This is a very bad, incoherent piece. I received
this feedback from a reader concerning my most
recent article for Institutional Investor . I
dont expect everyone to agree with me, and I welcome
negative feedback because it provides an opportunity to learn.
But this stung. If this comment had been about almost any other
article Ive written this year, Id probably have
filed it under lets agree to disagree.
Looking back, however, Im not sure this reader was wrong.
While I stand by my original thesis, I think I could have made
my case more clearly. So here is what I meant to say:
We are in the freakiest investment environment ever.
Investors are buying bonds because they are looking for capital
appreciation essentially gambling that the price of an
delivering negative (if you are in certain parts of Europe
or Japan) or almost no (if you are in the U.S.) current income
will go up. And investors are buying stocks solely for income.
Dear reader, this is an upside-down world.
In my original article I addressed a group of stocks I call
bond substitutes: stocks bought solely for their dividend
yield. They are a special group of companies that have been
around forever and that are usually perceived to be
high-quality companies think Coca-Cola, Kimberly-Clark
Corp. and Campbell Soup Co., among others. I picked on Coke
just because it is one of the most quintessentially American
companies. I figured Id just use Coke as an example to
make a much broader point about the dangers of focusing solely
Equity returns come from two sources: stock appreciation and
dividends. Stock appreciation is mathematically driven by two
variables: earnings growth and price-earnings change. In other
words, take any stock in your portfolio, go back five years,
and you can deconstruct the return you received from it by
looking at the sum of three variables: earnings growth, P/E
change and dividends.
Lets return to the example of Coke. Five years ago its
stock price was $27 (today its $42), earnings were $1.50
(today $1.69), and investors collected about $5.90 of
cumulative dividends, or about a 4 percent annualized return on
the $27 purchase price. If youd bought Cokes stock
five years ago, your annual total return (price appreciation
and dividends) would have been about 13 percent a year 4
percent from dividends and 9 percent from stock appreciation.
The stock appreciated for two reasons: earnings grew 2 percent
a year and P/E increased 7 percent a year (from 18 to 25). In
other words, a 13 percent total return = 4 percent dividends +
2 percent earnings growth + 7 percent P/E expansion. (It took
me two whole minutes to come up with these rough calculations;
I am trying to be vaguely right here, not precisely wrong).
Anyone who bought the already fully valued Coke stock five
years ago made a great total return of 13 percent, not because
the business did well the fundamental return from
earnings growth and dividends was only 6 percent but
because its P/E ratio went from high (18) to very high
Today investors look at Coke, admire the return it has
delivered over the last five years, mull over its 3 percent
dividend, and say to themselves, Three percent is better
than the 1.4 percent I get from Treasuries. When they do
this, however, they focus on one shiny object (the dividend
yield) but ignore the other parts of the aforementioned stock
market math formula that are less shiny (earnings growth and
P/E) and are barely positive in this example and will likely
Coke is a mature company that already has conquered the
world unless it goes to
Elon Musk , it is done on this planet. And it has a lot of
consumption trends going against it. Consumption of its fizzy
drink in developed markets is on the decline; each can of Coke
packs a full dose of your recommended daily consumption of
sugar (sorry, Warren Buffett). And diet drinks simply scare
consumers, as they are not quite sure what kind of Frankenstein
process Coke had to go through to remove the sugar and calories
and turn the drink into whatever it is. Cokes earnings
may very well grow. But you can make a reasonable argument that
they will actually shrink over the next five to ten years.
Growth in Cokes earnings is not guaranteed in the U.S.
Constitution, no matter how American this company is.
Cokes valuation of 25 is very rich. (For simplicity I
am using 2015 numbers.) Can this number go to 35 or even 50?
Sure, why not? As Keynes famously said, The market can
stay irrational longer than you can remain solvent (or
sane). But lets be clear: buying at those
valuations is not investing, its gambling. Do it and
youre not much different from a fellow who goes to Las
Vegas, prays and puts his chips on red. You are betting that
the music will continue to play and interest rates will remain
where they are, or that investors will continue to pay a lot
for a little.
If Coke continues to pay its dividend, which is probably a
very safe bet, but its earnings dont grow, and its P/E
ratio declines to 15 (which at that point will be a generous
number), then ... well, lets revisit our equation.
Cokes total return over a five-year period = 3 percent
dividend + 0 percent earnings growth minus 10 percent P/E
decline = 7 percent a year. (If the P/E ratio lands at
13, the loss will be 9 percent a year). Youd better have
perfect musical pitch.
I suggest you think of this as a public service
announcement: If you own stocks solely for their dividends, you
are ignoring the other parts of the stock market equation that,
though they are less shiny (and less tangible) than dividends,
are just as important to your future returns.