In "my portfolio" updates, I typically take a deep dive on one of the stocks I either own or am considering entering. Often, I'll choose a company that is making waves as with my article on Boeing (NYSE:BA), or when I wrote about the market's silly tantrum regarding Facebook (NASDAQ:FB) (how has that worked out?). Alternatively, I might highlight a fantastic company trading at a depressed valuation, as when I wrote about Starbucks (NASDAQ:SBUX) (up over 50% since).
However, as I was trying to allocate my capital this month, one thought kept popping up: wow! There are a lot of overvalued stalwarts.
Stalwarts are the world's durable, long-term wealth compounders, the Warren Buffett set it and forget it investments, the companies that have enduring moats and brands, and the companies with a robust history of increasing revenue, earnings, and cash flow while maintaining stable balance sheets. To quote the great man, these are "businesses that are so wonderful that an idiot can run them. Because sooner or later, one will."
I love stalwarts, and they form the backbone of my portfolio. The stalwarts are where I try to rack up dividends, add stability, and - by selecting them at favorable valuations - beat the market by a small margin. This is in contrast to the High Growth Picks segment where I try to drive outperformance by assuming risk.
Only one problem: remember the "favorable valuations" part? I cannot seem to find those lately.
Now, I get it: quality attracts a valuation premium. The Coca-Colas (KO), Procter & Gambles (PG), Johnson & Johnsons (JNJ), and the Colgate-Palmolives (CL) of the world will always attract a slightly higher multiple than the rest of the market. These dividend-growth-investing staples are so good and own such durable brands and pricing power, they are worth overpaying a little for.
The problem arises when overpaying a little becomes overpaying a lot, and that is where we sit today. Many of these companies trade at unconscionable multiples, and the erosion in those valuations will lead to long-term underperformance.
To illustrate this point, let's say you had invested in Coca-Cola in March of 1998.
Typically these "you got lucky and had the foresight to invest in dividend growth investing company XYZ way back in ABC" stories are really, really good stories. Whoops, I got rich kind of stories.
Not this one.
If you had invested $100,000 into Coca-Cola in March of 1998 and reinvested all the dividends, it would only be worth just over $200,000 for an annualized return of 3.6%.
Some readers may claim foul here, pointing out that we have witnessed two market crashes since. Yet if you had invested that same $100,000 in the S&P 500 on the same date and with the same dividend reinvestment, it would be worth just over $290,000 today for a more reasonable annualized return of 6.7%. You would have almost 50% more money.
That is a big deal.
That is one of the world's all-time great wealth compounders meaningfully and significantly underperforming the broader market over a multiple decade time frame.
Thus, we must ask why?
Look no further than the valuation. In 1998, KO earned 1.43 per share against a stock price of about 67$ (not split adjusted). This gave the stock an insane PE ratio of 47.2.
That is the kind of PE ratio companies pounding out 30% year-over-year growth deserve. It is not the sort of multiple that should be given to a slow growing Stalwart like Coca Cola. If you want market-beating returns with Coca-Cola, you need to pick your spots.
Present valuations are not as absurd as they were then, but they are stretched: Coca-Cola is sitting at a PE ratio of ~32, an unconscionably high multiple for a company with its growth prospects. If you are buying KO at these prices, you are not going to be happy with your returns in 20 years.
Author's Note: I used a logarithmic scale to try and tell the real story. You can ignore the blip up in 2018 which was due to one-time events. The real story is in the longer-term trend.
While many might point to the relatively attractive yield that rests at about 3.3%, the payout ratio now hovers at 77%. Without meaningful earnings growth, Coca-Cola has little room to increase the dividend. In fact, the dividend could be at risk if the company were to suffer a few years of earnings declines.
Clearly, if you were to buy the company at this valuation, one would expect growth, no?
Author's Note: Not growing.
Well, that hasn't been the case. Coca-Cola's 10-year revenue is essentially flat, as are its earnings. The company actually suffered a revenue decline over the last year. Furthermore, the company is guiding earnings to be flat over the coming year, and it carries a PEG ratio of 4.20.
Here is the problem: there are not all that many more people in the world to sell Coca-Cola to. The company's much lauded marketing, dominant positioning, distribution network, and market penetration propelled it to spectacular heights over the last half century, but that market is now relatively saturated. Coca-Cola can be bought in every country in the world except North Korea. Think about that. That fact is staggering and indicates just how robust the business has been over the last half century, even while it speaks of a less bright future.
Worse, Coca-Cola is facing generational headwinds. Consumers are drinking less and less soda. The media and public health network has embraced the fact that sugary sodas are terrible for people. Soda has been recognized as a significant contributor to the obesity and Type II diabetes epidemic. While diet sodas at least represent a non-sugary, non-caloric alternative, there continue to be questions regarding the long-term safety of these non-sugary alternatives.
Younger generations - particularly my fellow millennials - are drinking less soda than ever, opting for coffee, tea, flavored waters, and even more trendy options such as matcha or kombucha. The media even decries sugar as potentially unhealthy as tobacco. Between the younger generation's preferences and continued media attention, there is every reason to think consumption will continue to decline.
To add to the list of problems, soda makers carry regulatory risk. Although Bloomberg's ban on big soda portions was ultimately repealed, it ably demonstrates the legal risks that are present. In fact, during the public debates surrounding this ban, soda makers declared a goal of decreasing soda calorie consumption by 20% by 2025. This is not the sort of statement you want to be pressured to make about your company's primary source of revenue.
