zaterdag 15 juli 2017

The Complex History of Johnson & Johnson

I have a soft spot for Johnson & Johnson.  What many investors don’t realize is that Johnson & Johnson proper doesn’t actually do anything in the sense that most people think it does.  Rather, it’s a holding company with controlling stakes in 265 individual operating businesses; firms with their own executives, employees, boards of directors, bank accounts, offices, products, and services that do business in every country on the planet.  The parent holding company’s job is to provide operational support for these subsidiary companies, including sourcing low-cost capital through borrowings (it is one of only three industrial businesses with an AAA credit score) and moving money from one to another in a way that allows lucrative opportunities to be seized; e.g., distributions can be declared from a profitable, but slow growing company, and dumped into a new idea that needs to scale quickly.  The holding company itself has increased the dividend payable per share to its stockholders every year, without exception, for 52 years; through recessions, wars, inflation, you name it.

The 265 individual companies that fall under the parent Johnson & Johnson holding company umbrella generally belong to one of three categories:

  • Consumer Healthcare: Things like baby powder, baby shampoo, baby lotion, Listerine mouth wash, Tylenol pain reliever, Rogaine hair loss treatment, Band-Aid bandages, Aveeno face washes, Neutrogena skin care, Lubriderm skin care, Bengay muscle relaxer, Neosporin disinfectant, Pepcid heartburn relief, Nicorette nicotine gum, Motrin, Benadryl, Sudafed, Mylanta, Visine eye drops, and Acuvue contact lenses to name a few.
  • Medical Devices: Everything from sterilization products for hospitals to blood glucose monitoring systems.
  • Pharmaceuticals: World-class drugs treating everything from cancer and diabetes to HIV and schizophrenia.

For example: Have you ever heard of McNeil-PPC, Inc.?  Probably not.  According to Wikipedia, its predecessor was founded on March 16, 1879 by Robert McNeil, who was 23 years old and paid $167 for a drugstore “complete with fixtures, inventory and soda fountain” in Philadelphia.  Decades later, it expanded into pharmaceutical distribution.  In 1959, it was acquired by Johnson & Johnson.  By infusing additional resources into the firm, McNeil-PPC, Inc. setup its own subsidiaries, including one called McNeil Nutritionals LLC.  That latter business entered a joint partnership with Tate & Lyle, the British agricultural giant, to develop an artificial sweetener.  After years of scientific discovery and perfection, the product known as Splenda was born.

If you didn’t know about this, when you visited Splenda’s website and saw “McNeil Nutritionals, LLC” as the owner, you wouldn’t know some of those earnings are being paid up to McNeil-PPC, Inc., which in turn find their way to the parent Johnson & Johnson company in New Jersey.  If tomorrow, a really promising drug appeared on the horizon, Johnson & Johnson’s parent company could declare dividends from McNeil-PPC, setup a new operating LLC, infuse the cash into it as part of the capitalization structure, reassign executives and talent to get it off the ground, and shave off ten or more years of ramp-up work.

urthermore, what makes Johnson & Johnson unique is that it is one of the only businesses in the Fortune 500 that explicitly rejects the “shareholder maximization is the highest priority” dogma that arose during the 20th century.  The enterprise is guided by its Credo, which is a work of art.  Quite literally.  The words, engraved at corporate headquarters, were penned prior to the 1944 initial public offering by the firm’s most famous Chief Executive Officer, letting new owners know that, while generating a return for them was important, it was far down the list to serving patients, doctors, suppliers, and employees; the theory being that there are multiple constituents with a vested interest in the prosperity of a firm, and that sometimes, doing the right thing long-term required sacrificing earning power today.  It’s a moral and ethical triumph that, I believe, should be replicated by other corporations and taught in business schools.

Following the Credo is what saved the firm’s reputation during the Chicago Tylenol murders of 1982.  When it became clear someone had tampered with capsules, slipping cyanide in them and killing those who took the pills, Johnson & Johnson immediately put the safety of their customers ahead of the income statement.  They did not attempt to minimize or deny the situation.  It pulled 330 million pills off the shelf and went from 34% market share to 0% overnight, according to Alan Hilburg.  He said they didn’t have a crisis plan, they had the Credo.
The company also immediately retooled their factories to create a visual metaphor for safety, introducing an aluminum tamper-evident seal, plastic coating, and pill capsules that couldn’t be broken apart easily.  Within 90 days, the consumer trust was so high that market share skyrocketed to 46%.

What’s so magical about the Johnson & Johnson credo?  Judge for yourself.

Our Credo

We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services. In meeting their needs everything we do must be of high quality. We must constantly strive to reduce our costs in order to maintain reasonable prices. Customers’ orders must be serviced promptly and accurately. Our suppliers and distributors must have an opportunity to make a fair profit.

We are responsible to our employees, the men and women who work with us throughout the world. Everyone must be considered as an individual. We must respect their dignity and recognize their merit. They must have a sense of security in their jobs. Compensation must be fair and adequate, and working conditions clean, orderly and safe. We must be mindful of ways to help our employees fulfill their family obligations. Employees must feel free to make suggestions and complaints. There must be equal opportunity for employment, development and advancement for those qualified. We must provide competent management, and their actions must be just and ethical.

We are responsible to the communities in which we live and work and to the world community as well. We must be good citizens — support good works and charities and pay our fair share of taxes. We must encourage civic improvements and better health and education. We must maintain in good order the property we are privileged to use, protecting the environment and natural resources.

Our final responsibility is to our stockholders. Business must make a sound profit. We must experiment with new ideas. Research must be carried on, innovative programs developed and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched. Reserves must be created to provide for adverse times. When we operate according to these principles, the stockholders should realize a fair return.

It’s worked in spades.  Johnson & Johnson has been one of the most successful blue chip stock investments of all time.  The underlying economic engine and incentive systems unleashed by the business model are so superior to most other firms, that even if you bought it at absurd valuation levels, such as during the Nifty Fifty era, you still beat the S&P 500 if you held it for 25+ years.  It has a structural advantage its competitors can’t match.

