Recently I was bouncing about Yahoo Finance's "People viewing [insert ticker of your choice] also view:" feature and happened upon General Mills (GIS). Now from the onset there would be nothing that unique about this latest stumbling: General Mills is a formidable food processor and is perhaps the best known cereal maker in the world with brands like Cheerios, Wheaties and Lucky Charms. Additionally, GIS has "paid shareholder dividends uninterrupted and without reduction for 113 years." Of particular interest to me is the fact that General Mills has not only paid a dividend, but has also increased this dividend for the last 9 years by an average annual rate of just under 10%. So what made me stop and extend my gander towards this fortuitous occurrence? Let's see if you can discover it firsthand:
Time's up. If you happened to miss the big red arrow, the answer was an astonishing Beta of 0. Not a low beta of say 0.2 or 0.1; but rather a non-existent measure of systematic risk. The implication of such an absence is relatively straight forward. Using the "grail" of basic investing - the Capital Asset Pricing Model (CAPM) - one understands that their required return is a function of the constraints: risk-free rate + Beta times (return on market less risk-free rate). Now obviously there are a variety of underlying qualifiers to these assumptions, but let's just look at the simplicity of the math for a second. We'll make up some reasonable numbers: risk-free equals 2.9%, return on market equals 10% and of course our Beta is 0. Using these numbers we find a required return of 2.9%. (Required return= 2.9%+ 0*(10%-2.9%) In fact using any numbers with a Beta of 0 will result in a required return equal to the risk-free rate. That is, a Beta of 0 within the CAPM implies that an investor should seek compensation such that they are rewarded in a manner that assumes they are not taking any risk.
Immediately this should be triggering alarms in your head. It is true that General Mills has a seemingly endless moat of brands like Cheerios, Betty Cocker, Pillsbury, Haagen-Dazs, Green Giant, Hamburger Helper, Old El Paso, Totino's, Nature Valley, Progresso and Yoplait along with many others. However, no matter how strong an economic moat might seem, or actually be, that certainly does not indicate that it is immune from being breached in the future. More specifically, while General Mills is likely quite sturdy at the moment, in no way is it a "risk-free" investment. In fact, depending on the price that you pay, GIS could likely be a rather risky proposition. So given that the 30-year treasury is presently yielding about 2.9%, using CAPM for General Mills yields a logical required return of 2.9%, and assuming some sort of market efficiency such that required return approaches estimated return: why would anyone ever choose GIS over a risk-free alternative?
That's a good question and I'm glad you asked. The answer is relatively straight-forward: using a beta of 0 in this instance (or really any instance that you're pricing equities) likely doesn't make a whole lot of sense. Incidentally, I also checked Google Finance and MSN Finance for their quoted GIS Betas and found 0.16 and 0.17 respectively. But I will maintain that even these more reasonable estimations likely don't do much in detailing the value of the underlying partnership. That is, a Beta of 0, 1, 3 or somewhere in-between tells you almost nothing in isolation and very little when comparatively combined. In fact, if you're like me, once I have purchased a partnership at a price that I feel is reasonable, I would actually prefer for my security to bounce around rather abruptly. My focus is a growing stream of purchasing power over time which in turn necessitates a growing stream of earnings power; what the market does from there doesn't really concern me (unless it's on the verge of doing something irrational).
Let's walk through a couple of scenarios to better illustrate this point. Imagine that your primary concern is not a given rate of return, but rather a growing stream of income over time. Which do you choose: General Mills or a 30-year Treasury yielding 2.9%? For the dividend growth investor out there, this one is likely pretty easy. While GIS doesn't have the storied track record of increasing its dividend of say Johnson & Johnson (JNJ), Coca-Cola (KO) or Procter & Gamble (PG), it is reasonably clear that General Mills is committed to rewarding shareholders via constant or increasing dividends. If you take this in combination with its 3.3% current yield, then really there's no contest between GIS and a current Treasury. Even if General Mills only increases its dividend by an average annual rate of 3-5% over the next 30 years, this would absolutely dismantle the income return that you would get from a Treasury. Now it is true that you would have to factor in the probability of GIS cutting its dividend, but I would feel overly confident in suggesting that GIS will provide more income in a 30-year time period than a constant 2.9% yield. In turn, for those of you that are concerned about price fluctuations, I would advocate treating investing in wonderful businesses in a similar manner as buying long-term CDs.
