April 25, 2015

It’s Been Awhile Since I Looked at Nestlé SA

This afternoon, I looked at one of my favorite companies in the world for the first time in awhile, Nestlé SA out of Switzerland. It’s a beautiful firm with a fantastic long-term record resulting from the quality of its underlying assets. I haven’t really talked much about it for a couple of years, but it’s always in the back of my mind. Were I go to into a 50-year Rip van Winkle sleep and only permitted to own five companies that couldn’t be bought or sold during that period, Nestlé would be on the list.

Earlier this year, I did mention it briefly when I sold off the KRIP’s non-permanent shares of the packaged food, beverage, and consumer staples companies across the board so that, with the exception of a single business, every share was gone within those accounts.  The main reason was many of the stocks were relatively young positions that had not yet graduated to the status of legacy.  (The non-discussed portfolios still retained some Nestlé but I don’t talk about any of that often – stuff like the fact I’ve had my parents indirectly hold quite a bit of Nestlé for their retirement funds for nearly a decade and I doubt I could bring myself to sell the shares even if they went to 40x earnings; I still had my youngest sister in the Coca-Cola DRIP we had built for her over the past twelve years.  I do not now, nor will I ever, discuss those in depth on this site.  I probably shouldn’t even be talking about the KRIP as often as I do.) 

The problem wasn’t the absolute value of the firms, but the opportunity cost.  It had grown far too high.  I broke out an example of my thinking in the post contrasting what was happening with Wells Fargo vs Pepsi. I saw a handful of incredible bargains and needed more funds for the KRIP to put to work in these securities.  For those of you who don’t want to click to the other post, here is how bad the dislocation had become:

PepsiCo offered approximately:

  • 5.00% earnings yield (20x earnings)
  • 7.00% projected earnings per share growth
  • 2.83% dividend yield
  • Corporate credit rating of A
  • Payout ratio: 54.3%

Wells Fargo & Company offered approximately:

  • 10.00% earnings yield (10x earnings)
  • 8.00% projected earnings per share growth
  • 2.83% dividend yield
  • Corporate credit rating of AA-
  • Payout ratio: 23.2%

I was able to use the existing money to buy far more future earnings and dividends, straight out of Ben Graham’s 1949 Intelligent Investor treatise, which illustrated how you can diversify a portfolio sideways to lower risk and increase cash flows during times of large dislocation (Graham was often a fan of re-running conservative coverage ratios on your railroad bonds and swapping out between issues if one suddenly offered a much better margin of safety for a comparable yield).  There came a moment when I reached a tipping point; when some of these bank, tobacco, oil, and technology companies were offering 2x the profits, 2x the dividends, and a fraction of the payout ratio, inaction was no longer acceptable.  And you know how I like inaction; my turnover rate for all of fiscal 2012 was 0% with not a single share of stock sold.  I buy rarely and buy for keeps.

Even though I knew I was doing the right thing, I did hate getting rid of the KRIP’s Nestlé shares.  Almost everything else I could tolerate except that.  The permanent shares that I don’t talk about weren’t enough to offset the feeling of loss because the corporation had never fallen to a deep enough valuation to permit me to buy big, in a very meaningful way.  Every time I went to the grocery store, I’d sulk down some of the aisles and think about how much smaller my stake had become, even though I knew it was the right choice.  (It was a case of my temperament clashing with my intellect.  The “permanent” shares I sometimes reference, the ones I plan on leaving to the kids and grandkids, are my way of resolving that conflict so that both parts of me are satisfied under all conditions.)  Still, there aren’t a lot of businesses that compare.  There is a reason Nestlé has been called the quintessential “get rich slowly” company. It’s like an oak tree in your yard. You never actually realize how big it is getting until you go back and look through old photo albums, then you wonder when it happened. (One illustration that will highlight this point: The year I was born, the cash dividend was around 0.09 CHF. This year, it is 2.04 CHF. Each piece of ownership in the firm is now paying you 2,267% more money each year than it did thirty years ago. That assumes you never reinvested any of your dividend distributions; had you done so, the figure would be much higher.)

Nestle Dividends

When I was born, Nestlé paid a dividend of 0.09 CHF per share. Today, it pays a dividend of 2.05 CHF per share. That was achieved despite a very generous dividend payout policy; a testament to the underlying quality of the company’s holdings, as well as the management culture.  A successful investor wants a portfolio filled with such holdings.  Get your hands on those, at a reasonable price, and market fluctuations become essentially meaningless as you have no intention of selling your stake.

