Standing the Test of Time
Jeff Bezos, the founder of Amazon, once articulated that a question he is asked over and over again is, “What’s going to change over the next 10 years?” Bezos goes on to express that it is a common and interesting question, but he is almost never asked, “What’s not going to change in the next 10 years?” He continues by explaining that in his mind the second question is actually the more important of the two – because you can build a business strategy around the things that are stable in time.
As I sit here composing this letter, I can’t help but ponder the year that was 2022. From Russia invading Ukraine to inflation surging around the world, there is an ample amount of events to discuss. With all the rapid and unexpected changes last year, you may be wondering, “What will this year entail?”
We could use this letter to discuss inflation, employment, retail sales, industrial production, and/or home sales and what our best guess is of where these will be in the next few years. Make no mistake, all of these are important indicators showing economic growth and are items we are certainly aware of. However, the difficulty arises in determining how these indicators will change over the next 5 – 10 years and then what the market’s reaction to this will be. I will opine that I do not have the slightest clue and am quite skeptical of anyone who claims to know. The silver-lining is we can still form an investment strategy without precisely knowing this information.
Professional investor Morgan Housel once wrote a piece about Warren Buffett and one of Morgan’s friends. It was late 2009 and Buffett and Morgan’s friend were riding around Omaha together. The global economy was quite crippled at this point in time and Omaha was no exception. Stores were closing week after week and various businesses had already boarded up.
Morgan’s friend asked something along the lines of, “It’s so bad out there right now. How does the economy ever bounce back from this?”
Warren said to him, “Do you know what the best-selling candy bar was in 1962?”
“No.” Morgan’s friend said.
“Snickers,” said Warren. “And do you know what the best-selling candy bar is today?”
Again, Morgan’s friend said, “No.”
“Snickers,” said Warren.
Then, there was silence. That was the end of the conversation.*
The takeaway I believe Buffett was trying to get across is that focusing on what is highly unlikely to change is more important than trying to anticipate how something might change.
*To this day, Snickers remains the best-selling candy bar worldwide.
If we take this frame of thinking into account, how do our portfolio companies compare? Of course, there is no way of knowing for sure what companies will exist 20 years from now and past excellence is no guarantee of future survival, but we can still make a few observations. In a 2001 study by McKinsey, researchers estimated the average listed lifespan of a US company at just 15-20 years (down from 30 years in the 1970s). More recently, in his 2017 book titled Scale, Geoffrey West documented the alarmingly high rate of corporate mortality. He noted that of the 28,853 companies that traded on the US stock market between 1950-2009, nearly 80% had vanished over that period.
How does this compare to the core stocks? As a group, the average age of our core stocks (which we think of as businesses we have partial ownership in) is 92 years old (see Appendix). Nearly half of these businesses have been around for more than a century and a handful have even been around for more than 150 years. Of course this does not mean these businesses are guaranteed to be around for another 20-30 years, but it does seem to imply they must be doing something right. Any company that can survive a couple World Wars and/or The Great Depression probably has something special going on. There must be some kind of competitive advantage that the company possesses.
We can use Abbott Laboratories as an example to better explain this.* Abbott was established in 1888 in Chicago by Wallace C. Abbott. The company was among the founders of the scientific practice of pharmacy and has since expanded its business line to include nutritionals, devices, diagnostics, and established pharmaceuticals while also spinning off Hospira in 2004 and AbbVie in 2013.
Over the years, ABT has faced its fair share of trials and tribulations. From product recalls to class action lawsuits, the company has not always gotten everything right. However, even with all the struggles, the business has endured and thrived, with the long-term empirical result being ABT’s dividend record. Bloomberg only has data going back 44 years, but over that time, ABT has increased its annual dividend from $0.0225 per share to $7.52 per share. Said another way, ABT has grown its dividend at an annualized rate of over 14% for the past 44 years after adjusting for share splits and spinoffs (see chart below). Effective long-term compounding creates immense value but requires both survival and the persistence of high rates of return on reinvestment.
*If interested, there is a free electronic book titled, A Promise for Life: The Story of Abbott, on the company’s website that details its rich history over the last 130+ years. The following is the direct link: https://webstorage.abbott.com/PromiseForLife/EN/index.html
We believe there are a few particular qualities that have allowed ABT to stand the test of time. Unlike other healthcare companies, approximately 50% of ABT’s sales are direct to consumers and patients. This has allowed the company to build a recognizable brand with several brands holding a leading market share in their respective markets. Another positive attribute of Abbott is that there are few competitors in its markets, thus resembling an oligopoly. Its markets are often highly regulated also. For instance, both the pharmaceutical and medical devices segments need government approvals for their products, which means the amount of research and development dollars necessary to develop these products is often immense. Both of these attributes (an oligopolistic market structure and highly regulated markets) along with the company’s collection of patents and trademarks create high barriers to entry for new competitors.
