The Dividend Mailbox

How Compounding Can Turn Underperfomers Into Big Winners

February 23, 2024 Greg Denewiler Season 1 Episode 32
The Dividend Mailbox
How Compounding Can Turn Underperfomers Into Big Winners
Show Notes Transcript

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In this episode, Greg analyzes the wisdom of renowned economist, Jeremey Seigle. Between his investing classic "Stocks for the Long Run," and "The Future for Investors," Siegle maintains that you don't need high growth numbers or a flashy industry, only consistent growth. Although it is seemingly counterintuitive, Seigle presents the power of compounding from a new perspective. Most investors would hope stocks go up, and the quicker the better. But there is an argument for how a stock that goes sideways, or even downward, can be beneficial to your long-term total return.

Later, Greg provides an update on Emerson ($EMR) where faster dividend growth seems to be on the horizon. In case you missed it, the original Emerson Electric ($EMR) story is linked here: EP 17 - The Dilemma with Slow Grow

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Greg 00:11

This is Greg Denewiler, and you're listening to another episode of the Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last. 



Welcome to episode 32 of the Dividend Mailbox. And today we're going to hit a few topics. The first one's going to be Jeremy Siegel's book, “Stocks for the Long Run.” He's done several editions; this is the latest one. In there, one of his chapters goes over comparing two companies and then looking at the total return over an extended period of time, several decades. The conclusion is probably going to be a little bit surprising. You don't have to be in the center of having something that's extremely popular to make a lot of money, and that's what we're going to talk about today. Then we will do a quick update on Emerson Electric. They just had an earnings announcement; it looks like the stock is starting to improve as far as earnings. And for a dividend growth story, you have to have earnings growth. 



So we're going to continue on with the kind of line of thought that I mentioned in the last episode where we're going to look at declining industries and we spent some time going over Chevron. What I do want to stress though is you can still get extremely attractive returns when it's not a flashy industry like technology, where you've got these high growth, just extremely popular stocks. But what's important is how the companies are managed and how they compound cash flow over time. And again, that's what our whole goal of this podcast is all about. So the best way I can illustrate this is basically to paraphrase Jeremy Siegel's book “Stocks for the Long Run,” which came out originally in 1994. It’s probably considered one of the classic investment books, and he's done several updates, the latest one he did last year. 

For those of you who are not too familiar with Jeremy Siegel, he taught at the Wharton School of Business, University of Pennsylvania, in their MBA program. He's been around for a long time. He's kind of one of the go-to people as far as interviews on the business channels, and he's also been involved in some research that is included in the CFA (Chartered Financial Analyst) program. Jeremy Siegel is also the Chief Economist for WisdomTree, which is one of the largest ETF managers out there. WisdomTree manages DGRW, which is one of the ETFs that we use, and we have mentioned it several times in the past. So, he is a very credible source. 

In Jeremy Siegel's revised edition of Stocks for the Long Run, he goes through part three of the book, and he talks about Standard Oil and IBM. Now, unfortunately, the way I've set this up, you probably already know the outcome, but it's still great to go through it. He creates this scenario, and he says: let's imagine that it's 1950 and you've got an uncle that has just died and that uncle left 10, 000 to your newborn daughter. It comes with a small hitch, and that is, you have to make a decision and you have to pick one of two companies. The first one is Standard Oil of New Jersey, which is now ExxonMobil, and the second one is IBM. And then the next condition is that you have to reinvest — whichever one you choose — you have to reinvest all the dividends back into the stock, and then you can't touch it until 2010 when your daughter turns 60 years old. So, which one would you pick? 

Well, going back, you have to remember, of course, oil, by the time you got to the 1973 era when we had the big oil embargo and oil finally started to move — before that, oil didn't do a whole lot. Up until 1973, you could buy a gallon of gas for 29 cents a gallon. They used to have what they called gas wars, and sometimes it would drop below 20 cents a gallon. That's where it stayed for the longest period of time. But then you had this company called IBM, which in the 1960s and 70s was a dominant, high-growth perception company. By the time you got to the mid-1970s, IBM was coming out with the personal computer, and this was a stock that everybody thought they should own. 