It's Not All Bad - Future Directions for KO
The executives over at Coca-Cola are smart people. They do not have their heads in the sand, and they have seen what I have seen. Coca-Cola is not taking these hits lying down.
First, people will never stop drinking soda, sugary or otherwise. Fact. Sales are not going to evaporate.
What's more, though, with an eye towards changing consumer preferences, Coca-Cola has diversified its offerings into potentially healthier alternatives such as Costa Coffee, SmartWater, Gold Peak Tea, or Mojo, the Australian-based Kombucha brand. Initial results are positive, as KO was able to generate a 6% increase in organic sales this last quarter. For a company with essentially flat revenue over the last decade, that is a big deal.
However, it is too early to break out the fireworks and start the parade, and it is far too early to use our hard-earned money to support a lofty valuation multiple. It will take significant growth in these alternative brands to meaningfully move the needle for this $200B company. Soft drinks continue to account for well over half of Coca-Cola's revenues, and the company's earnings guidance is flat.
What we are talking about is a company with little growth for about a decade that has only just started to improve the situation. This is not the sort of company you want to pay 30 times earnings for.
If you want to buy Coca-Cola for its 3.3% yield and the expectation that this dividend will grow at or slightly above inflation, I think that is okay. But you have to know what you are getting into. Coca-Cola's stock is unlikely to outperform the market from here.
Chasing Yield and Overvalued DGI Stocks
You can cast the net wider, though, and look at many of our favorite Dividend Growth Investing Stalwarts. In the chart below, I have included some of the world's great DGI stocks, along with the PE ratios, PEG ratios, and 10-year EPS CAGRs. It is quite clear that these companies have attracted premium valuations and, in most cases, lack the recent performance or expected growth to merit them. Remember: this is in 10 years of economic expansion.
Although it doesn't quite fit into the above data points, another dividend Stalwart, Realty Income (NYSE:O), is trading at a stratospheric P/FFO ratio and a historically low dividend yield.
I would love to stash many of these companies in my portfolio, but I know these prices won't be giving me happy thoughts in 20 years.
We are in the midst of a yield chase. Bonds are not providing investors with income, and many investors do not find themselves prepared to dig far into the REIT and MLP world in search of yield. Thus, they have bid up stocks like Coca-Cola in search of that yield. While I can understand this reasoning, this process has made the valuation of many of these DGI Stalwarts untenable.
Even more worrisome, we are seeing articles declaring companies with significant business risks already in play such as AbbVie (ABBV) being declared SWAN (Sleep Well at Night) stocks as investors waltz down the quality ladder in search of yield.
Single Stock Risk
We have covered the lack of upside, but now let's talk about the risks in play with these stocks. Any of these companies could suffer a meaningful, long-term decline in the underlying business.
I know. You're thinking "nope, not Coca-Cola." Yet, 20 years ago, we would have put General Electric (GE) right at the top of the all-time best companies list. Now look what has happened. In the last few years, we have seen Campbell Soup (CPB) and Kraft Heinz (KHC) fall from the ranks of the beloved.
If you buy overvalued DGI stalwarts at these prices, you are assuming risk while buying yourself very little chance of desirable returns. The risk-to-reward profile is skewed against you.
If you are a retiree and care only for the dividend checks, this might be okay, but if you are looking to drive a meaningful total return, I would recommend you look elsewhere.
Making Money While I Sleep Portfolio - April Update
Given the choice, I would love to fill my Stalwarts section with wonderful companies such as MMM or CLX. On dips, I have been able to add to such wonderful companies in the past. More recently, I have been forced to chase after great but not quite as wonderful companies due to valuation concerns. Quality has seen quite a bid in this market.
Thus, I departed from my normal investing pattern this month:
I opted to contribute to a combination of my highest conviction fast growers - Amazon (AMZN) and Facebook (FB) - some of the Chinese companies that remain on sale - JD.com (JD), Alibaba (BABA), and Baidu (BIDU) - as well as some reasonably valued stalwarts - Becton, Dickinson (BDX), Charles Schwab (SCHW), and Lockheed Martin (LMT).
Oh… and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). I loaded a huge amount of this month's contribution into Berkshire, a new position for the MMWIS Portfolio. Not only that, but also the contribution was a comparatively large one, breaking my typical 10% rule.
Well, I feel comfortable with it, and I think it is as good a value as can be found in this market. Berkshire's valuation is not excessive, and it is well enough diversified to reduce single company risk. It feels as though I am purchasing shares in an expense-free ETF managed by a true master investor. If you don't see places you would love to put your money, you could do a whole lot worse than that.
While Berkshire's future won't be as bright as its last half century, I have every reason to expect it to outpace the market by a percent or two over the long run, exactly what I am looking for from my stalwarts.
One other thing to note: while I continue to be bullish on China and the three companies mentioned in particular, I have decided to trim my monthly allocations to Chinese companies. In the past, my total Chinese percent of monthly purchases has been quite high, and I do not want to over expose myself to the unique risks of investing in China.
Thanks for reading! I appreciate your comments, and, as always, good luck investing!
Disclosure: I am/we are long BRKB, GOOG, BDX, XOM, SCHW, LMT, AMZN, FB, JD, BABA, BIDU, JNJ, MMM, O, ABBV. 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.