Specifics are always useful so to give you an idea of real-world numbers, let’s imagine you go back to the 1980’s when Misses Greedy Dwarf and I were born.  Say that our parents and grandparents got together and, between them, kicked in $50 a month for us, respectively, by sending a check to the Johnson & Johnson dividend reinvestment program.  It was already one of the biggest healthcare companies in the world.  Nearly every widow in the country owned it.  It had a prominent place in the portfolio of most mutual funds.  This was not some little-known firm but, rather, a global medical conglomerate with the founding family ranking on the then-newly established Forbes 400 list.  This would have taken nearly nothing; hardly any sacrifice; veritable pocket change.

What would we have today had this occurred in some alternate universe?  Ignoring the minor fees which wouldn’t have made much difference, anyway, here’s what each of us would have brought into the marriage property sitting on our joint balance sheet:

    • Misses Greedy Dwarf: 396 months, at $50 each, for total out-of-pocket savings of $19,800.  It would have grown to 3,719 shares worth around $339,582.97.  She would be collecting $11,157 in annual cash dividends.
    • Greedy Dwarf: 394 months, at $50 each, for total out-of-pocket savings of $19,700.  It would have grown into 3,650 shares worth around $333,272.98.  I would be collecting $10,950 in annual cash dividends.

Combined, that’s 790 aggregate months of saving, at $50 each, for total out-of-pocket cash contributions of $39,500.  It would have grown to 7,369 shares worth around $672,855.95.  We’d be collecting $22,107 in annual cash dividends.

Here’s the crazier part.  Imagine that our fictional alternate-dimension family handed us the stock certificates today and stopped contributing entirely.  We decided to lock the shares away, ignoring them and never putting any new money into it other than reinvested dividends.  If the firm compounded at less than its long-term average (it is much bigger, after all, so let’s shave off a few points), by the time we were Warren Buffett’s age the stake would have grown to $243,926,664.  That’s not a typo, it’s a quarter-of-a-billion dollars.

Even assuming some higher inflation inputs, the purchasing power equivalent would be just shy of $32,000,000 in today’s money.  Compounding is a nutty thing when you get your hands on a great asset, even in small amounts, and leave those assets alone for almost a century.  I can say with near absolute certainty that Johnson & Johnson will be in most of the family trusts we end up setting up for our children and grandchildren.

How did it come into existence?  By what workings did the modern Johnson & Johnson corporation, with all of its good, arrive on the commercial scene?  Travel with me back in time.

The Birth of Johnson & Johnson

In the 19th century, Sylvester and Louisa Wood Johnson had eleven children.  They were “farmers and cattle breeders in Crystal Lake, Pennsylvania” according to Barbara Goldsmith’s 1987 recounting, Johnson v. Johnson.

One of their sons, Robert Wood Johnson (1845-1910), relocated to East Orange, New Jersey to work with a man named George Seabury, with whom he established a pharmaceutical partnership called, appropriately enough, Seabury and Johnson.  Robert hired two of his younger brothers, Edward Mead Johnson (1853-1934) and James Wood Johnson (1856-1932) to work for him.

In 1883, when Edward Mead was 30 years old, and James Wood was 27, they decided they wanted to be their own bosses.  They quit their brother’s firm and setup a new business called Johnson & Johnson, using a simple logo the latter wrote by hand.  This business prospered.  Robert saw how well they were doing and, again according to Goldsmith’s examination of the family historical record, approached them about working together despite having parted ways not that long ago.  He left Seabury and Johnson, signing a non-compete agreement that banned him from the industry for a decade.  However, in 1886, he sought an exemption from the state that allowed him to discard his earlier promise on the theory that consumers benefited from the competition.

Robert infused his money into Johnson & Johnson and the boys were granted incorporation of their enterprise in 1887.  The “new” Johnson & Johnson consisted of “fourteen workers on the fourth floor of a small New Brunswick, New Jersey, factory”.  Barely a month and a half later, as the controlling stockholder, Robert demoted James from the position of President and assumed the role himself.

A driven, overbearing man, Robert was obsessed with preventing germs and infection, much to the benefit of society.  As Goldsmith put it, “In a time when the post-operative death rate in hospitals ran as high as 90 percent, when the cotton used in surgical dressings was made from the sweepings from the floors of textile mills, the Johnson brothers began to utilize [English surgeon Joseph Lister]’s methods of sterilization on a large scale to produce ‘the most trusted name in surgical dressings’.  Using an India-rubber-based adhesive, the Johnsons manufactured pre-packaged surgical dressings that were the forerunners of the Band-Aid.”

By the time he died in 1910, Robert Johnson had built the Johnson & Johnson company into “a plant consisting of forty buildings” and held 84% of the corporation’s stock.1  All was not lost, though, because back in 1882, he had married a woman named Evangeline who was the daughter of an affluent doctor.  They had three children.

  • The eldest son, Robert Wood Johnson, Jr. was born in 1893.
  • The middle son, John Seward Johnson, was born in 1895.
  • The youngest daughter, Evangeline Armstrong Johnson, was born in 1897.

Though he had little to no interest in his family – all he cared about was the business and couldn’t even be bothered to step away long enough to attend vacations with them – he left the Johnson & Johnson stock to his children.  Specifically, he instructed that his common stock, along with its voting power, be split evenly among the two sons so that each ended up with 42% of the Johnson & Johnson business, and he set aside a small block of preferred stock for his daughter as he didn’t believe women should be involved in running enterprises nor equally inherit; a misogynist belief that ran through the empire up until recent decades when female family members were forced to hand over control of their decision making to their brothers and, at the business, women weren’t even allowed in the executive dining room.

