Charlie Munger is famous for saying “Invert, always invert”. Time to do a little inverting! Today we’re going to perform a little thought exercise about a really common investment. I won’t tell you the name of this investment until the end of the article. As we go through this thought exercise, try to guess what company it is. Do you think it’s a good investment? Will it help us gain financial independence, or send us back to wage slavery? Let’s find out!
The business we’re going to look at today is a really large business, founded in 1957. It has a significant chunk of global GDP. Its products and services span the complete gamut from consumer products to finance, and energy. Practically any industry you can think of, this company is involved somewhere.
That’s not to say that this company is a static behemoth. It keeps up with the times, and trades new companies in (and out) of its portfolio frequently. This has allowed our company to grow profitability over its 59 years. New investment decisions are handled by a investment committee that looks at a variety of factors before deciding to acquire a new company.
This company is also a global enterprise, and does business in nearly every country in the world.
Our mystery company pays a dividend of about 2.18% yearly. Before Mr. Market got crazy, dividend yields use to average around 4% – which would have been very healthy for an early retiree. Alas, this is no longer the case. Anyone hoping to invest now will only get the paltry 2% dividend.
Dividends have been growing on average at about 5% annually. For the 2.18% dividend yield to grow significantly (say to 4%), it would take roughly 13 years.
That 2.18% dividend yield is 44% of corporate earnings, which means 55% of earnings are available for growth, share repurchases, and other corporate needs (anybody need a private jet?).
Usually, when you encounter a high PE ratio, you expect to see fast earnings growth. Unfortunately that’s not the case here, our company is a slow grower. It has been growing sales at a rate of 2-3% for the last few years (adjusting for inflation).
How can dividend growth be faster than sales growth? Mainly, via share repurchases. Economies of scale may also be a contributing factor.
With sales growth like that, you’d expect to see the stock in the gutter, but EPS growth has actually been reasonable (due to stock repurchases). If the company ever stopped purchasing shares, EPS growth would probably fall to these 2-3% growth levels. That would be a very sad day for investors, but economies of scale can only get you so far…eventually the law of large numbers comes into play.
The law of large numbers at work – Once a company gets to a certain size, it becomes really hard to grow quickly (or even faster than GDP). How has our little enigma grown compared to U.S. GDP?
This slow sales growth is (I think) set to continue for quite some time, due to slow global GDP growth rates. Investors better hope those share repurchases work out!
Like most large companies, our mystery company is traded on the public markets. As I write this, the company has a PE ratio of 21.95. That’s pretty high. In the past, the company used to trade at an average PE of 15. Mr. Market has been very optimistic lately.
As the share price has been bid up over the years, share repurchases have become less effective (high share repurchase price = lower ROI).
Earnings yield (the PE inverted), is a mere 4.5%. For those hoping to live on the 4% Safe Withdrawal Rate (SWR) for the next 50 years, that’s frighteningly close to 4%.
The mystery company also has a price to book value of 2.67. Definitely not cigar-butt style investing here. This kind of metric defines a premium priced company.
What Company Is It?
So what company are we talking about? Well it’s not exactly a company at all. Instead, it’s a rather large collection of 500 companies. If you haven’t guessed already, I’m talking about the S&P 500 index. Much of the data presented here was collected from www.multipl.com (Great site, btw).
Essentially when you buy into a S&P index fund, this is the ‘company’ you’re buying….for better or worse. Low growth rates, high PE ratios, and moderate dividend growth. The S&P500 is like a giant global conglomerate. This ‘company’ is only as stable as the economy, and also experiences regular declines when the economy goes into recession.
Most common personal finance advice says to invest in a stock index fund (frequently the S&P500), and leave it alone. It’s often said that, “You’ll do fine if you follow this strategy”. Maybe, or maybe not…
That same good advice is actually making success less likely. As everyone (and their grandma) sends those billions of dollars to 500 companies; it pushes up stock prices into nose-bleed territory. Yields get pushed down to very small numbers. Meanwhile, to maintain dividend growth, S&P 500 companies are almost required to keep purchasing shares.
Dollars invested in the S&P 500 today will earn 4.5%. I’m using simple earnings yield here, but some experts believe using Shiller PE 10 data for the earnings yield is even more predictive (Schiller PE 10 earnings yield in this case is only 4%).
Those people hoping to see 7% from the S&P 500 are placing their hopes on economic growth. The only problem is, economic growth has been terrible lately.
As you may already know dear reader, the frequently cited 4% rule came from the Trinity study. When the Trinity study was originally conducted, researchers looked at “successful retirements” in both stock and bond investments. When reading the study (and I recommend you do), two things should smack you upside the head (like a wet tentacle):
1. Only 30 years: The Trinity study only looked at success during 30 year periods. Most financially independent early retirees have much longer time horizons – maybe 50 or 60 years.
2. Slower Growth: Data used for the study (1925 to 1995) was during periods of higher GDP growth. This would have the effect of producing higher returns for portfolios in the Trinity Study.
If we consider the need for longer retirement time horizons and tiny GDP growth (in our modern times), doesn’t it make sense to be more conservative than the 4% rule might suggest? I think it does.
Given the S&P 500 earnings yield, the Trinity’s 4% rule will just barely work (today). Any significant economic blip could cause problems for a early retiree’s portfolio…Especially during the early years where spending is closest to the 4% SWR. If that economic blip goes on for an extended time period, financial independence failure could happen.
Mr. Tako’s Perspective
In my posts here at Mr. Tako Escapes, I always mention my 3% rule. It’s more conservative than 4%, but also more likely to work given today’s reality: Low real GDP growth and very low earnings yield.
I’m personally sticking to my 3% rule. In today’s environment, 4% is just too close for comfort.
What do you think? Is the 4% SWR your go-to withdrawal rate?
[Image Credit: Flickr]