The Total Return Nuance Of Slow Growth Vs. High Expectations

|
Includes: MMM, T
by: Eli Inkrot

Summary

In a previous article, I highlighted the idea that a faster dividend growth rate does not necessitate that a security is a “better” dividend stock.

That article was focused primarily on dividend income.

This commentary focuses on the total return part of the equation.

Recently, I came across the concept that 3M (NYSE:MMM) was a "better" dividend stock than AT&T (NYSE:T). The idea was simple: while AT&T had a higher starting dividend yield, the anticipated growth rate is much greater for 3M. Eventually, faster growth beats slower growth, and thus, it's easy to see why someone automatically choose a security like 3M.

The reality is not so simple. As I illustrated here, there's a big difference between "eventually" providing more income and seeing that occur in practice. In looking at AT&T and 3M in particular, the amount of time it would take for 3M to take over the income lead was anywhere from 13 to 28 years, depending on if you're talking about yearly, aggregate or total income growth.

That's an important counterpoint to the notion that "higher growth must win." It's mathematically true, but you must be aware of the time frame involved. If your investing time horizon is say 10 or 20 years, you could be mistakenly selecting a security that doesn't quite work toward your goals in a way that an alternative selection might. Moreover, this is also presuming that AT&T remains a "slow" grower and that 3M keeps up its faster pace for decades. Should something change, the income tradeoff - in this case decades - could be lengthened further.

So before you automatically pick the security with a higher anticipated growth rate, it can be instructive to work with a few numbers to get a baseline. If you're primarily focused on income generation - be it today or in the future - above average starting yields have a sizable advantage that ought to be considered.

This past comparison was done with an income focus as the primary consideration. For this article, I'd like to expand the thought process to total return. That is, we know that AT&T is apt to produce much more income than 3M in the coming years, but this may only be half of the story. Equally important for many is the concept of total return. So let's come up with a few examples to get a better feel for what this might look like. (Additionally, what follows this part of the discussion is apt to be more instructive anyway.)

We'll keep the growth rates exactly the same as the previous article: 2% for AT&T and 8% for 3M.

For AT&T, you have factors that work for and against the growth rate. Acting as a negative, or at the very least a drag to potential growth, is the history and size of the business. Over the past decade, AT&T has grown earnings per share by less than 2% annually. So now, with a company sitting with a market cap of well over $200 billion, you have to come up with a pretty solid argument that suddenly say 1.5% annual growth would turn into 3% or 5% as many analysts are anticipating.

Working for the potential growth rate are a number of factors ranging from the acquisition of DirecTV and increased radio spectrum to gaining assets in other countries. The acquisition in particular is what many are proposing will be a source of growth. Naturally touted synergies may or may not come to fruition, but this does allow for the possibility of increased content and the ability to cross-sell offerings.

In addition, AT&T provided guidance for adjusted earnings to grow in the mid-single digits for this year. Still, you'd rather be pleasantly surprised instead of needing excellent performance to justify an investment. Plus, on the payout front, the dividend is still increasing by 4 cents annually to get the balance sheet in shape, so caution could still be the word as far as future growth is concerned.

Should AT&T grow its earnings and dividend by 2% annually for the next five years, the future earnings per share number would be nearly $3. Over the past decade, the average earnings multiple for AT&T has averaged around 14. With this assumed P/E ratio, the future share price would be about $42.

In addition, you would anticipate collecting a touch over $10 per share in dividend payments during the half-decade period. As such, your total expected value - prior to thinking about reinvestment - for a share of AT&T over the next five years might be $52 or so. This results in a total expected gain of just under 6.5% per year. We'll keep that number in mind for the moment.

With 3M coming up with a baseline growth assumption is a bit easier: the company recently told you what it was shooting for. For the next five years - covering 2016 through 2020 - 3M anticipates 2% to 5% organic local currency growth, a 20% return on invested capital and a 100% free cash flow conversion. More pertinent to this discussion, the company has the objective of achieving 8% to 11% annual earnings per share growth for the next five years.

In addition, 3M expects earnings for 2016 to be in the $8.10 to $8.45 range, indicating a 7% to 11% increase of last year's adjusted numbers. Thus in both a short term and intermediate-term sense, the aforementioned anticipated growth rate is more or less on par with the company's goals (if anything slightly on the lower end).