With uncle Edward Mead Johnson already working on his new firm and no longer a part of the Johnson & Johnson he founded (see footnotes), the boys’ uncle and company co-founder, James Johnson, stepped back into the role of President, taking the 17 and 15 year old into his home.  Robert Jr., realizing he was the only living Robert at this point, dropped the diminutive (he would later become “General Johnson” following World War II) and was hired at Johnson & Johnson as a lowly millhand.  Goldsmith says in her research that James used to confide in his daughter at the unpleasant nature of serving as the President of a company he co-founded, yet having to come home to answer to his teenage nephews, who between them were unstoppable due to the combined 84% stake they held.

General Robert Johnson and Seward Johnson Establish the 1944 Johnson & Johnson Family Trusts

It is with these two brothers – General Robert Johnson and Seward Johnson – that the 20th century Johnson & Johnson saga begins.  It is they, and their personalities, mistakes, and behaviors, that caused so much destruction and, in the case of the former, societal good.

For 22 years, James Johnson ran Johnson & Johnson for his nephews, who did things like take trips around the world to scout for new manufacturing plants. He protected and grew the business, churning out earnings and dividends for the stockholders, while providing products that saved lives and eased suffering.  When James died in 1932, the now-experienced-38-year-old Robert Johnson, a brilliant, driven egomaniac, took the reigns of his birthright and named himself President of the firm after coming to agreement with his submissive brother, Seward, that they would always act in concert, and it would be he, and he alone, who sat in the big chair at Johnson & Johnson.

Upon assuming his position, he went about re-telling the history of Johnson & Johnson so that the original two founders, uncles Edward Mead and James, were written out and his late father, Robert Sr., was treated as the founder in newspapers, magazines, and biographies.  One account says that the company portrait of James, who had raised him after his father’s death and loyally served as the President of the business he founded, was shoved in a closet for almost two decades, as if he had never existed.  It was only after his aunt shamed him into rehanging it that it was brought out of storage.

Although he made a total mess of his family, reportedly destroyed his own son before reconciling, and set in motion of series of events responsible for the implosion of the Johnson family clan, General Johnson was one of the greatest corporate executives who ever lived.  He also radically improved civilization through his charitable work.  Today, the Robert Wood Johnson Foundation is the largest health-based philanthropy in the United states, with almost $10 billion in assets, distributing around $400 million per annum to do everything from researching ways to develop human capital to finding methods to fight childhood obesity.

One family member described him as charming on the outside but a shark on the inside.  Other than his treatment of women, he followed the Johnson & Johnson credo, which he developed and penned himself, in both spirit and letter.  He would fire anyone, on the spot, who put profits ahead of quality.  He would interview even the lowliest employee so he could figure out what could be improved without the bureaucracy obfuscating his view of ground-level conditions.  He demanded total, complete, and absolute loyalty and control.

General Robert was obsessed, in outcome, anyway, with the power of compounding.  He wanted both the firm, and its stock, to grow so he had a policy of low dividend payouts, reinvesting most profits into growth.  In 1944, he decided an IPO would be the best way to raise capital for expansion, accelerating the rate at which his empire was spreading across the world.  He used this as an excuse to solve three other problems:

  1. Even though he owned 42% of the stock and Seward owned 42% of the stock, Robert wanted majority voting power so he could reign without contest.
  2. He wanted the family to leave the stock untouched so it could compound into a truly impressive amount of wealth.
  3. He wanted the male members of the family to continue holding all of the influence, with the females subjected to them.

He convinced his brother to put 45% of his holdings, or 18.9% of the entire Johnson & Johnson company, into a series of six trusts over which he (Robert) and two “yes-men” associates would serve as trustees including the right to vote the stock (Seward had five children already born and was about to become father to a sixth).  Robert didn’t trust outsiders so he had Johnson & Johnson’s in-house counsel, Kenneth Perry, draw up the trust instruments.  Concerned only with his own power and desire to see the fortune compound, the trust instruments were iron-clad and severe in command, modeled after the now-well-known generation skipping trusts made famous by the Rockefellers.  According to Goldsmith:

  • Each of these trusts contained 15,000 shares of Johnson & Johnson, then valued at $500,000 [Note: This is around $6,779,500 in today’s inflation-adjusted terms.  Also note, one of the heirs insists her trust only began with $250,000, not $500,000, so there is some degree of ambiguity].
  • Seward’s children would receive annual annuities ($6,000 per year, or $81,350 in inflation-adjusted terms) plus discretionary payouts, which Robert clearly didn’t intend to exceed more than token amounts.
  • Each child would have the right to declare beneficiary / beneficiaries for the trust.  Upon their death, the trust would dissolve and the person or people listed as beneficiaries would inherit everything
  • Seward’s son, Seward Jr., would become trustee of his sisters’ trusts upon his 21st birthday, and be entitled to vote their stock on his 33rd birthday.  The women couldn’t be trusted to run their own affairs.

Robert also setup his own, similar trusts for his bloodline at the same time.

The combination of low dividend payouts and high trust retention, along with beneficiaries themselves getting next to nothing relative to the trust value that was accumulating, led to a series of family tragedies, battles, deaths, and scandals that make a Mexican soap opera look tame in comparison.  There was a Polish maid who got her hands on more than $300 million of the family fortune and turned it into $3.6 billion.  There were allegations of rape and incest.  There were drug overdoses and suicides.  There was an alleged murder plot.  There were numerous lawsuits that resulted in tens of millions of dollars going to lawyers.  There were family members who married and divorced as if they were changing coats.  On the plus side, there were staggering charitable donations that benefited civilization.

One of Seward’s children accurately summed up the trusts General Robert convinced his brother to establish as thus: “Those trusts weren’t set up for love and caring, they were done because Uncle Bob wanted to control the vote on ninety thousand shares of stock without experiencing the tax consequences of ownership.  Those trusts were never supposed to take care of us, we were supposed to be taken care of in other ways.  I might sue my trustees.  Every time I ask them for something, they throw it up in my face that they have to protect the remainderment for my heirs.  I wrote them a letter and quoted the trust agreement; it said that this money was being put away for my welfare, my good, not for someone to get after I die.”