Over the centuries, through booms and busts, war and peace, Nestlé pumps out more and more cash, in multiple currencies, selling everything from chocolate and coffee to ice cream and frozen dinners. It can raise prices with inflation; it can sell more products as the global population expands; it can repurchase shares to increase the equity of each remaining share; it can acquire competitors; it can launch new products. Nestle is to packaged foods what Coca-Cola is to soft drinks and Procter & Gamble is to consumer staples. Whenever another firm does something stupid, like Kraft selling off its Tombstone and DiGiorno pizza businesses a few years ago, Nestlé shows up, checkbook in hand, and adds it to the family. This strategy has been very successful.

Nestlé owns 468 factories, located in 86 countries.  It owns 2,000 brands and has 330,000 people on the payroll.  The business has around 30 product lines that generate sales of at least 1 billion CHF per year (a little more than $1 billion in USD). Take a moment to think about that and let it sink in fully. Were it to ever break up, something I would fiercely oppose, Nestlé would be converted into dozens of firms that, by themselves, would rank among the largest food, snack, and beverage companies on Earth overnight. It would be like the breakup of Ma Bell or Standard Oil, only instead of telephones and petroleum, the owners would be receiving stock certificates in companies that make everything from Butterfingers to Gerber baby food.

Nestle CheeriosFor those of us here in the United States, it’s somewhat hidden. Most Americans don’t even realize that one of the other best companies of the past century, General Mills, decided to team up with Nestlé almost a quarter of a century ago to combine their expertise – General Mills with its powerhouse trademarks and Nestlé with its global scale and distribution. The two food giants created a new company called Cereal Partners Worldwide. It’s completely unfathomable to most of the people reading this given how ingrained General Mills is in the culture since the 1950’s, but Cheerios, Shredded Wheat, and the other General Mills brands are all sold under the Nestlé name throughout 95% of the world. When someone buys a bowl of Cookie Crisp in the United Kingdom, the cash is getting sent to CPW, where it is then split between General Mills and Nestlé.

Similarly, Nestlé owns 29.6% of French company L’Oréal, the largest cosmetics and perfume company in the world.  The Paris-based group owns household brands such as Lancôme, Garnier, and Maybelline.

That’s how ubiquitous Nestlé is.  Even when you don’t realize it, the odds are something in your shopping cart is enriching the stockholders.

That is the reason I say that if I were 18 years old, Nestlé would not be in my top ideas of how to make a lot of money quickly – that’s not what it does – but I would make a point to pick up shares whenever I could afford them, adding to the collection if the valuation was good. I’d put them aside as if they didn’t exist, refusing to sell them come hell or high water, so I could be showered with dividend checks from Switzerland as I began to approach my 50’s and 60’s. That means anytime they were reasonably under 20x earnings, I’d pick up at least a few more, putting them into a brokerage account the same way some folks collect vintage cars or postage stamps.  Sure, if we were to go through another Great Depression, the shares might fall 50% or more.  I wouldn’t care – they wouldn’t be for sale.  As long as the world needs to eat, drink, and snack, it seems likely that Nestlé will be the company selling the lasagnas, bottled waters, and candy bars, sending those profits back to the owners. 

I believe the reason so many inexperienced investors in the United States are clueless about the company comes down to an over-reliance upon the Internet and a fundamental inability, or rather, unwillingness, to do research.  As of this moment, Nestlé SA shares in Switzerland offer a dividend of 2.05 CHF on a share price of 63.10 CHF. This means the current gross dividend yield is around 3.23%. Many financial sites report the dividend figure adjusted for a 35% withholding tax to the Swiss government, dropping it to approximately 1.33 CHF, making the dividend yield appear as if it were 2.12%.  A handful of financial sites use the special dividend withholding rate the Swiss allow U.S. citizens to enjoy due to a joint tax treaty between our two nations, 15%, resulting in a 1.73 CHF dividend with a yield of 2.74%.  Yahoo Finance doesn’t even show any dividend at all on the ADR shares, which is, of course, absurd.  

