Warren Buffett penned the following in the 2011 shareholder letter when discussing non-productive assets - a topic that came up time and again during the Q&A at the annual meeting in May 2012, when gold was trading around $1600 per ounce:
“The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As 'bandwagon' investors join any party, they create their own truth – for a while.”
If you remember back to when gold was running up towards $2,000 per ounce, the conversation was often based around this line of logic: (A) Some broad macroeconomic statement – fill in as you see fit; and (B) As a result, gold is worth more than its current price. Obviously, this fails to address a critical component of the equation: the relationship between price and value. The gold enthusiasts wouldn’t hear it. The price action proved they were “right,” and that’s all they needed.
Again, let’s go back to Buffett; this is from his interview with the FCIC discussing the housing boom and bust:
“The basic cause was, you know, embedded in, partly in psychology, partly in reality in a growing and finally pervasive belief that house prices couldn’t go down. And everybody succumbed, virtually everybody succumbed to that. But that’s the only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise--and it’s quite interesting how that develops--originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”
This perfectly encapsulates the conversation around gold: Every move higher was loosely tied back as a reaction to the “events” mentioned above. Regardless of where gold prices had started, this line of logic suggested that they must move higher. Eventually, the price action alone was all that anybody needed to justify more; it alone became the premise for an investment in gold (with charts showing its astounding run over the prior years as further “evidence”).
I don’t bring this up to pick on the gold bugs; I think we may be in the midst of seeing a similar story play out in equities. With interest rates at their lowest levels in decades, fixed income looks quite unattractive by most measures. In addition, the recent run up among the major U.S. indices (which makes poor fixed income yields look even worse by comparison) has further fueled the conclusion that exposure to equities is a must.
One particular group of stocks are commonly perceived as a sound alternative to fixed income securities - dividend payers. As the thinking goes, dividend-paying companies offer the best of both worlds – in many cases the yields are higher than long term bonds; in addition, they offer the potential for price appreciation over time. This idea has become increasingly prevalent amongst the most popular investment blogs (“Dividend Growth Investors” are a dime a dozen) – and more importantly, it has started to be reinforced in a meaningful way by price action.
To be clear, I think we are still in the very early stages, assuming this were to play out at all; however, I think an example would shed some light on what companies fit this description (from my view).
Waste Management (WM) has spent the better part of the past decade giving back profits to investors in the form of dividends and share repurchases. As a result, sales and earnings – on an absolute basis – have been relatively stagnant; this measure looks materially better only after accounting for the decrease in shares outstanding from the aforementioned buyback. However, WM is running into a problem – while earnings haven’t moved higher for many years, the company continued to reward shareholders with higher and higher dividends. As a result, the payout ratio (on 2012 figures) has roughly doubled – from about 40% to 80%. They’ve alleviated some of the problem by pulling back on share repurchases (at least in 2012), which bought them a bit of breathing room; after averaging a collective return to shareholders (via dividends and buybacks) of more than 100% of net income for years on end, reality looks like it’s starting to set in. In addition, the company has nearly $10 billion in debt – a level that has increased by about 20% in the last five years, but with unchanged interest expense due to lower rates.
On the plus side, the stock sports a solid dividend yield of 3.7% - and one that’s been growing; this, along with earnings/cash flow stability, means that it is a likely favorite among the dividend crowd. Year to date, the stock has moved 13% higher. It currently has a trailing P/E around 20x.
This is one example, and isn’t even particularly egregious; however, it’s not too difficult to imagine what will be said if this stock is eventually trading at 25 or 30 times earnings – “it still has a dividend yield higher than 10-year Treasuries!”
If this were to play out (and to reiterate, I don't think we're there today), just remember how quickly things can change – as gold investors have realized over the past eighteen months, it would take many years of dividend payments to cover the losses on an equity position where the earnings multiple cratered from 25, to 10-15x.
About the author:
I hope to own a collection of great businesses; to ever sell one, I demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.