The Johnson Family Trusts Were Effective But the Family Culture Was a Failure

The interesting thing about the trust funds that General Johnson had established is they were extraordinarily successful.  They did what they were intended to do – consolidate voting power, transferring significant assets into the grandchildren’s hands as each $500,000 trust blossomed into $600,000,000+ while stopping the second generation from spending it – but the family culture failed due to intractable character flaws of both Robert and Seward.  They hurt, in some form or another, nearly everyone with whom they were involved.  The case study I did of the family fortune for the purposes of learning about the mistakes (and how best to avoid them) is one of the few times I felt physically ill.  Coming from a good family, I can’t wrap my head around the fact people grew up that way, with so much neglect, abuse, entitlement, self-sabotage, and lack of purpose.  There is a brokenness there that seems hopeless.  No amount of capital can possibly compensate for the short end of the stick some of them were handed.  Frankly, I don’t know how a sensible person could grow up in that environment and emerge normal.  I hope some of them find happiness.  While the fortune left behind has done wonders for scientific and healthcare philanthropy, it’s torn asunder their family tree; certainly more of a curse than a blessing in my estimation.

For all of his foresight, General Johnson failed on the wisdom front.  He helped his family amass more money than they could ever spend, but he didn’t help them amass wealth.  In fact, he left them impoverished in a lot of ways that matter.  As I see it, wealth is a combination of several things coming together: Good health, financial independence, achievement, excellence and pride in your work, a loving family that you know has your back and wants the best for you (give me the sound of multiple generations running around laughing and talking, the scent of a roast in the oven, and a good book off in a corner and that’s my idea of heaven), personal integration so you know you’re living your moral and ethical values, surrounding yourself with people who challenge you, an understanding somewhere deep within your soul of who you are as a person that nobody can take away from you – that core identity that makes you who you are.  Wealth is waking up and looking around saying, “There is nowhere else I would rather be, nobody else with whom I would rather be experiencing this moment, and nothing else I would rather be doing.”  Yes, the money is a wonderful tool in facilitating that but that is all it is – a tool.  Alone, it isn’t enough.  It will never be enough.  Money should never be the most interesting thing about you.

In any event, the Johnson family hasn’t had anything to do with Johnson & Johnson, at least in any meaningful sense, for decades.  The $257 billion enterprise is the highest quality, most diversified health care blue chip in the world.  I have little doubt that, all else equal, the probabilities indicate a decent-size block today should be worth an obscene amount in fifty years due to that structural advantage I mentioned, even if there are ugly periods in the interim.  Professional non-family management has had the reins for more than a generation as the Johnson family stake continues to fall in firm importance, crowded out by the shares you, your friends, and your family hold in index funds, mutual funds, dividend reinvestment plans, and brokerage accounts.  If you told me I could only hold ten stocks for the rest of my life, it would be on the list.


1 His brother, Edward Mead, was no longer involved in operations by this point.  In 1895, he started a side business called The American Ferment Company.  In 1897, he left Johnson & Johnson to work on it full time, setting up shop in Jersey City, New Jersey.  In 1905, he formerly incorporated as Mead Johnson & Company; the specialty product being digestive aid.  A few years later, in 1910, Mead Johnson & Company developed a blockbuster infant formula that had the distinction of being the first physician-recommended breast milk replacement in the United States.  The firm ended up moving to Evansville, Indiana, to get better access to the raw agricultural commodities it needed, and grew fantastically.

The role of CEO passed down the line, from father-to-son, for three generations until Bristol-Myers acquired it in a buyout.  The deal, announced in August of 1967, involved an all-stock purchase (both common and preferred) worth $240 million.  Wikipedia, which sources Reckert, Clare M. “Exchange of Stock Set; Merger Deal Set by Bristol-Myers“, The New York Times, August 25, 1967, states that prior year sales were $131 million with earnings of $7.3 million.

In 2009, Bristol Myers Squibb (as it was now known, following other mergers) conducted a two-part split-off (or “carve-out” as it is sometimes called) that involved an initial public offering for 10% of the business.  Mead Johnson, which had expanded to $2.9 billion in sales by this point, raised $720 million in gross proceeds, far exceeding the $562.5 million that had been hoped.  The cash helped strengthen Bristol Myers Squibb’s own balance sheet.  The remaining 90% of the stock was made available to shareholders who were willing to swap their stock in Bristol Myers Squibb for stock in Mead Johnson.  This facilitated what amounted to a tax-free asset exchange and a massive share repurchase.

Today, Mead Johnson is a stand-alone, $18 billion nutritional behemoth.

zondag 9 juli 2017

Why Warren Buffett calls himself 15% Phil Fisher

If you follow Warren Buffett’s Q&A session at the Berkshire Hathaway shareholder meetings, you have probably heard the Berkshire Hathaway CEO describe himself as as 85% Benjamin Graham and 15% Phil Fisher. The useful examination that follows is: In what regard is Buffett 15% Phil Fisher, and would it be wise for us to emulate likewise?

My view is that Phil Fisher’s appeal comes from plugging in answers to the limitations of Benjamin Graham’s philosophy and offering one superior edge.

The two limitations of Graham’s philosophy are that the types of bargains he found during the days of “Security Analysis” do not exist any more. Warren Buffett found an insurance operation in the 1950s trading in the $30s that was worth over triple the amount that he paid. The percent of publicly traded stock trading at a 70% to 90% discount is dramatically less than what Graham could find when he was scouring the detritus of The Great Depression.

Secondly, Graham made his money by purchasing undervalued stocks and then selling them at fair value within a few years. The extent of undervaluation must be so steep that it covers the taxability of the event. With a 23.8% tax being applied every time you switch investments, you must overcome this capital-cutting that the buy-and-hold investor does not have to endure.