Nestle Nescafe Vending MachineThat means depending upon where you look, the dividend yield as of this afternoon appeared to be somewhere between nothing and 3.23%.  Part of this is Nestlé’s own fault – the company is truly global in scope and publishes its annual report in multiple languages; it refuses to add another layer of complexity by directly listing its shares in the United States, which would require it to create another filing using U.S. GAAP rules for the financial statements, which differ in some ways from the International standards.  The result is the ADR trade in the pink sheets and don’t have a lot of available information on them compared to what would be easily accessible if Nestlé decided to do a secondary listing on The New York Stock Exchange.  When your company is worth nearly a quarter of a trillion dollars, though, you get to do whatever you want and investors will find you.  Is it inconvenient?  Yeah, but it makes sense.  If anything, it causes the stock to be a little cheaper than it might otherwise be by reducing demand, so I’m happy with it.

When you are examining the dividend yields of Nestlé SA to be held in a fully taxable, regular brokerage account, the correct yield to use would be 3.23% for your analysis. This will provide as close to an apples-to-apples comparison as you can get when looking at other food firms. To illustrate, General Mills is offering a dividend yield of 3.00% as of yesterday. Most investors are going to have to pay a 15% tax rate on those shares to the U.S. government, so it would put Nestlé at an illogical advantage for you to compare its net-of-tax yield with the pre-tax yield General Mills offers.  Thus, while most U.S.-based financial sites show General Mills with a higher dividend yield, the net dividend yield is actually richer for Nestlé.

To value the firm, you need to look at the annual report and financial disclosures, run the calculations in Swiss Francs, then decide whether it is attractive relative to the current market price.  If it is, you run the U.S. dollar translation to see if the ADR are trading near parity or, better yet, at a discount, purchasing the shares if you find they are.  Right now, it appears fairly valued – you’re getting a 5.32% earnings yield and a 3.23% dividend yield.  It’s not a great bargain, but it is a fair one.  For the 25+ year owner, I think that’s the best you can hope for and the most you have a right to expect.  Sure, it would seem like a missed opportunity if it crashed tomorrow but you can’t live your life that way – you buy value where you can get it and in a fair, stable economy and political system, time does the rest.  (At current earnings, I’d be all over it if it were 51.00 CHF or less.  That’s nowhere near the 1973-1974 pricing or even 2009 pricing that comes during disasters, but it would be a very beautiful thing to sit at home collecting 4% in cash on your money with a firm that has historically increased its intrinsic value per share at a rate as high as Nestlé has; a difficult feat for mature businesses but one that it seems to do with dexterity and consistency.)

Sometimes, because my commission rates are so cheap, if a good business is fairly valued – one of the firms on my “100” list that I think represents an extraordinary enterprise with very large advantages, I’ll randomly pick up $500 or $1,000 of it and then act like I never spent the money.  It’s surprising how fast it piles up, especially when you’ve been doing it for over a decade.  I put in a tiny buy order that will execute on Monday for my personal accounts, throwing a handful of new shares onto my family’s balance sheet.  It’s one of those things I do that, by itself, may not seem significant, but adds up to very nice stores of additional wealth years down the road.  The small things matter.  It also keeps the companies on my radar as a sort of “get paid while you watch” list until the day one of those holdings happens to approach deep value territory and a considerable commitment can be made.

So I may still have far less Nestlé than I did before the KRIP purge (which still holds none and I’d still do again if presented with the same choices and opportunity cost), but I think over the next few months, I’m going to be adding to the permanent holdings a few thousand dollars here, a couple thousand bucks there, to at least see it grow over time.   It won’t be much, but it will at least satisfy this irritation I have at having given up a company that is unique among most publicly traded securities.  I’m only comfortable doing that because the valuation gaps have closed recently – those businesses I was buying back in March are up 20% so, while they are still attractive, they aren’t nearly as discounted as they were, and Nestlé has fallen since I sold the KRIP shares, changing the calculation.

Nestle SA Headquarters

Nestlé SA headquarters in Switzerland.

  • Ahmad

    An Article of Beauty,
    Thanks Joush!

  • Anon

    “5.00% earnings yield (20x earnings)”
    “10.00% earnings yield (10x earnings)”

    :-) Thank you! This will help other readers understand earnings yield.

    • http://www.joshuakennon.com/ Joshua Kennon

      No problem. The earnings yield is 1 divided by the valuation multiple (p/e ratio). It gives you the percentage you’d be earning if you thought of the stocks as a bond that paid out 100% of the profits to owners in the form of dividends.

      I’ve touched on it a little bit in the past here and here.

      The problem, of course, is that it doesn’t help you when the underlying earnings picture is changing. Think about Apple back when Steve Jobs was re-hired or a horse and buggy manufacturer when automobiles were invented; the past profits, and earnings yield, didn’t matter anymore because the future profits were going to be much, much different. It’s not the be-all-end-all, but I would be looking very closely if a business were selling for an earnings yield substantially below the 30-year Treasury. Such a firm would require a decent growth rate to overcome the initial handicap.

