The steadier path

Growth stocks offer the highest returns—if you can find them in advance! That is no sure thing. Twenty years ago, the two fastest-growing US industries were technology and healthcare. Had one invested in the 10 largest companies in each sector, 14 of those 20 holdings would have trailed the Morningstar US Market Index.

The chart below depicts the cumulative performance of each stock versus the index. “More than Double” means that an investment in the security would have more than doubled the index’s return, “Between Equal and Double” indicates that the stock at least matched the index’s gain but did not double it, and so forth.

(However, thanks mostly to Apple’s AAPL enormous gains, a basket of those 20 growth stocks would have thrived. The triumph of diversification!)

Rather than chase hares, one could instead buy turtles. This has been Warren Buffett’s customary route, as exemplified by his 1972 purchase of See’s Candies. Although such investments cannot keep pace with the best of the glamour stocks, they are individually safer, because they 1) require little forecasting expertise and 2) are less burdened by investor expectations.

John’s widgets

Let’s consider a stylized example. Last year, John’s Widgets reached a milestone: $10 billion in sales. Hurrah! There is, however, a catch: The company has peaked. Not only has it found essentially all its potential customers, but those clients also have already been upsold. From what management can see, its operations are fully mature.

Further assumptions:

  1. The company earns $2 billion in net income.
  2. Its aftertax cash flow matches its net income.
  3. That entire cash flow is paid as an annual dividend.
  4. Our hypothetical shareholder promptly reinvests those dividends, buying additional shares.
  5. The stock’s price/earnings ratio is 20 and remains that way throughout the decade.

Let’s see what JW’s 10-year total returns would be, evaluating five potential scenarios.

Poor: Negative 2.06% annualized

In this scenario, JW’s business falls short of management’s expectations, causing its annual revenues to decline by 3% per year. Not surprisingly, JW’s total return is negative.

The good news for turtle investors is that, with thriftier stewardship, JW’s return could have been acceptable. This case assumes that the company’s belt-tightening did not keep pace with its revenue downturn. But had JW reduced its expenses by 3% per year rather than the stipulated 2%, the stock would have notched a small gain.

The bad news is what happens if management is asleep at the wheel and fails to cut costs. Even if the company does not spend a single dollar more, maintaining expenses at their initial level, its operating profits would disappear entirely by Year 10. That would leave JW both bleeding red ink and with slumping sales—a bad place indeed!

The moral of the story: If a turtle’s business deteriorates rather than holds steady, the quality of its management becomes critical.

Disappointing: 5.00% annualized

This calculation is easy to understand. If both JW’s revenues and expenses are frozen, its stock is effectively a bond, returning no more and no less than the amount of its annual dividend.

One might hope for more, because even if JW were unable to achieve unit growth, the company should have managed to raise its prices along with inflation. Still, a 5% total return isn’t terrible. For example, even when aided by a raging bull market, 13 of the 50 largest US growth stocks from autumn 2015 have fallen short of that mark.

Middling: 8.15% annualized

With this example, JW can increase its prices by the yearly inflation rate, which I establish at 3%. The company’s expenses increase similarly. Consequently, the company’s stock performs like a bond—but this time, not as a traditional note, but instead as an inflation-protected note that carries a 5% real yield.

The result is an 8.15% annual gain. (The total-return calculation from combining a 5% dividend with 3% growth is multiplicative.) Coupled with consistency of the company’s business results, which should make for a relatively stable P/E ratio—although of course not untouched, as the model stipulates—that’s an agreeable outcome.

Good: 12.88% annualized

Once again, revenue growth tracks inflation, but management does so while economizing, growing its annual expenses at 1% per year instead of the preceding case’s 3%.

Although that level of afterinflation cost reduction is modest—the organization could get there solely through employee attrition—the effect is substantial. Thanks to its improved profit margins, JW’s Year 10 net income would increase by 53%, ballooning from the previous example’s $2.69 billion to $4.12 billion. That’s real money.

Great: 17.70% annualized

In the fifth and final scenario, JW at last achieves unit growth. As it turns out, management underestimated its business prospects. Besides raising its prices each year by 3%, thereby mirroring the inflation rate, the company manages to sell another 3% of widgets.

That makes for an excellent return, based on three items: 1) the ongoing dividend, 2) 34% cumulative unit growth, and 2) higher margins. The latter two factors propel JW’s Year 10 earnings to $6.26 billion—more than triple their starting point!

The caveat

This exercise is highly simplified. In truth, even mature companies do not distribute their entire profits as dividends. Along with making such payments, they also repurchase shares (largely to the same effect) and, usually, reinvest some proceeds into their businesses.

(Also, their price/earnings ratios aren’t fixed. However, as I learned when tinkering with the model, that assumption doesn’t greatly affect the results, unless the P/E change is drastic.)

That said, creating a more realistic model would add complexity without providing significant insight. Regardless of how its profits are spent, history shows that, over time, a typical mature business posts annualized total returns that are 3 or 4 percentage points above the prevailing Treasury-bond rate. That would make for roughly an 8% return in today’s conditions, which tracks the “Good” scenario.

Final note

This column serves as a complement to the ubiquitous “dividend stock” reports published so frequently by Morningstar (and other research firms). Those articles attempt to identify the most desirable turtles. This installment, in contrast, provides the economic rationale for why investors might wish to own such companies in the first place.

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