So, here's what I'm going to do, and here's how Jeremy Siegel presents it. Not only do you have to choose between these two companies, but we’re also going to give you the statistics of how they perform for the next 60 years. What that's going to do is hopefully make it easier for you to decide. Everyone wants tomorrow's Wall Street Journal, but sometimes that can be the worst thing that happens to you and you're about to see one explanation of why. You're going to see how both companies perform, but what you don't know is what the total return is over the period, or how the stocks actually performed. 

So, the first thing we're going to look at is revenue per share, and over the 60-year period, IBM's revenue grows at 10.6% a year, and Standard Oil of New Jersey grows at 8% a year. 

Then we're going to look at dividend growth. The dividend for IBM grows at 9.7% a year, Standard Oil's grows at 6.8%. 

For that 60 year period, IBM's earnings grow at 11.3% a year, and Standard Oil's grows at 7.6%. Now, I mean, again, I can't stress this enough, and if you haven't learned, if you've listened to very many of these, you should know that even these small percentages over a long period of time can make a huge difference. The difference between 7.6% and 11.3% is in effect basically 50% faster earnings growth. So that is a significant difference. 

Now the final thing we're going to look at is called annual sector change. What this means is, “Okay, IBM over the next 60 years, the technology sector grows and becomes a bigger part of the overall economy, while oil actually slightly shrinks.” So that's part of what I was alluding to earlier, even though oil demand did continue to grow over that period, the actual sector, how it was represented in the marketplace and in the S&P 500, shrank by a little bit. 

So, every one of these metrics favors IBM, and some of these are somewhat significant. But now we're going to get to the second part of this. Going from 1950 onward, the average price-to-earnings ratio for IBM was 22.5. It was more expensive because it had higher growth, which is normally the way the market prices things. The average price-to-earnings ratio for Standard Oil was 13. So, it was valued at not quite half. 

The average dividend yield for IBM over that period was 2.2%. The average dividend yield for Standard Oil was 4.2%. So, you started out with twice the dividend rate for standard oil as far as the percentage that it paid out. However, IBM's dividend grows at a faster rate, 9.7%. So even though standard oils’ average yield is 4.2% at the start, because it only grows at 6.8% a year, over 60 years IBM's dividend does eventually surpass what you earn on Standard Oil. 

So Standard Oil is cheaper, both when you look at the P. E. ratio, basically how the stock trades to earnings, and then also the dividend yield. That is a significant factor, in fact, it's huge, because now we're going to look at what were the actual results. You probably already know by the way I've set this up, but what you don't know is just how dramatic the numbers played out. But if you're like most investors, the problem is, and you see it in the market right now — everybody wants to own Microsoft, Apple Computer, or Amazon. These things are very expensive, and the dividend yields on all of them are extremely low even though they do grow faster than the S&P 500. 

But here becomes the big dilemma. Long term, is that what you really want? Because, if you were probably back then, like most people, and you were given the numbers of how the next 60 years played out, you just weren't given the outcome of the return, you would have picked IBM. Well, it's not a bad choice because on your $10,000, when you went to the bank and opened up the safety deposit box, IBM was worth $15 million in 2010. So your daughter has a pretty good retirement that she can fall back on. However, if you had gone with Standard Oil, your daughter could have bought you a new house amongst a lot of other new things because she now has $33 million. So, that more than doubled the return of IBM. And again, you've got significantly higher growth rates on basically all the major metrics. Revenue growth, dividend growth, earnings growth, those are what drive the bus. They're all significantly higher for IBM. But, guess what? When you compound a higher cash flow for a long period of time, miracles happen and it's the whole power of compounding. 

It's not really easy to follow and it's why a lot of people miss it, I think, as far as investing in the long term, looking at total return. What you're able to do is you're able to continue to buy more shares of standard oil at the beginning because you're getting more cash to buy them with and then they're also cheaper than how IBM is priced. Really what you have is you have faster compounding from a standpoint of the cash flow that you're able to buy and then that earns more cash flow. Even though IBM's growth rate is higher, it just takes so much longer for it to catch up that it really never does. 

