It is always appealing to think the past will repeat itself. While market dynamics and economic cycles are often more complex than even the best economists can predict, it is always tempting to think the present will stay the same forever.
One of the strongest concerns that many dividend growth investors with a long-term perspective have is that cyclical stocks will offer limited income and total returns over the next decade because of how short business cycles have become. Essentially, since many market leaders in cyclical sectors have been flat over the last decade, some investors think these companies are too risky to own.
It is true that most market leaders in key cyclical sectors such as GE(NYSE:GE) and Caterpillar (NYSE:DE) are have underperformed most leading dividend stocks in the consumer staple sector over the last decade. The S&P 500 and its tracking exchange traded fund, (NYSEARCA:SPY), is also still well-off this indexes 2007 highs. Also, it is true that many of the best performing stocks over the last several decades have been dividend stocks in the consumer staple sector, such as Altria (NYSE:MO), Kimberly-Clark (NYSE:KMB), Procter & Gamble (NYSE:PG), and AT&T (NYSE:T).
If the past repeats itself perfectly, consumer staple companies with strong dividends will keep rising 10% or more annually over the next decade, and cyclicals will rise and fall repeatedly, offering inconsistent income and total returns to long-term investors.
Still, as a history major, one fact that has held up well for centuries is that history often rhymes, but it seldom repeats itself in exact form.
There are three main problems with the argument that consumer staple companies will continue to outperform cyclicals over the next decade. First, everybody now believes this argument, and cyclicals such as GE and Cummins trade at 11-12x estimates of next years likely earnings, while companies such as Coke (NYSE:KO) and Procter & Gamble trade at the highest valuations these stocks have traded at in these companies' respective histories.
Second, the massive housing and real estate bubbles in the U.S. and China will likely make aggressive fiscal and monetary policies more rare over the long-term, and lengthen future business cycles. Third, while this has been one of the weakest economic recoveries in modern history, the financial collapse and severe recession will likely lead to a much stronger and healthier economy longer-term.
Capitalism is both self-destructive and self-corrective. The recent financial collapse has resulted in massive regulation and lower lending rates, but banks are also now better capitalized than at anytime in modern history. Also, while consumers had heavier debt loads than ever before, consumers are also now more conscientious about saving and borrowing. Regulation and debt has led to a slower recovery in the short-term, but a solid financial system and stronger consumer will likely eventually lead to a stronger and more sustainable period of real economic growth longer-term.
It is human nature to see the best and worst case scenarios when planning for the future. Still, the most likely outcome is that the economy neither crashes or booms, but rather continues to grow at a slow but steady pace.
This is why the argument that cyclical companies cannot be the cornerstone of a dividend growth investor's portfolio seems wrong. With cyclicals still trading at historically cheap valuations and most leading consumer staples trading at the highest price to earnings ratios these companies have been at in decades, cyclicals should continue to outperform the S&P 500 by a wide margin if the economic recovery accelerates even modestly.
This is also why looking at cyclicals as poor long-term investments simply because of many of these company's recent under performances is a weak argument as well. Cyclical stocks such as Deere , GE , Apple (NASDAQ:AAPL), and IBM (NYSE:IBM), have risen dramatically over the last 20 years. With the exception of Apple, most market leaders in cyclical sectors have also offered strong income and total returns to long-term investors who bought these companies at any time from the 1970s to the mid-nineties.
With the economic recovery likely to accelerate in coming years and inflation tepid, the best income producing investments of the future will likely differ markedly from some of the best performing defensive stocks of the last decade. There are also many fairly conservative income producing investments such as Master Limited Partnerships and REITS, that will also likely significantly outperform most dividend stocks if the recovery accelerates even modestly and inflation increases as well.
To conclude, it is always tempting to assume the present will stay the same forever. Investing for an uncertain future is always difficult. Still, the best long-term investments are usually made in times of uncertainty. With the twenty-four hour news cycle and constant fear-mongering in the press, it is easy to see the market as boom or bust, but overly bearish and overly bullish investors have both been consistently wrong since 2008. With fixed income offering minimal to no returns, many leading defensive companies overvalued, and pessimism still high, cyclical stocks likely remain under moderately to significantly under owned by most investors. While many defense stocks have outperformed the broader indexes by a fairly wide margin over the last decade, past performance is not always indicative of likely future results.