Probably the most frequently asked question that I have ever gotten from readers is some variation of this: With the recent stock price increases of the past four years in mind, does it still make sense to buy the top-quality companies in the world like General Mills, Procter & Gamble, Johnson & Johnson, PepsiCo, General Electric, Coca-Cola, ExxonMobil, and Nestle at these prices?
It’s a question that you’ll ultimately answer for yourself, but here is how I think about it: the consequences of overpaying for an excellent business and holding for the long run are quite minimal compared to almost any other financial mistake that you can make. When you are dealing with the kinds of companies that are relentlessly growing profits and dividends year in and year out, you will find that the company “grows” into its valuation within a year or so, and then it’s off to the races.
Since general philosophy works best when it is accompanied by illustrations, let’s use a blue-chip company that I do not discuss on this website enough: General Mills. Some of you already know the company’s backstory: it has been paying out a dividend non-stop since the 1800s, making this company one of the few enterprises in the history of the world that a father could pass on to a son, and then he could pass on to his son, and then he could pass on to his son, all the way from the Benjamin Harrison presidency to the Barack Obama presidency and beyond.
General Mills managed to keep its dividend steady through the duration of WWI and through to the signing of the Treaty at Versailles in 1919, and when Germany broke the treaty seventeen years later by militarizing the Rhineland, General Mills did what it has always done: announced a dividend for shareholders. Through WWII, the Cold War, Vietnam, the fall of the Soviet Union, 9/11, high unemployment, and trillion-dollar deficits, General Mills has been putting more and more cash into the pockets of its owners. When you have a company with a product line like that, why quibble over a few bucks in valuation?
General Mills never gets much attention—Wall Street commentators never seem to get excited about Cheerios, Yoplait, Pillsbury, Hamburger Helper, Betty Crocker, Bisquick, Wheaties, and Chex Mix, yet over the past ten years the cereal powerhouse of the Americas has delivered total returns to investors of 11.07% annually, as profits have grown from $1.43 per share in 2004 to $2.69 as we enter the 2014. The dividend likewise has grown, from $0.55 per share in 2004 to $1.52 as we enter 2014. General Mills now pays out more in dividends annually today than it made in total profits just ten years ago.
Now, as we look at the valuation, we can see that those $2.69 in profits are trading for $49 per share. That works out to a P/E ratio of a little over 18. That may seem high compared to the 14-15x earnings you could get in 2009, 2010, and 2011, but 18x earnings is on the cheaper side of where General Mills traded in the 1980s, 1990s, and the early 2000s.
Since 1997, there was only one year in which General Mills’ profits did not move linearly upward. For 2015, General Mills is expected to make $3.20 in profits. My guess is this: prices of 18-20x earnings for a company of General Mills’ quality is the historic normal and should be the going forward rate for a company with such a diversified source of stable cereal and food profits, and people that buy around $50 or so today are getting a fair deal on their shares.
But let’s say I’m wrong. Let’s say that General Mills is about to enter a period of slightly slower growth to the point where it only trades at 14-15x earnings on an ongoing basis. By the end of 2015, the profits that General Mills generates will be enough to justify the January 2014 valuation of $50 per share. People that don’t understand the strategy think that blue-chip investors are obsessed with the past, but the truth is much simpler: we are in search of a time-proven strategy. When you can identify companies that grow their profits regularly (and the dividends, too) then you are going to be happy to see the profits backing you in twelve to twenty-four months. While you wait, you’ll collect 3% or so of your initial purchase price in the form of cash dividends.
Here’s how I think about the valuations of the top blue-chip companies today: although they are higher than they have been the past couple of years, the current valuations are still quite reasonable based on historical norms. Even if you are wrong and overpay a bit, the profits will be there in a year or so, and you’ll collect a dividend while you wait. General Mills traded at 16x earnings in 2004 and delivered over 11% through today, where the valuation is 18x earnings. If things went backwards (from 18x earnings to 16x earnings) over the next decade, you might get 8-9% returns instead of 11%. And best of all, these are the companies that still chug out profits even when wars and economic catastrophes emerge to the fore. The downside protection is great, you should do well if historical norms are to be trusted, and you might have to wait a year or two for the valuation to catch up if I’m overly optimistic. The good news is that you get paid money every three months to wait, if that turns out to be the case.