Let's start with a riddle. I'll present you with two securities and you pick out which one performed better. The first security was able to grow earnings-per-share by 7.4% per annum and increased its dividend by 11.5% on an average compound yearly basis. The second one grew earnings-per-share by 3.8% on a yearly basis and increased its dividend by 6.9% per annum. So, if you could only invest in one, which do you choose?
If you owned the entire business, the answer could be a touch easier. Of course in the common stock world you do not own the entire business. Which, incidentally, makes things a bit more complicated than they originally appear.
It's not that difficult of a riddle, but there are two observable "tricks" involved. The first thing to note is that stock performance and business performance can be two drastically different items. Just because a business does well, this does not necessitate that the stock must precisely follow and vice versa. Indeed, the first security that grew its earnings and dividends at a faster clip returned an average of just 2.1% per annum as compared to something well north of 14% per year for the slower growth security.
The second "trick" is that the two securities are one in the same. The first security is Johnson & Johnson (NYSE:JNJ) from the end of 2004 through 2010. The second security is Johnson & Johnson from the start of 2011 to present day.
Let's look a bit closer. Here are those same numbers that were detailed above on an annualized basis:
At the end of 2004 Johnson & Johnson was earning $3.10 per share and paying out $1.10 as cash dividends. In the years to come earnings would steadily climb, moving all the way up to $4.76 by the end of 2010. Dividends were also materially higher - compounding by a double-digit rate to almost double over the course of six years.
Had you owned shares through that time period, your underlying earnings claim in the business would have advanced nicely (up about 54%) and your dividend income would have been up about 92% (and both of those factors are prior to thinking about reinvestment). Yet here's the interesting part: the share price actually declined during those six years from just over $63 to under $62.
In the second period earnings still grew, but certainly at a slower pace. The dividend has also been steadily increasing, but by no means at the same rate as in the past. And yet the share price of Johnson & Johnson during the last five and a half years went from $62 all the way up to $122. (And that's actually better than the annualized rate presumed above, as we're not through with 2016 yet.)
So what's going on here? From this information I glean three basic concepts.
The first thing, as mentioned above, is that share price does not have to perfectly reflect business performance all the time. As we just saw, wide discrepancies can and do take place. I would contend that this idea is often glazed over in the eyes of the general investor.
To be sure diligent analysis is the backbone of rational investing. If you don't have a guess as to what something might be worth, it follows that you don't have an investing leg to stand on. Yet understanding the natural ebbs and flow, along with the psychology of the situation, can be just as important in my view.
The thing of it is, you don't want to predicate your investing success on what other people may or may not do. It's hard enough to think about the level of business success; predicting the madness of crowds, as it were, borders impractical.
You could have looked at Johnson & Johnson back in 2004 and said, "well gee, this thing should earn $4.76 by 2010." And you would have hit the nail on the head business-wise. From there, especially in viewing the historical earnings multiple, you could have concluded that shares too ought to be worth say 50% more by that time or something of the sort. And yet the share price actually went down over this period.
You have to acknowledge the finicky nature of the pricing side. A lot of people get discouraged by this sort of thing: "The shares went nowhere!" When in actuality you were seeing a business get better and better with an improving valuation all the time. As we later saw, eventually this spelled great opportunity. It was investor psychology - tying too much weight to a stagnating share price - that would have gotten in your way.
The second thing to consider is valuation. At the end of 2004 shares of Johnson & Johnson were trading around 20 times earnings - which was more or less in line historically. Even so, the share price stagnated for years, so you had a progression with regard to value: reasonable to even more reasonable to quite compelling. By the end of the first period you had an incredibly profitable and strong business, which had raised its dividend for going on five decades, that was still growing but trading at 12 or 13 times earnings.
At the same time investors were clamoring on about the price not going anywhere, the value proposition was getting better by the quarter. There's an odd perception that occurs in the investing world whereby the general onlooker gets more enthused by higher prices and discouraged by lower ones. We make no such mistakes in our everyday lives, but for some reason there has always been this psychological investing barrier.
The second period depicted above was the mirror image. The business actually performed worse, but the valuation was sufficiently low to allow for outsized returns. The valuation, in my view, went from quite compelling to reasonable to at the high end of reasonable. It's an excellent case study watching a security go from 20 times earnings down to 12 and all the way back up to 20 again. It shows the interaction of valuation (namely expectations) and business performance quite well.
The third thing to note, in that same vein, is that the long-term owner would have actually preferred this route as compared to a hypothetical scenario whereby the share price increased by a steady rate over the last 12 years.
From 2005 through 2010 the share price actually declined. From 2010 through today, it has neatly doubled. A true ebb and flow example, especially in comparison to business results.
This first period of stagnation caused a great deal of investor angst: "My business is doing great, why doesn't the share price follow?" And surely instead of a stagnating price many would have preferred a nice, constant growth rate over the entire period.
Instead of negative figures in the first six years and double-digit growth in the second, I'll present a hypothetical: a constant share price growth rate of 6% per annum. Certainly that would give many investors a "warm and fuzzy" feeling. Yet it would not have helped the long-term owners' net worth.
Instead of a share price in the $60's from 2005 through 2010, here's a hypothetical: $67, $71, $75, $80, $85. That sure looks nice and tidy. Moreover, assuredly some would cheer the consistency. (Some might even point out the "attractiveness" of beta in that scenario.) And yet this would not be a preferred scenario if you think about the progression of your investment.
The long-term owner is apt to be a net buyer in one of three ways: "fresh" capital, reinvested dividends or on your behalf via share repurchases.
From 2006 through 2010 Johnson & Johnson spent nearly $24 billion repurchasing shares - buying out past partners on your behalf. Now let me ask a very straightforward question: "would you have preferred for Johnson & Johnson to buy out partners at $75 or $60?" The answer is obvious: a lower price allows more shares to be retired and in turn increases your underlying earnings and cash flow claim.
And naturally the same logic applies to other buying situations as well. If you're reinvesting dividends along the way, you naturally prefer to do so at lower rather than higher prices. The same rationale holds for "fresh" capital. Buying at $60, regardless if the future share price is $20 or $200, is a better use of funds than buying at $75.
It's obvious when you think about yourself as a net buyer in these terms. Yet so many investors get caught up in the day-to-day and "rooting" for ever higher prices, even as their next paycheck is earmarked for future purchases. It's analogous to pumping gas and rooting for the price to increase before you're done fueling. So many bemoaned the precise thing that was actually allowing for a long-term benefit.
In short, I would contend that it's immensely useful to have this sort of knowledge in the back of your mind as you go about the investing world. So many people get caught up in the stock price not performing "properly" or as it should this month or year (or five years). It's such a futile endeavor. Eventually prices more or less reflect business results, but in the interim a whole lot of things can happen. If Johnson & Johnson is susceptible to such wide disparities, it should be clear that no security is spared. The good news is that you can learn and benefit from, rather than wallow in, the natural fluctuations that come about.
Disclosure: I am/we are long JNJ.
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.