Friday, January 14, 2011

KO and JNJ: Defensive Stocks?

I know it has been a decent but not great decade for stocks like Coca-Cola (KO) and Johnson & Johnson (JNJ). The businesses did just fine while the stocks were less impressive. This comes down to simple math. They sold at extremely high multiples of earnings ten years ago.

Step back a bit and the picture looks a whole lot different.

Twenty five years ago Coca-Cola was selling for $ 3.33 per share (split adjusted so apples to apples).

Today, Its annual dividend alone is $ 1.76 per share.

At that time, Johnson & Johnson was selling for $ 3.24 per share.

Its current annual dividend is $ 2.16 per share.

So at the current dividend rate, both stocks produce more than the full value of the initial investment from the dividends alone every two years.

These days both stocks are selling in the $ 60 to $ 65 per share range.

At current prices, both stocks have increased in value substantially in twenty five years excluding their not insignificant dividends. Include those dividends and the increase in value is more than 30-fold.

Either way, a far better return than the S&P 500.

As larger companies, I wouldn't expect a repeat of something as impressive going forward. Still, I think they're capable of producing more than solid risk-adjusted long-term results especially if purchased at a fair price or, better yet, at a nice discount to value.

What's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation. As always, the ability to judge value matters a whole lot.

In fact, long-term outperformance (I'd argue at lower risk of permanent capital loss) is not unusual for businesses with durable competitive advantages and high return on capital like Coca-Cola and Johnson & Johnson. In other words, the past twenty five years looks amazingly similar for something like Pepsi (PEP). Try to find any previous twenty five year period where these companies do not outperform. It's not easy.*

Not impossible, just more an exception to the rule.

These businesses are still frequently referred to as "defensive" (seems to be almost daily on various business media outlets) yet have routinely outperformed over a longer horizon. An ability to produce attractive returns at lower risk at a minimum suggests the title "defensive" is an inadequate one. Even if shares of these higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered.

So does the reduced likelihood of permanent capital loss and more narrow range of outcomes.

Increases to intrinsic business value over the very long haul -- not exceptional trading abilities -- does the heavy lifting as far as generating returns.

Long-term compounding effects.

Considering the alternatives available to market participants, it seems incredible that so many choose to treat the stock market like a casino.

I've said before that what really matters, of course, is how these businesses and ultimately their shares will perform going forward. Getting that at least mostly right still requires plenty of work.

In other words, just because something has done well in the past guarantees nothing.

Adam

Long positions in KO, JNJ, and PEP established at lower than recent market prices

Related posts:
Altria Outperforms...Again - October 2010
Grantham on Quality Stocks Revisited - July 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
Defensive Stocks? - April 2009

* Over the shorter run -- less than five years or so -- anything can happen as far as relative performance goes, of course. Over shorter time frames, it's easy to see why these are perceived to be defensive investments. They generally don't go down as much when the market crashes, and they don't go up as fast during bull markets. It's when looked at across several bull and bear markets that their merits become more obvious. Anyone buying the higher quality stocks expecting them to outperform during the next bull market is likely to be disappointed. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul -- at least a full business cycle or two.
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