Aside from the fact that following Graham’s strategy subjects you to more taxable events, you must also recognize that value investing is not nearly as self-propelling as buy-and-holding growth stocks.

In Common Stock and Uncommon Profits, Phil Fisher described this difference as follows:

“The reason why the growth stocks do so much better is that they seem to show gains in value in the hundreds of percent each decade. In contrast, it is an unusual bargain that is as much as 50 percent undervalued. The cumulative effect of this simple arithmetic should be obvious. In what other line of activity could you put $10,000 in one year and ten years later (with only occasional checking in the meantime to be sure management continues of high caliber) be able to have an asset worth from $40,000 to $150,000?”

If you choose an investment that you believe is worth x but is trading at 0.5x, the question is: What does the subsequent performance look like once x is achieved? But if a business is worth x and trading at 1.25x, and is growing at 15% for the next decade, you can see why the passivity of the latter is rewarded because the enormity of the growth overcompensates for any valuation that needs to get burned off when you overpay by a little bit.

When I try to look for value investments, I am willing to accept less on the value side if I get more on the growth side. In other words, I’d prefer the stock trading at 0.6x its value rather than 0.4x its value if I think the former stock is going to grow at 6% once it gets its act together. That is why I have liked IBM. It has probably traded at a discount between 20% to 30% discount during the time I covered it, but that discount intermingles with mid single digit earnings growth. In Buffett-like terms, I’d like to see the intrinsic value increasing during the same time I’m waiting for the market price to shift from undervaluation to fair valuation. I call it Fisherifying your Graham stocks.

If I had to get specific and reconcile these different philosophies into a coherent investment philosophy, I’ll offer this. I’d put 75% of assets into higher growth buy-and-hold-forever stocks like Brown Forman, Colgate-Palmolive, Hershey, and Nike, and then the remaining 25% into Fisherified value stocks like DineEquity during the 2010 through 2015 stretch when it was cheap at the beginning of the period while simultaneously increasing its intrinsic value due to the receipt of significant one-time franchise fees. I’m not sure there is much of a place for a strict Graham value stock, which I define as a stock trading at the sharpest discount to fair value X with no heed to whether the intrinsic value of X is expected to grow.

zondag 2 juli 2017

Dividend Income for June 2017

Dividend income, it’s amazing! Seriously, as I progress further and further in my financial independence journey I become increasinly convinced that dividend income is what keeps me on course. Monthly savings differ and stock prices love irrational ups and downs, but dividends from established businesses are something you can count on – month after month.

Everyone that plays or watches sports knows that keeping your eye on the ball is more important than taking into account what the other players are doing. It’s how you win the game, be that football, basketball, tennis or any other ball sports. And winning the financial independence game is what it’s all about.

Why do I like the boring and recurring nature of dividend income? Well, there’s two very good reasons.

First, every time a dividend payment hits my account I’m filled with joy that I made money without having to lift a finger. While I was sleeping, going out with friends, running on the beach, reading, and generally enjoying life businesses all around the world worked their asses off to forward me a piece of their profits. It’s a great recurring stimulus.

Second, I can take advantage of the double compounding effect. On the one hand I get to see how these dividends increase year after year, semi-automatically almost, while on the other hand I get to put fresh income immediately to work in the stock market again. As a result, I propell my passive income forward faster and faster as I progress.

Once that passive income surpasses my monthly expenses I’m effectively financially free and I could potentially retire early. So let’s see where I landed in June with regards to free-of-work income!

Dividends received

All dividends below are listed in Euros, and are after foreign withholding taxes and a 30% income tax levied by the Belgian federal government.

- Unilever: 121,65 EUR
- Reeds Elsevier: 221,1 EUR
- Realty Income: 50,7 EUR
-ExxonMobil: 122,7 EUR
-Royal Dutch Shell: 673,65 EUR
-Emerson Electric: 93,3 EUR

In total six companies’ dividends landed in my brokerage account, most of them being quarterly regulars. The total dividend income adds up to 1.283,10 EUR.

The dividend covers all my monthly expenses and I still have some dividend income left. This means I could save my entire income from working!

How was your month in terms of dividends? Have you recovered from the dividend bonanza of the past couple of months?

zondag 25 juni 2017

Monthly dividend stocks are mostly gimmicky

Between 2007 and 2009, approximately 34% of American stocks that pay dividends quarterly cut their payout at some point during the recession. The part I find worthy of examination? The fact that 56% of stocks that paid monthly dividends ended up cutting their payout during the recession. The same corporations that suggested you should invest in them for their cash flows had a disproportionately higher likelihood of slashing their payouts than the regular American companies that made no special promises about the future of their dividends.

How should we analyze this?

My view is that many companies have opportunistically recognized that the ability for savers to use their funds to create a meaningful monthly cash flow has been severely compromised in the past decade. There are no savings accounts or U.S. bond investments paying out 5% anymore. Adjusting to the circumstances, many of these investors took up the purchase of things like real estate investment trusts or master limited partnerships. Five years ago, no one outside the most sophisticated investor class had heard of these things, and now mom and pop investors found themselves rushing in with 10% to 15% of their net wealth to try and improve their household’s monthly passive income cash flows.

This created fertile soil for company executives to develop a marketing angle to boost the price of their stock above what a sober analysis of the underlying assets would reveal. How many people in the investor community would pay more to receive ten cents per share each month rather than a lump-sum $1.20 payout each year? Exactly. And therein lay the opportunity.

Sometimes, this just meant getting investors to pay more for an ownership stake in an asset than should be warranted. The theory is that you get investors to bid up the price of a stock to 1.3x compared to the price that existed before the switch to monthly dividends. Aside from the usual reason why businesses like rising stock price, it is permits borrowing at rates because any equity-based financing is an advantage for the company because you are diluting the business when it is trading at a price higher than what it is worth. Basically, using the stock to raise capital is the equivalent to giving up $0.70 in value financiers in exchange for each dollar that they give you in return.