But we haven't yet considered capital appreciation. Now it is true that a dividend growth investor doesn't necessarily focus on an increasing price, but it just so happens that if you build a rising stream of income over time, then capital appreciation will likely come anyway. Let's explore this point a bit. Imagine that General Mills is able to grow its dividend by an average annual rate of 5% over the next 30 years. This indicates a 14.3% yield on cost. In other words, if you happened to buy GIS today at around $40 a share, your current yield in 30 years' time would be about 14.3% if General Mills' share price remained stagnant at around $40. Interestingly, you would still be receiving dividend payouts in excess of the 2.9% required yield that CAPM delivers. "Required by who," would be the appropriate response as market efficiency would seemingly never catch up. But the lasting realization is that it is overwhelmingly unlikely that the market is going to offer a 14.3% yield on General Mills. Instead, it is much more likely that GIS will continue to trade in a "reasonable" yield range such that the price is forced much higher. Let's look at the historical yield for GIS over the last 14 years:
Two notes should be made here. First, the low price was used in each year to achieve the highest yield possible. In doing so, a higher yield indicates a higher dividend denominator which translates to a lower end value. In essence, it's a more conservative way to estimate future price increases. Second, the dividends quoted are fiscal year and not calendar year. Looking at the last 14 years, there's a pretty good indication that the market happens to value GIS such that the highest dividend yield is between 2.5% and 4.2%. Thus it seems reasonable that this trend will continue into the future. If General Mills is able to increase its dividend by 5% a year for 30 years, then it would have a dividend value of $5.70. ($1.32*(1.05^30)). If you divide $5.70 by 2.5% and 4.2% you find respective price values of $228 and $135.71. In other words, given an increasing dividend of 5% each year and a reasonable range of current yields in 30 years' time, one should expect an average annual capital appreciation in the range of 4.1% to 6%. That is, General Mills has a reasoned likelihood of returning more value on both an income and appreciation basis than the current treasury, and yet an oft-used model details that GIS isn't all that different from a "risk-free" security.
Of course, even for the non-dividend growth investor out there (can you imagine) there are likely more fundamental ways then beta to find the applicable valuation. As this dips, if only somewhat, out of my forte I would like to turn this portion over to the ever-capable fellow Seeking Alpha contributor Chuck Carnevale and his exceedingly useful F.A.S.T. graphs.
Here we see a variety of valuable information. Incidentally, this is also where I found the low prices that are listed in the previous dividend yield table. We can see that the long-term stock price of General Mills tends to hover about a multiple of earnings. It is true that even 15 years might not be a long enough time frame, but the idea is that over a lengthy period, the premiums that investors are willing to pay are based on how much a firm earns. From 1999 until 2012, we see that earnings per share grew from $1.02 to an estimated $2.56, or at an average annual rate of about 7.3%. Likewise, we can note that operating earnings grew at an average annual clip of 7.4%. Given that General Mills was priced at a bit of a premium in the beginning of this historical analysis, and that it approaches a reasonable level today, one would expect that the capital appreciation of GIS tracked earnings growth, albeit at a slightly slower pace. We can also see the added value of dividend growth as represented by the rising light blue area. Let's confirm our initial intuition:
Here our observations are endorsed such that capital appreciation equals an average annual rate of return of 5.3%. In other words, over this period price tracked earnings growth, but was lower due to the beginning analysis premium and current price reasonableness. We see that dividends tacked on an additional component of return, which happens to make the total return move with earnings growth quite nicely. But of course, historical metrics are informative to review, but they are not very enlightening when considering the future. To this message, I would like to make two points. First, for the dividend growth investor, an analysis considering the reasoned probability of an increasing dividend is likely to be your primary focus. Not just increasing, but increasing in such a way as to appropriately compensate your future purchasing power. But for the non-dividend growth investor, or even the DGI with a solid valuation tilt, I would advocate that you simply scroll down the F.A.S.T. graph page:
Here we see earnings are projected to grow at 7.9% a year over this time horizon. A quick check to an outside source and we find that this is reasonable. It should also be noted that the F.A.S.T. graph tool allows you to manually override the assumptions for a more detailed scenario analysis. Because the current valuation appears reasonable, we see that our total return is projected to track earnings once you consider the growing dividend. Payouts, it should also be noted, grow at the rate of earnings; which also appears reasonable given the current and past payout ratios.
Incidentally, I actually did the Beta calculations myself for General Mills throughout a variety of different time periods; finding anywhere from -0.01 to 0.32. But that's not the point. The point is that as great and revolutionary as CAPM was, the weight of valuation shouldn't be placed on the shoulders of a single metric. In fact, for the dividend growth investor, they likely wouldn't care what someone else thought about the systematic risk of a wonderful business relative to an index that they also pay little attention to. More than that, I contend that a company's earnings growth, economic moat, pricing power, fundamental nature, growing payouts or at least the ability to grow/pay dividends, high returns of shareholder funds, sustainability and the reasoned probability of meeting the investor's specific requirements are apt to be much more important than how a security fluctuates within an arbitrary group of holdings. Perhaps I'm in the minority here, but a Beta of 0, 1 or 3 tells me little about the prospective merit of an underlying business partnership.