One area of the dividend growth universe that I have been slow to appreciate is the chain store segment that consists of firms such as Target (TGT), Ross Stores (ROST), Wal-Mart (WMT), and Walgreen (WAG). From the perspective of growing dividends, these firms have been knockouts over the past decade. Target has grown dividends by 15.0% annually over the past 10 years, Ross Stores by 25.0%, Wal-Mart by 18.5%, and Walgreen by 16.5%.
To be sure, these have been very nice dividend returns. But my initial hesitation towards chain stores concerns the type of brand equity that chain stores have and the need to rely on good management to continue success. For instance, when someone buys a drink, they often seek out a Coke (KO), Pepsi (PEP), or Dr. Pepper (DPS) because they enjoy the taste and appreciate the product itself. The brand equity for chain stores is a little different. If someone shops at Wal-Mart, it's not because customers have any preference for products bought at Wal-Mart. Rather, customers choose to shop at Wal-Mart because the brand represents an expectation: very low prices. If a new firm shows up on the block that can consistently underprice Wal-Mart by 15% on most items, then the appeal of shopping at Wal-Mart would shift to the new competitor over time.
And this feeds in to my second concern about chain store investing: the need for competent management. I prefer companies like Johnson & Johnson (JNJ) where mediocre management leads to stagnation, as opposed to companies where bad management seems to guarantee catastrophe. A look at 20th century America reveals a parade of once-dominant chain stores like Woolworth's, Sears Roebuck (SHLD), J.C. Penney (JCP), Ligget, and A&P which lost their seemingly iron-clad grips on the American consumers. Because of the vicious competition and the fact that large chain stores tend to engender fickle customer loyalty (compared to something like Tylenol or Lay's Potato Chips), I came to be skeptical of considering chain stores long-term investments.
But awhile ago, I came across a great argument by Charlie Munger, the Vice Chairman of Berkshire Hathaway (BRK.B), who also serves on the Board of Directors at Costco (COST). At a speech to the USC Business School a while back, Munger had this to say about the chain store business model:
"On the subject of advantages of economies of scale, I find chain stores quite interesting. Just think about it. The concept of a chain store was a fascinating invention. You get this huge purchasing power-which means that you have lower merchandise costs. You get a whole bunch of little laboratories out there in which you can conduct experiments. And you get specialization.
If one little guy is trying to buy across 27 different merchandise categories influenced by traveling salesmen, he's going to make a lot of poor decisions. But if your buying is done in headquarters for a huge bunch of stores, you can get very bright people that know a lot about refrigerators and so forth to do the buying.
The reverse is demonstrated by the little store where one guy is doing all the buying. It's like the old story about the little store with salt all over its walls. And a stranger comes in and says to the storeowner, "You must sell a lot of salt." And he replies, "No, I don't. But you should see the guy who sells me salt."
So there are huge purchasing advantages. And then there are the slick systems of forcing everyone to do what works. So a chain store can be a fantastic enterprise…
…in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important. … In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm. And these advantages of scale are so great, for example, that when Jack Welch came into General Electric (GE), he just said, "To hell with it. We're either going to be #1 or #2 in every field we're in or we're going to be out."
Munger's logic has helped shape my consideration of chain stores as a potential investment. I had always been skeptical of a company like Wal-Mart's brand strength-after all, I could start a business called Tim's Sugar Water and sell it for 25% less than Coca-Cola, but I would bet that the customers would continue to buy Coke, Diet Coke, Sprite, etc. But if a new chain can sell products for 25% cheaper than Wal-Mart, it would eventually lead to the end of the Big Box retailer. But here's the part of Wal-Mart's economic moat strength that I had been underestimating-other firms can't negotiate contracts with suppliers that would enable them to sell goods at a low price. Wal-Mart has a razor-thin net profit margin of 3.5%, and they rely on extremely high volume to generate profits for shareholders. An upstart firm could not come close to negotiating a contract nearly as favorable as Wal-Mart, and they could not turn a profit if they tried to undercut Wal-Mart on pricing.
I think that conservative dividend growth investors can certainly do well by adding a chain store firm like Wal-Mart to their portfolios with the caveat that the monitor side of a chain store investment requires more diligence, than say, a firm like Coca-Cola. If the management at Wal-Mart did something foolish like raising prices on customers to get higher margins in an attempt to generate more wealth for shareholders, a door may open for a new competitor to steal market share. Remember, in 1960, no one could imagine a world where Sears Roebuck didn't dominate retail and Coca-Cola didn't dominate the beverage industry. Coke's still dominating, but Sears Roebuck is a shell of its former self. Target, Wal-Mart, Walgreen, and Ross Stores all appear poised to raise dividends substantially over the coming decade-there's a spot for each firm in a conservative dividend growth portfolio - but beware that you may eventually have to determine an expiration date for your chain store investments.