Looking at today's environment where you've got some companies, a handful of companies, that are growing extremely fast. You have some of them that do pay dividends but they're much lower yields because the stocks have performed so well, they're fairly expensive. You don't have much compounding there. You've had a huge total return coming from the stock prices. But, one of the things you have to remember is that historically it's really been impossible for a company that's a top performer — that's a top 10 performer for a decade — to hold that space for a long period of time. There's competition, there's evolution in the capital markets, and you give some of that stock price back. With standard oil, you never had the big stock price move. Actually, you did in the seventies, but what you have is a big piece of that return that has come from a dividend and cash flow. When the stock price backs off, they don't take that cash flow from you, they only take the stock price from you. So, in the case of companies that are growing extremely fast, if the stock drops 30%, that's virtually your entire return because the dividends are less than 1%. 

Now, let's just say that you cheated and you took the — I hate to do this, but I'm going to call it the sissy way out — and that is: “No, I'm not going to take that kind of risk and put all my money in one stock. I'm going to buy the S& P 500.” Well, the S&P 500 actually came out in 1957, but they had the composite, roughly the same thing. If you put your $10,000 in the S&P 500, it would have been a little less than 5,000,000 in 2010. So, your daughter would have had a decent retirement still, but she's not going to Europe every month. 

So basically, what this example is designed to do, and part of what Jeremy Siegel stresses, is that it's not about flash and it's not about finding high growth and what's really going to do good for the next three months or even the next three years. It's what's going to continuously compound your money. 

I'm going to continue on the Jeremy Siegel train a little bit here. He wrote another book and it's called “The Future for Investors” and the subtitle is “Why the Tried and the True Triumph Over the Bold and the New.” It's a good book to read because one of the examples that he gives in there, and it's kind of along the same line, is you don't have to have a lot of growth, you just have to have some growth. In fact, you really want a stock that doesn't move for several years and you're able to reinvest before it really starts to move up. And I was first introduced to this concept when I read the book because it really is kind of a light bulb that goes off and it's extremely hard to practice. He goes through an example where the best thing that can happen to you is you buy a stock, it immediately goes down, and it stays down for the next 10 years, i. e. standard oil, and you continue to reinvest those dividends at lower rates, and you're getting a higher yield because the stock price is less and the dividend grows. And then at the end of that 10 year period, the stock gets revalued. It shows some growth potential. It's what happened to Microsoft in 2000 and 2006 the stock was at 23 and didn't go anywhere. It was really lagging the S&P 500. The thing was trading at 10 times earnings and you could buy it at that valuation for about five years. Well, we all know what happened after that, and that's how you can really make a lot of money. That's the example that Jeremy Siegel goes through in his book, “The Future for Investors,” how it's all about compounding and it's not all about your statement going up every month and feeling better about yourself. 

I think I should also add in full disclosure, our particular practice as far as how we manage these portfolios — we don't take the dividend and turn around and reinvest it into the same stock. We will look for other situations that are cheaper or more attractive, or if the current stock is still attractive. We like to choose what we pay for it and when, and that's also partly how we continue to diversify the portfolio. 

So, on that note, Declining industries can still do extremely well. They tend to have much cheaper stocks. You do have to be a little careful, you really have to pay attention to management because what you try to really avoid is a cigar butt where you only have just a few puffs left. It's really stressing; is the dividend sustainable and can they grow it? Really focusing on trying to get that 7% growth rate a year, which will double your money, and double your income in 10 years. 


So now I would like to transition into one of the companies that we've mentioned in the past is Emerson and it's one that we hold. One of our goals of this podcast is to be transparent and look at, okay, if a company is having an issue, what does that look like? What does the catalyst need to be for it to turn around? How's it potentially going to affect the sustainability of the dividend? And just look at the ways that these investments play out because they are always evolving. 

We've covered Emerson twice before, and I would encourage you to go back and listen to episode 17 when we first mentioned it. They had the dividend growth when we originally bought it and went into the model portfolio in 2012. It was really more of an industrial-oriented company. They manufactured measurement equipment in the oil and gas business, pressures, flows. They had a garbage disposal company, but they've sold that off recently. One of the things that's happened, they basically tried to reinvent the company, go into some higher growth areas, go into more software-based stuff. And it really has been a several-year transition. While they've been doing that, one of the things that happened, and you see this frequently, is they only raise the dividend by about a penny a year, sometimes a half a cent a year, just to keep their 60-plus-year track record of dividend growth intact. But that's not why we own these things. We had it on our watch list because we weren't getting dividend growth and we're at that point now where, look, you know, we need some dividend growth, and we need earnings to grow relatively significantly to get us back on track, or this is one that we may have to swap out for something else. 

