent investors with a long-term view and a focus on dividends that stayed the course would have been richly rewarded long term.
This represents another reason why I don't fear recessions. Strong, well-managed companies are for the most part proven capable of surviving economic stress and then thriving once again when it passes. Rarely do great companies go out of business just because of a recession. Some do, but it is rare, and due diligence can avoid most calamitous situations.
PPG Industries Inc. (NYSE:PPG)
V.F. Corporation (NYSE:VFC)
Genuine Parts Company (NYSE:GPC)
W.W. Grainger Inc. (NYSE:GWW)
Hormel Foods Corporation (NYSE:HRL)
Air Products and Chemicals Inc. (NYSE:APD)
Kimberly-Clark Corporation (NYSE:KMB)
The Sherwin Williams Company (NYSE:SHW)
Substantial Operating Stress During The Great Recession But Remained Profitable
I offer this next set of Dividend Champions that experienced more severe operating stress during the Great Recession. The primary take-away from examining this group of companies is to illustrate that not all companies whether they be Dividend Champions, growth stocks, cyclical stocks or any other type of common stock each possess their own unique characteristics and risk levels.
Not all common stocks are the same, and therefore, investors should not think of all common stocks in the same way. This is a primary reason that I tend to eschew academic studies that I believe study the behavior of stocks too generally. Even though every company in this article is a Dividend Champion, the differences between each individual company are too broad and divergent to draw valuable conclusions upon as a group. As I previously stated, "the devil and the angels are in the details."
McGraw-Hill Financial Inc. (MHFI)
Lowe's Companies Inc. (NYSE:LOW)
Franklin Resources Inc. (NYSE:BEN)
Dover Corporation (NYSE:DOV)
Illinois Tool Works Inc. (NYSE:ITW)
Severe Operating Stress
This next set of Dividend Champions represent examples that I would never invest in. A rising dividend income stream is a metric that I covet, but I also covet stability and consistency of operating results, and of course reasonable and sound valuation. Consequently, even amongst a universe like the Dividend Champions list, I believe in selectivity. This offers further evidence that not all common stocks, even Dividend Champions, are the same.
Cardinal Health Inc. (NYSE:CAH)
Leggett & Platt Inc. (NYSE:LEG)
Nucor Corporation (NYSE:NUE)
Cincinnati Financial Corporation (NASDAQ:CINF)
REITs and Utility Stocks
I offer the following examples of Dividend Champions, one utility stock and one REIT, as additional evidence that not all stocks are the same. In both of these examples, I believe that high-yield that is growing moderately is the primary salient feature of these companies. Consequently, I would not analyze them the same as some of the other Dividend Champions. Understanding the unique characteristics of each company or class of companies is vital to successful portfolio management.
Consolidated Edison Inc. (NYSE:ED)
The Unique Nature of REITs
HCP Inc. (NYSE:HCP)
Summary and Conclusions
I don't fear recessions or market corrections because I believe in focusing more on the financial strength and health of the companies I invest in. Steady and consistent earnings growth, a growing dividend income stream and fair valuation are attributes I covet most now that I've matured. Furthermore, not all stocks are the same, and therefore, they should not be looked at the same way.
To me, investing is analogous to the lessons I learned as a child from the famous children's story "The Three Little Pigs." As long as I build my house (portfolio) of bricks (a sound foundation of strong fundamentals), the big bad Wolf (recessions or corrections) cannot blow it down when he comes around. Possibly a shingle or two might blow off the roof and create a minor leak, but when my foundation is strong, I will remain safe and secure.
In this part one of this two-part series on why I don't fear market crashes or corrections, I primarily focused on blue-chip Dividend Champions that generated exceptional operating results even during the Great Recession. Additionally, I included several examples of companies with less-than-stellar operating results through the Great Recession, but nevertheless, still maintained their record of consecutive dividend increases. In part 2, I will look at fallen angels that once were Dividend Champions. The primary objective of my next article will be to illustrate that prudent dividend growth investors that exercise continuous monitoring and due diligence could avoid any potential disaster, or at least the majority of damage that a fallen angel might bring.
Disclosure: Long MCD, CL, JNJ, DOV, ED, KMB, GPC at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: The author is long MCD, CL, JNJ, DOV, ED, KMB, GPC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.