It is also helpful for debt-based financing because the market capitalization of a business is a factor in determining the interest rates that the business must pay.

I mean, look at this list from Lisa Springer of Street Authority in 2013 that gave examples of the 22 best monthly dividend stocks to buy. Only 6 of those 22 companies are paying out monthly dividends right now at rates that are higher or equal to the amount that they were paying in 2013. It hasn’t even been four years, and over 70% of the monthly dividend payers on the list have already failed. And that was from a self-selecting group that she presumably culled for some type of fundamental characteristics that looked good at the time.

An important side note. Realty Income deserves a pass because it actually has real rental income coming in, has been doing monthly payouts since 1994, and was created with stable cash flows in mind out of a sincere desire to address this corner of the income market. This is different from the latest crop that seek to opportunistically exploit the income investor class while interest rates and alternative income investments are lacking.

Stocks that pay dividends each month deserve criticism because they are often preying on you to bid the price up to shore up their own finances. My own research on those 22 stocks mentioned in the Springer recommendation list led me to observe five things: (1) 17 of those 22 stocks had leverage that was greater than 5x the annual cash flows; (2) 15 of them were borrowing at rates greater than 5% at the time the list was created, which is notable because of how low corporate borrowing was at the time; (3) 14 of them had a share count that was at least 25% higher by 2015 compared to 2013; (4) only 3 of them were paying out dividends each month before it became fashionable in the aftermath of the financial crisis; and (5) only 7 of them have higher stock prices than was the case at the time the article was written, which is remarkable because of the general bull market conditions.

Do me a favor and read that paragraph again because it took me almost two hours to tabulate that data.

I know balance sheet analysis isn’t anyone’s idea of a good time. But when it comes to these monthly stocks, you have to do your homework. Check to see whether the dividends are supported by current earnings. See how much greater the balance sheet debt is compared to the cash flows. Find out the interest rates on the existing debt. Make an educated guess as to whether that debt burden will be refinanced at higher rates. Look to see if there has been meaningful dilution in recent year.

Usually, companies become monthly dividend stocks because they “resort to it” rather than have a strong desire to connect with income investors. These payouts are very ephemeral. They might pay the bills for a month or two, or maybe even a year or two. But they can’t withstand recessions. Heck, as the last few years have shown, they can’t even withstand the good times. You’d be much better off stocking up on shares of Johnson & Johnson, ExxonMobil, and Coca-Cola and integrating their quarterly payouts into your budget. Why? Because when the business is built to last, so will the dividend payments.

Full disclosure: Long KO, XOM , O

zondag 18 juni 2017

Oil Stocks: The next hundred years

ant to address one of the more insightful questions that I have received about oil stock investing. It generally goes like this: Does the non-renewable nature of petro-carbons pose a significant risk to the long-term survival of oil majors like ExxonMobil, Chevron, Royal Dutch Shell, BP, Total SA, and ConocoPhillips?

This is a smart risk to consider. If you own an asset, and if you reinvest into it over the course of your lifetime, you should be fixated on the risk of whether there will be something leftover for you at the end of your compounding period. In the past, I have lamented the path of Wachovia investors who receive large chunks of dividend income in the 1980s, 1990s, and early 2000s only to find it all collapse from $40 to $2 in the fall of 2008. All your years of compounding and delaying gratification didn’t mean squat because you ended up multiplying the final figure by a near zero number.

When you think about the future of oil, I want you to first think about its history. What was the precursor to John David Rockefeller’s Standard Oil Trust that was launched in 1882? The answer to that question would be a book in its own right, but he built his wealth by turning gasoline into fuel while his competitors treated gasoline as a waste product to pour into the Cuyahoga River and watch it burn. He manufactured paraffin which we use to make candles. He created benzene, the cleaning fluid and varnish ingredient. And perhaps least known of all, he was the manufacturer of white petrolatum which got marketed under the trade name Vaseline and is now part of Unilever’s multinational empire today.

I mention this because it is important to note that there are plenty of marketable products that arose out of the early gas industry and have served as bridges to the next frontier. The same man who got rich off of petroleum was doing just fine with whale oil. The riches from the latter funded the ownership stake and development of the former.

Aside from the generic PR, there is reason to take it seriously that the major oil stocks have gone to great lengths to rebrand themselves as energy companies. Perhaps this rebranding has been a bit premature, but the industry’s signal that it is moving beyond oil is the right one to convey. ExxonMobil has bought in heavily to chemicals, and Chevron has followed suit. Shell has heavily diversified into natural gas. Total SA is making pledges and setting quotas for the amount of energy it will generate from renewable resources. Conoco dug in even deeper on its commitment to oil, and I suspect the harsh experience during the recent price decline will modify their strategy in the future. And BP has been busy with litigation costs from the 2010 oil spill and maintaining its dividend, and will probably get around to energy-source diversification during year two or three of the next big oil spike.

In years like 2008, ExxonMobil brought in $35 billion while only allocating $20 billion towards stock repurchases and dividend payments to shareholders. Of the remaining $15 billion, some of it went to cash and others went towards investment into new drilling projects.

Fifteen to twenty years from now, that $15 billion in retained earnings won’t go towards new drilling projects. Instead, it will go towards nascent technologies. Maybe it will be wind. Maybe it will be nuclear. Maybe it will Charlie Munger’s favorite energy source—the sun.

You don’t need to predict what will be the next major energy source. Instead, just as whale oil profits provided the “start-up funds” for Rockefeller to develop refineries, I expect that oil and natural gas cash flows will be used to fund the entrance into new markets for the major oil stocks of today.