Well, they just reported the quarter. They really, um, I'm not going to call it “blew it out,” but they had a really strong quarter. They're showing a definite turnaround there. They have earnings projections this year of $5.30 cents. They pay a $2.10 cent dividend. If you look at the dividend payout ratio for the last 20 years, they've had about 50%— actually, it's 55%. So, if you just get a 50% payout on $5.30, That's $2.60. That's like 20% dividend growth right there. If you go out to the estimates in 2026, they're at $6.15. It may go up a little bit because of the earnings today, they're projecting higher growth rates. 50% of that is $3.05. That's a 45% higher dividend than where it is right now, so that's two years out. 

But of course, one of the remaining questions is, yeah, they're showing where they have more earnings growth now, the payout ratio is improving, and they've got room to grow the dividend, but we've got to see how friendly they are to shareholders and focus more on shareholder return. One of the things you always worry about as an investor is how a company spends its free cash flow. Are they going to look to continue to acquire? Are they going to focus on buying back stock? Or are they going to put energy into growing the dividend and get it back more towards the six to ten percent range where they've been in the past? Personally, I think that they will start to raise the dividend at a faster rate. The precedent for this company goes back decades, really going back all the way to the turn of the last century. This company has been a dividend-oriented story. So, from that standpoint, I would put some weight in it. But the reason why I can't sit here and be certain about it is because they do have a new management team in there and they are definitely growth-oriented. What we're interested in is a balance of the two. We'll have to see if that's where they're at. One indication that will help us out maybe a little bit is they have committed to a $500 million buyback this year. They completed $150 million in their first quarter, the next three quarters, they're supposed to buy back another 350 million of stock. They are committed to giving money back to shareholders. We just prefer to see a lot of it come back as a dividend. 

So as far as dividend growth in Emerson, we bought it in June of 2012. On a quarterly basis of what it went into the portfolio, the dividend has gone from $18.80 up to $24.60 recently. Well, that's only a 2.5% growth rate. We paid $44 for it, today, the stock hit a little over $105. Stock price wise it's performed, but comparing it to the S&P 500, it has lagged. You know, another way to look at this is, yeah, Emerson Electric stopped raising their dividends for several years. It was actually a drag in our portfolio. Not that we were ever losing any money in it from what we paid for it. But we paid 2,108 for it. It appreciated to 4,900 and we received 1,036 on it. Well, That gives you a return of 183%. Here's another way to look at this. You could realistically say that we took the cash flow out of Emerson Electric and, you know, roughly a year ago, some of that cash went into Williams Sonoma, which has been a double for us since then. And, if you purchased Microsoft in 2012 with some of these dividends from Emerson Electric, you're way ahead of the S&P 500 right now. So, it's always a portfolio story. 

Emerson is starting to be a story that looks like it's going to be successful and we're going to continue to hold it now that it's basically being repriced as more of a growth company and the dividend growth rate should pick up, it hasn't yet, but I emphasize should. They have the ability to really start raising the dividends more aggressively now, and that ultimately is how these stories can really work well. Going forward, it's a candidate to outperform the S&P 500. 


Now, just another little update here. The dividend on the S&P 500 is at a run rate right now of $73.40 based on the latest quarterly payout for the S&P. With the index at, for all intents and purposes, at 5,000, that's a 1. 47% yield. So, right now with our target of 3% and we're trying to get slightly better dividend growth, it's not too hard to significantly outperform the S&P right now from a dividend yield standpoint without going into some of these dramatically higher yields where you're in a whole other space and it's a whole different mindset. Another thing to keep in mind, and this is just our belief, is that even though the S&P 500 had a great return last year, the dividend only grew by 5%. Our portfolio, and really, the entire sector of just the more value and dividend side of the S&P 500 grew by very little depending on what index you looked at. Actually, maybe even declined last year. But our dividend, as we mentioned before, grew by 18%. So, it is something that you really need to be committed to and you have to make sure that headlines don't get you away from what you're trying to accomplish long term. 


So, as we wrap up, valuation matters, what you pay for dividend growth matters, dividend growth itself matters, and compounding that dividend matters too. All three of these are constantly evolving. One of them will have a bigger impact over a period of time than the other one. But it's balancing all three and getting them working towards the ultimate goal of the portfolio, which is total return and growing your income. 


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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.