Last year around this time, I wrote an article about total returns (link to the article). In it, I pointed out that:
The return from an investment in common stock of a company is made up of the following:
1. Dividend Yield
2. Earnings Growth/Contraction
3. Multiple Expansion/Contraction
4. The reinforcing or balancing interaction between earnings and multiples
Therefore, in simple terms, the mathematical total return can be expressed as the formula below:
Total Return = Dividend Yield + % Change in EPS + % Change in P/E + (% Change in P/E * % Change in EPS
The lesson is clear: While earnings and dividends are enormously important, it would be foolish to ignore multiple expansion/contraction and the reinforcing or balancing interaction between earnings and multiples.
One thing I failed to point out in my article was that, when the majority of the returns for the past few years can only be explained by multiple expansion and dividend yield, you should start worrying about the implications most of the time. And you should especially start worrying if the multiple expansion is forced by some sort of bubble formation in one or more of the financial assets categories. This forgotten point may prove to be a timely cautionary reminder in the current market environment.
Let me use Kimberly Clark Corp (KMB, Financial) as an example. For simple illustration purposes, I will combine the multiple expansion and interaction between multiple and fundamental as one variable (courtesy to Morningstar for the data).
During the past 5 years, while the fundamental (I used operating income as a proxy) of KMB has actually slighted deteriorated, KMB’s shareholders have managed to reap a 17.59% annual compounded total rate of return. What is worrisome is that all the total returns during the past 5 years are explained by valuation change and dividend yield. It is true that may be some of the valuation change is deserved given the low valuation level in 2008 and 2009, but the divergence between performance and valuation is fairly obvious.
What has caused this divergence and what are the implications?
One thing especially worries me is the spill-over effect on equity from the “chasing for yield” phenomenon in the fixed income world. The literacy part is that investors have been bidding up dividend stocks in search for alternative yield to safer fixed income investment. Numerically, the result is the following table, part of which is borrowed from Howard Marks' memo.
The next question is so what, then what? When the 10-year treasury’s yield was 6%, no rational investors will be willing to swap 10 year government bond for a 3-4% dividend yield stock such as KMB. But when the 10-year treasury’s yield is a paltry 2%, suddenly KMB’s 3-4% yield looks pretty damn good. A 3.5% yield would imply a 28.5 times multiple, which is remarkably close to where KMB is trading at today. Coincidence?
Of course the multiple can be justified if interest rates stay low for a long period of time, which seems to be the expectation. The risk obviously is what happens when it doesn’t. Again, to use the numeracy filter, let’s look at the table above. Let’s say the yield for money market fund somehow shoots up to 1%, which is what it was in 2004. Income investors would demand 3-4% for government bonds and perhaps 5% for high grade bonds and dividend yield from high quality businesses. If this plays out, then a 5% yield would translate into a 20 times multiple for KMB, a 30% decline from the current multiple.
However, rates can’t go below 0% sustainably so the upside of multiple expansion is most likely capped, unless the fundamental of KMB’s business change dramatically from present level which is unlikely given the size of KMB and the business model.
Therefore, it seems to me that shareholders of KMB is not far from the dreadful situation of “heads I lose and tails I don’t win much.”
If we look across the board for the consumer stable sector, KMB is not the only stock with such low risk reward characteristics. I worry that the Fed-propelled bubble has already impacting parts of the equity market, as an unintended consequence. Energizer (ENR, Financial), Colgate-Palmolive (CL, Financial) and Clorox (CLX, Financial) are all following suits. Any investors in these companies should be worried about the second-order and third-order consequences from a mild rate hike.