I should also mention that this transition may still be decades in the offing. Exxon itself doesn’t even imagine that peak oil will hit until the 2040s, and then will gradually taper off thereafter. Energy source changes tend to make place over multi-decades; it doesn’t happen overnight like the iPhone overtaking the Blackberry. My own view is that the pace of technological change will be driven by necessity. If Americans continue to enjoy $2 per gallon-type pricing for much of the next decade or two, the pace of progress will be slow because the status quo will be satisfying enough. However, if the price moves above the $4 mark or so, then innovation will be spurred on faster by discontent with a high gas price status quo.

Despite the low prices of the past few years, oil businesses will see a period of high commodity prices again. This means that there will be a large amount of retained earnings. As surely as Unilever purchased the Dollar Shave Club after its start-up success or Coca-Cola bought a 16.7% interest in Monster Energy or Johnson & Johnson acquired Rydelle Laboratories to get its hands on the Aveeno brand, the major oil companies will see the rising energy firms and acquire them. Waiving around 40% premiums can buy your way to a lot of market access.

If this is something you worry about, I suppose you could mitigate the risk by draining your dividends out of the paying corporation and then reinvest them elsewhere. For instance, if you have built up a sizable position of 3,300 Royal Dutch Shell shares, you could take the $12,400+ in oil dividends and make an investment into a timeless business like Brown Forman, Colgate-Palmolive, or Hershey. You’d effectively milk out all of your initial investment amount within fifteen years and build a standalone diversified portfolio of stocks in case some sort of worst-case scenario plays out that is different from what you had initially planned.

But with mega-cap behemoths, the businesses tend to remain intact after technological change so long as there is an identifiable bolt-on acquisition to make in the sector. I suspect that will be the case with emerging energy technologies. And plus, companies usually run into trouble because they get out-branded or there is a competitor with a lower cost in a razor thin industry. Well, if these firms encounter a solar competitor, they could even fund start-up alternates because wealth in the commodity sector gets created by economies of scale and operating efficiencies which the oil majors already possess in abundance.

In short, I think oil stocks will be fine to buy over our lifetime because the pace of change will take place over decades and these companies have the cash to buy a market position in whatever energy source becomes the next backbone of the world’s economy. And, if this isn’t assuring enough, you could always have oil dividends get paid out as cash and use the proceeds to fund other investments. I don’t know what energy production will look like in 2070, but I suspect the legacy shareholders of Exxon, Chevron, Shell, BP, and Total SA will be the ones creating commodity-sector wealth.


maandag 12 juni 2017

A chicago native donates $2 million walgreen stock to wildlife refuge

eventy years ago, a lawyer in Chicago named Russ Gremel invested $1,000 (the economic equivalent of $13,000 in 2017 purchasing power) to buy shares in Illinois’ pharmaceutical giant The Walgreens Co. Over that time, he collected substantial dividend checks and watched that position balloon into over $2 million in value through 11% compounding from the capital gains exclusive of the dividends.

A few thoughts:

Gremel was able to turn $1,000 into $2,000,000 over seventy years without needing to reinvest the dividends. Had he reinvested into Walgreens stock, his compounding rate would have soured to 14% annualized. That would have turned his $1,000 investment into $14 million.

Am I suggesting that he shouldn’t have spent the dividends? Of course not. As Britain’s distinguished man of letters Samuel Johnson wrote in Rambler #58: “Wealth is nothing in itself, it is not useful but when it departs from us; its value is found only in that which it can purchase, which, if we suppose it put to its best use by those that possess it, seems not much to deserve the desire or envy of a wise man.”

There would be no value in just accumulating wealth for its own sake. By collecting the dividends, Gremel was able to use the Walgreens stock to both support his lifestyle and make a donation to a wildlife refuge.

Specifically, he was able to collect $1,000 in dividends in 1966, $2,000 in 1975, $4,000 in 1982, $8,000 in 1989, $16,000 in 1996, $32000 in 2003, $36000 in 2015.

That may seem low when compared to the final dollar amount that Gremel was able to donate but is not that unusual for a fast-growing company that is trying to rapidly open up new locations by reinvesting earnings into more corner stores rather than ship them off to shareholders. From 1970 through 2015, Walgreens had an average dividend payout ratio of 11.1%. Because he held it for so long, he was able to receive over $732,000 in cumulative dividends during his holding period even paying out cash dividends wasn’t really a party of Walgreens’ strategy.

When reading about Gremel’s investment success, the obvious follow-up question is: Does this have any instructive value? How can you make an analogous decision today that will be as useful to you over your lifetime as Walgreens’ stock was to Gremel?

In an interview discussing his rationale for purchasing Walgreens stock shortly after graduating from Northwestern’s law school, Gremel said that figured “people would always need medicine and women would always need makeup.”

This insight could be validated numerically by paying attention to Walgreens’ same-store sales. From 1970 through 2015, Walgreens saw same-store sales increases of 6% per year. It translated into about 7.5% earnings per share. This means that Walgreens shareholders were able to capitalize on a sort of double compounding—not only did their shares represent new locations that were cropping up across North America, but the existing locations were also adding single digit growth to profits. That combination, sustained year after year, is how you get 14% compounding for over half-a-century.

Qualitatively, an investor could have noticed Walgreens’ moat by paying attention to the fact that Walgreens management was insistent on placing all stores in high-profile locations at intersections and other prominent corner locations such that the immediate visibility would form a competitive advantage with spur-of-the-moment shoppers.

If you wanted to recreate Gremel’s success in your own life, you should pay attention to those “same store sales growth” figures because they often provide an insight into the sustainability of the business model. If a business is under-saturated in a given area, and the existing stores are showing mid-single digit same store sales growth or higher, you have probably found a good buy-and-hold investment candidate assuming the price you pay for the stock is rational. These days, there is a food/beverage company that is trouncing its competitors in terms of same-store sales growth that allows you to create Walgreens-type wealth if you keep your eyes open and pay attention.

Next, it is worth observing that these types of individuals have a deep stealth wealth streak. In Gremel’s case, he said: “I never let anybody know I had that kind of money.” This pattern shows up again and again with individuals that accumulate wealth and don’t purchase luxury goods.