As mentioned above, the company has faced struggles in its past and today the company’s most recent challenges stem from its baby formula, Similac. There were reports about contamination of powdered Similiac at one of Abbott’s plants in Michigan. This led to the Michigan facility ceasing production in February of 2022. Being idle for several months only exacerbated the shortage of baby formula in the U.S. The plant has since reopened, but this not only impacted ABT’s sales in its nutritional segment, but also likely tainted its baby formula reputation to some degree. Given this, the near-term headwinds the company faces in regards to currency headwinds, (65% of the company’s sales are international) and difficult year-over-year comparisons (due to a probable decline in COVID testing sales), ABT’s sales and earnings may be depressed for the next year or two. Does this mean we should suddenly completely sell out of the company and give up on it? We would beg to differ.
Given the company’s product markets, its ability to innovate, improve efficiency, and grow, we find it unlikely that ABT will no longer be around in 10 – 20 years and believe it is quite probable that it will be a bigger company at that point than it is today. The company’s balance sheet remains strong and it has several innovative products such as Alinity, FreeStyle Libre, MitraClip, and Aveir that should help drive future growth.
Critics would argue that using ABT or any other company that has a lengthy history as an example of a successful company is showing survivorship bias. Sure we can look back at dividend or earnings statistics from now successful companies, but how do you know before hand? I think that is precisely the point we are trying to express. Determining which company will be the next Amazon is extremely difficult and the odds are not in your favor. So why not pick from a universe of stocks that have already stood the test of time and shown their durability time and time again? Some may argue these companies’ growth days are behind them, but we would argue these same things were likely said when these companies were 30, 40, 50 years old. In our opinion, a majority of these companies appear to still have decent growth runways ahead of them as well as deep/deepening moats.
With the S&P 500 down over 18% this year, a common question people tend to ask is “What is the market going to do next or where is the market headed in 2023?” We can provide historical data since 1928, showing consecutive calendar year losses have only occurred approximately 9% of the time. This may be comforting to some, but it doesn’t mean the market is going to be up in 2023.
Personally, I feel much more comfort when thinking about the actual businesses we own, especially in bear markets. While it is never any fun to watch stock prices go down, what we are much more concerned about is business risk. What are the chances a competitor comes in and disrupts this business? If a stock’s cash flow, earnings, and dividends continue to grow year after year, eventually the stock will follow and the S&P 500’s daily movements will matter much less.
Although an equal-weighted portfolio of our core stocks outperformed the S&P 500 by approximately 9 percentage points in 2022, some of our stocks were hit harder than others. An example of a core stock that saw its stock price decline while earnings and dividends grew is Microsoft. Its stock price was down approximately 29% in 2022, yet the company grew its earnings per share and is expected to grow earnings again in 2023. A similar occurrence took place with the stocks Accenture and Home Depot. All three of these companies were down more than 20% in 2022, yet earnings grew and consensus analysts’ estimates show growth for 2023.
If you look at just the financial results, personally, I think it would be hard to guess the share prices would be down much at all, much less 20%. The obvious criticism is that the valuation on these companies got ahead of itself. That is a fair argument and in hindsight, it is one that is probably more true than not. However, these companies were not trading at astronomical valuation levels of say 50x earnings when we bought them. Perhaps, we should have looked to trim some of the positions more heavily, but most of the time valuation is not cut and dried. In other words, it is not easy to tell if a stock is too expensive – especially if you have a long-term time horizon of, say, a decade. A cherry-picked example of this would be Coca Cola or PepsiCo. You could have paid a price to earnings ratio of 63x for Coca Cola or 100x for PepsiCo in 1973 and still achieved a 7% compound annual growth rate (CAGR) over the next 46 years (to 2019), versus the 6.2% CAGR the MSCI World Index returned over the same period. While it is highly unlikely we would be interested in buying a company trading anywhere near those levels, once we find a business we like and are able to buy it at a reasonable price, we then tend to let the company do most of the heavy lifting for us.
The stock market could very well continue to decline further into 2023, and this would most likely cause the market values of the companies we own to decline alongside with it. Bear markets happen and ups and downs are part of the life of investors. You may be wondering, if a specific company is better positioned today than it was a year ago, why is the stock price so much lower than it was a year ago? One answer could be the rise in interest rates has impacted all asset values. Yet another answer could be, as the famed investor Benjamin Graham once said, “In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.” Said another way, sentiment drives stock prices in the short-term, but financial results drive the long-term outcome.
So, what’s going to change over the next 10 years? Interest rates? Geopolitical relations? Ways of transportation? We would bet a lot will change. However, even with the many changes that are probable, in our opinion, the likelihood of individuals still buying Band-Aids, Tylenol, Bounty paper towels, Crest toothpaste, and/or Scotch tape (all products produced by the companies we own) remains quite high.
From all of us here at Monarch, have a Happy New Year!
–Written by Adam Beard