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Beware of Bubble in “Safe” Stocks

We are in an unusual investment environment where government securities have negative yields and equities have been in the bull-cycle for eight years now. Despite a nominal increase in Fed rates from 0-0.25% to 0.5-0.75% in 2016, historically low interest rate environment combined with appreciating asset prices across most asset classes for many years, the search for yield has been a central theme for both institutional and retail investors. Seemingly low-risk and stable companies often trade based on dividend yields (i.e. consumer staples, regulated utility, etc.). While it is true that their collective risk profile is on the lower end of the spectrum, relative to the entire universe of companies out there, their perceived “safeness” also needs to be contextualized to their valuation. When you think you are consistently clipping coupons (like a bond) as earnings steadily grow and interest rate environment remains depressed, the virtuous cycle keeps working until it doesn’t! Who cares if you get 5% dividend yield if stock price drops by 30%?

Below is a summary excerpt from two great articles from Intrinsic Investing and Institutional Investor. They are a bit dated (August and October 2016, respectively) but nonetheless applicable today and in fact, from Donald Trump’s victory on Election Day (November 7, 2016) to yearend 2016 alone, S&P gained another 5%.

Dangers of Dividend Obsession

  • Investors are buying bonds because they are looking for capital appreciation, gambling that price of an asset delivering negative or no income will go up
  • Investors are also buying stocks solely for income – bond substitutes that are perceived to be high-quality companies like Coca-Cola, Kimberly-Clark, Campbell Soup, etc
  • Equity returns come from stock appreciation and dividends: stock appreciation mathematically driven by earnings growth and price-earnings change; you can deconstruct returns by looking at earnings growth, P/E change, and dividends
  • Coca-Cola:
    • 5 years ago it was $27 and today, it’s $42; earnings were $1.50 and today, it’s $1.69
    • Collected about $5.90 of cumulative dividends or about 4% annualized return; annual total return would have been about 13%/yr
    • During the 5-year period, fundamental return from earnings growth and dividends was only 6% but P/E ratio went from 18x to 25x
  • Today, investors look at Coke and admire the return it has delivered and mull over its 3% dividend and they say “3% is better than 1.4% from Treasuries”
  • Coke’s valuation of 25x is very rich – can it go to 35x or 50x? Sure, but that’s gambling, not investing
  • If Coke continues to pay dividends (which it probably will) but its earnings don’t grow and its P/E declines to 15x, then total return over a 5-year period is -7%/year (if P/E declines to 13x, that is -9%/year)

WD-40: A Case Study of the Bubble in “Safe” Stocks

  • One of the biggest risks in the market today comes from investors overpaying for conservative, income-generating companies
  • Mirror image of 1999 Dot-Com bubble, when investors overpaid for high risk, non-yielding stocks; today is characterized by eye-popping valuations for “safe” assets from bonds to the most conservative sectors of the stock market
  • WD-40 (NASDAQ: WDFC) is a case study of a seeming “safe” company whose valuation has been bid up so high by investors that it now represents a very risky bet on a perpetual continuation of today’s abnormal valuations
  • WD-40:
    • Maker of ubiquitous household product people use to make things stop squeaking; very solid company and found in over 80% of US households; higher penetration than Coca-Cola and Gillette razors; no meaningful competition and healthy returns on capital
    • Limited growth opportunity and limited reinvestment opportunity, so high payout ratio
  • Slow growth opportunities can make for great investments when they command strong returns on invested capital to return capital to shareholders in addition to producing modest growth
    • For instance, from 2001 to 2007, stock price appreciated 6.6%/yr while generating 3.2% returns from dividends (9.8%/yr total return; compared to 5.3% S&P returns)
    • This is exactly what made dividend yield-focused investing attractive
    • 2001-2007 period began and ended with 10-yr treasury yields of about 5%; using this as proxy for risk-free rate, generally stable attitudes towards low-risk assets
    • WDFC traded for 15-20x during the period
  • From 2001 to 2016, dividend generating power is essentially unchanged, demand or competitive landscape has unchanged, growth expectations are no different – but today, investors are paying 34x, or twice as much for each dollar of earnings
  • Seeing similar willingness with 10-year treasury yield with yield falling from 5% in 07, 3% in 13, and 1.5% today – this is equivalent to PE ratio on the treasury going from 20x in 07, 33x in 13, and 67x today
  • For context, at the peak of 1999 Dot-Com bubble, S&P was trading at PE ratio of 30x
  • High appreciation of WDFC has brought dividend yield to just 1.4%
    • Over the next decade, if you assume dividend growth of 5% per year, dividend contribution to total return will be just 1.7%; and if PE ratio stays constant, total annual return will be just 6.7%
    • What if PE ratio returns to the 17.5x pre-crisis average? Then assuming the same 5% earnings growth rate, the stock will end the next 10-years at a price of $93, down over 20% from today’s price of $117 – total return will be a terrible -0.6% per year
  • When investors overpay for these characteristics, they turn a safe company into a risky stock
  • Idea that WDFC’s PE ratio to be cut in half may sound outrageous; but given how low the dividend yield has gotten today, if the stock price is cut in half today, dividend yield is still only 2.8% (this happens to be the average dividend yield that prevailed in 01-07 time period)
  • WDFC is not an outlier; quality, dividend paying companies of all sorts are trading at abnormally high valuations

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