In some cases, this probably comes from a a place of humility. Gremel mentioned that his family lost an extraordinary amount of money in the stock market crash of 1929. The story recounts: “We went from comparable wealth to abject poverty in 24 hours. We had no money. There were no food stamps. There was nothing except your friends and neighbors.” The humility angle is that Gremel could have predicted that another crash would wipe out his Walgreens investment, and would make no sense in treating it as a fountain of power if it could all be gone in an instant.

Or, it could be a self-protective device. As Gremel let on—it was friends and neighbors that provided assistance during the Great Depression. If the community learned of Gremel’s success with his Walgreens investment, then he may have feared that his friends would view him as the small-town piggybank.

There is the old Willie Sutton quote that suggests he responded “that’s where the money is” when being interrogated about why he robbed the bank. Well, if someone in Jefferson Park fell on hard times, who would they ask: They guy they suspect has $2 million, or some other acquaintance whose wealth status isn’t ascertainable?

More benignly, Gremel could have kept his mouth shut to avoid being a robbery victim. After all, if you’re an aspiring Jefferson Park criminal, the phrase “that’s where the money is” could apply to Gremel and banks alike. Though it sounds like Gremel’s wealth remained on his brokerage account and didn’t translate into anything portable, there is no reason for him to expect a potential burglar to know that or rationally process that.

I like Gremel’s story because there are instructive nuggets. Find businesses with a common-sense basis for longevity. Look to same-store sales growth for validation. Receive dividends and enjoy the fruits of some of your wealth today because you’ll never again be as young as you are today. But also, err on the side of humility because wealth can tempt people into unvirtuous behavior and the easiest way to avoid temptation is to resist the first inkling of its encroachment.

dinsdag 6 juni 2017

Philip Morris Investment: Fayez Sarofim's way

Sayez Sarofim is a Houston-based investor that has seen his fortune climb on the coattails of buying-and-holding consumer stock investments. Coke, Nestle, McDonald’s–you name it–he bought it decades ago and holds it on the balance sheet of his Fayez Sarofim & Co. today.

. To date, Sarofim finds himself sitting on 16,711,214 shares of PM stock.

An aside to precede my commentary: Did you guys see that post on the Mr. Money Mustache website about a year ago when Peter Adeney talks about how it was much easier to build additional wealth once he was financially successful compared to when he was starting out and hungry for it?

It sounds a little bit counterintuitive, but the advantage that comes from pre-existing wealth is that you can afford to take the long view. This advantage was best explained by a character in the Terry Pratchett work “Men At Arms” and is called The Boots Theory of Social Inequity:

“The reason that the rich were so rich, Vimes reasoned, was because they managed to spend less money.

Take boots, for example. He earned thirty-eight dollars a month plus allowances. A really good pair of leather boots cost fifty dollars. But an affordable pair of boots, which were sort of OK for a season or two and then leaked like hell when the cardboard gave out, cost about ten dollars. Those were the kind of boots Vimes always bought, and wore until the soles were so thin that he could tell where he was in Ankh-Morpork on a foggy night by the feel of the cobbles.

But the thing was that good boots lasted for years and years. A man who could afford fifty dollars had a pair of boots that’d still be keeping his feet dry in ten years’ time, while the poor man who could only afford cheap boots would have spent a hundred dollars on boots in the same time and would still have wet feet.”

Put another way, it is a competitive advantage to be able to act upon your intellect and reason. If you calculate that the up-front costs for something are high but are the best option when measured across the entire contemplated use, you want to be able to have the actual cash on hand to pursue the more intelligent option.

The Vimes Theory and the MMM post express a philosophy that I imagine is executed by Fayez Sarofim in the stewardship of the firm’s assets.

If someone only owns 30 shares of Philip Morris International, the lack of price movement over the past four years might make you anxious and impatient. Everyone is talking about a bull market while that stock seems like the proverbial dead money. I’m sure someone on Seeking Alpha is probably putting it on probation or whatever term they use to say “Bad boy!” to their investments nowadays.

So what impulse does this need to get rich quickly trigger? Sell low!

On the other hand, consider how Fayez Sarofim can approach the lack of price movement.

In the past, Sarofim has said that studies of tobacco industry economics have left him breathless because the torrents of cash flows were so tremendous that it could enable Big Tobacco the cash cushion to purchase America’s leading food stocks (which have since been spun off).

He is already extremely rich, so he can afford the long game. He can enjoy the fact that his experience with the stock from a position of wealth is far more enjoyable. Between 2014 and 2016, Philip Morris International paid out $12.04 in dividends. When you own 16,711,214 shares, you do not view this as a “dead money” operation. You got to collect over $200 million in pure cash dividends as your share of profit from the investment. When your cash dividends are so extreme that you could buy hockey teams just by letting the tobacco dividends pile up for a few years, you are not going to fixate on the share price–no one is cursing at their Bloomberg Terminal when their holdings mail them dividend checks with two commas.

But this situation doesn’t only make Sarofim richer in the here and now. He can also look at the fact that Philip Morris International reduced its share count from 2 billion in 2008 to 1.5 billion in 2013 before the global currencies tightened against the dollar. He can see that this situation will temper or reverse, and within the next twenty-four months, Philip Morris will again have the free cash flow to repurchase its own stock. That, in turn, ought to improve earnings growth from 5.5% to 8-9%. That will bring about commensurate capital gains and dividend growth.

Assume that the future expectations in the paragraph above are held by Sarofim and my hypothetical investor. Who do you think is in a better position to actually be around in 2018 and 2019 to reap those higher returns–the frustrated guy with the “dead money” investment that isn’t permitting him to enjoy lifestyle upgrades or the guy that is collecting $70 million per year as the reward for being patient?

The Complex History of Johnson & Johnson

I have a soft spot for Johnson & Johnson.  What many investors don’t realize is that Johnson & Johnson proper doesn’t actually  d...