If 3M was able to grow its earnings per share by 8% annually, after five years you'd expect future EPS of just over $11. During the past decade the average earnings multiple for the security has been in the 16 to 18 range - call it 17. At this rate, you'd anticipate a future price of nearly $190.

If we suppose that the dividend will grow more or less in line with earnings, you'd suspect that this component could add $28 or so in the coming half decade. Your total expected value would be around $218. Expressed differently, you might expect a total gain of just over 5% annually.

This is an instructive exercise in my view. In the previous article, we already saw that a higher dividend growth rate doesn't have to necessitate a greater amount of income for quite some time. Here we have another realization: just because a company grows faster, this does not automatically make it a better investment on a total return basis either.

In this particular case, AT&T had the benefit of a very high starting yield to go along with an earnings multiple that facilitates capturing business performance (even if you suspect it will be slow). On the other hand, 3M's growing payout contributed less to the bottom line and the above assumptions indicate that you don't capture the full business performance as a result of future multiple compression.

Using the suppositions indicated above, once again, AT&T comes out ahead - in a somewhat surprising fashion, considering the anticipated growth rates presumed. Of course, there are a variety of additional considerations at play.

For one thing, slight changes can make a large difference. Should 3M continue trading at 20+ times earnings or if AT&T later exchanged hands at 10 times earnings, the "better" total return candidate could be quickly reversed.

The second thing to note is that the above demonstration selects an arbitrary time horizon. As businesses ebb and flow and valuations change, so too can the assumptions and expected value propositions.

Finally, you have to account for the very real possibility of being wrong. In my view, not enough people take this step. When you come up with a set of assumptions, you're going to get a very precise, down-to-the-penny output. Yet you have to remain cognizant of the idea that you're just making guesses about the future. Informed guesses to be sure, but there's a whole lot of room for error. Just because you suppose AT&T will grow by 2% and 3M by 8%, this does not make it so.

In light of this, I find it helpful to both develop a baseline and then create a wide range of alternatives to help you think about the process. Here's what that could look like for AT&T: Click to enlarge

The left-hand column provides a range of future earnings per share growth assumptions ranging from negative 2% per year up to 10% annually. (Note that dividends are presumed to grow in line with earnings.) The top row provides a range of ending P/E ratios - from 10 to 18 - for a five-year period. Where the components intersect represents the annualized return that you would anticipate based on today's share price. Naturally, it does not detail every possibility, but I would contend that it covers the majority of current expectations.

The yellow highlighted square is the demonstration that I completed above - 2% annual growth with an ending earnings multiple of 14. The actual output was 6.46% per year, but rounded to the closest number it becomes 6%. This sort of thing is important in that it provides you with a baseline to think about the security. Yet take a look at all of the other alternatives. What was assumed above is simply one scenario out of a sea of possibilities.

This is helpful because you can immediately get a feel for other assumptions. Should earnings not grow for five years and shares trade at 12 times earnings, that would still mean eking out a 2% annualized gain. Alternatively, should earnings grow by 5% annually and trade at 15 times earnings, suddenly you're looking at the possibility for double-digit gains. The green highlighted portion represents the current intermediate-term estimates from analysts.

We can complete the same sort of exercise with 3M:

The construct of this table is same as the AT&T possibilities highlighted above. What has changed is the range of expected growth rates and ending P/E ratios.

Once again, the yellow highlighted square represents the demonstration that was completed above and the green highlight notes current analysts' expectations. Your own view is likely to vary from what was presented previously. With the above table, you can easily and quickly adjust these expectations and determine an anticipated return.

For instance, if you suppose that 3M will grow slower than 8% or trade below 17 times earnings (as was certainly the case during the most recent recession) you'd likely conclude that this is not a compelling investment presently. Alternatively, should you expect faster growth or anticipate that shares ought to continue to trade at a higher multiple, this implies rather solid gains. Given that the future is unknown, your expected value naturally comes down to your current views.

In short, it's not enough to see a higher expected growth rate and automatically presume that it must be the "better" investment. The investment world tends to "price in" that sort of notion. As seen in the previous article focusing on income, it could be decades (if at all) before a higher dividend growth rate eventually "wins out."

Likewise, as seen with this total return demonstration, additional factors come into play such that a slower growth rate does not preclude a security from being a "better" investment. The takeaway is twofold: before deciding a "winner," you ought to consider the underlying dynamics of various securities - in this case, the interaction of yield, growth and valuation - while simultaneously leaving ample room for errors that are certain to come about.

Disclosure: I am/we are long T.

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.