      The big thing to realize is that dividends are virtually always (there are a few exceptions that aren’t relevant here) paid out of profits. That means the dividend yield is not in addition to the earnings yield. If a company sold for $100.00 in the market, and it earns $5 per share, and pays $3 in dividends, it would have a 5% earnings yield and a 3% dividend yield. The remaining $2 is being retained by the company for expansion, marketing, acquisitions, share buybacks, or whatever else. It makes a difference how well management hands that retained money – a dollar in Bill Gates or Sam Walton’s hands would be worth far more than a dollar in the hands of your random guy on the street.

      (By the way, this is the reason stocks fall when the Treasury bond increases – informed investors typically want 2x the earnings yield on a stable, slow growth business that they would accept on a Treasury bond because they are taking on volatility risk, bankruptcy risk, economic risk, etc. If interest rates tripled overnight, stock prices would fall so the general relationship between earnings yields and bond yields would remain intact. It deviates wildly in the short-term, but over the decades, after adjusting for inflation, investors are fairly consistent in the range that they will tolerate. Reversion to the mean is a powerful thing.)

      • Rob

        Great follow up post. I’ve been hearing more of earnings yield and keep meaning to sit down and study it more. I had not heard of ‘net retention’ before, but also sounds like something that would be extremely beneficial to dig into. As you mentioned, I am also very interested in the spreadsheets you utilize, always good to compare notes/strategies.

      • Jay Mack

        This site is so incredibly helpful. As a new father, I am wanting to harness the awesome power of time to help my children with lessons I wish someone would have taught me as a child. Your wisdom will go to great use and I’m incredibly grateful for your willingness to share.

      • Anon

        Sorry this message is late. I wanted to thank you for taking the time to explain everything in such detail. I’ve read this twice, and while I haven’t completely “digested” it, I’m going to keep reading it over and over I understand it more and more.

  • Dave Shaver

    Another great article; thanks.

    I’ve been researching trying to understand the advantages and disadvantages of buying Nestlé as an ADR v. directly on the SIX Exchange. It seems that Fidelity Brokerage allows purchase of either — the ADR is easy and you can request Foreign Market trading. Assume that commission cost is not material; I’m more interested in US-based tax reporting of withholding and related items like it differences in paperwork, long term value, DRIP plan, etc.

    To wit: If I am going to hold forever in a TAXED account, which is the better investment?

    Maybe I’m over analyzing the problem. :)

    The key reference does not discuss: http://www.nestle.com/investors/faqs/adrs-faqs

    • http://www.joshuakennon.com/ Joshua Kennon

      I can’t offer any tax advise.

      My thoughts? It would be impossible to determine which would be a better tax strategy because it would depend, in part, on when / if you ever re-translated those Swiss Francs back into U.S. dollars, triggering a currency gain or loss, how long you held the currency before translating it back, and a host of other factors that would be situation-specific (and might very well change in the future if Congress changes the tax laws).

      I would argue the utility of the dividend payment coming in either CHF or USD should receive primacy as a consideration.

      For larger investors who travel, it may not even matter. If you held a large Nestle position, collected dividends in CHF, and then reinvested those in other Swiss stocks, you could always get utility out of the positions in the end by going to Switzerland and spending the money on goods and services there. There might not ever be a need to convert them back into dollars at all.

  • http://www.joshuakennon.com/ Joshua Kennon

    I think those are all fine conclusions, myself. I particularly agree with blocking any non-0% tax rate ADR from retirement funds (you could still buy stuff like Unilever or Royal Dutch Shell Class B, obviously, since there is 0% withholding between the U.S. and U.K, but those are exceptions rather than the rule). My own mother wanted some Nestle in her retirement account but I swapped it for one of the brokerage positions, instead, for exactly the reasons you described. I treat my own family’s accounts the same, as well.

    I think the ADR vs direct listing is entirely one of convenience and personal preference at this point under present conditions. If you want your dividends in U.S. dollars, you plan on spending them in U.S. dollars, and you don’t want to handle the conversion yourself, the ADR are a wonderful tool. Some people like them even when making enormous acquisitions – what was it, back in 2009, one of Berkshire Hathaway’s subsidiaries was acquiring Nestle in large amounts, millions of dollars at a time, and they were buying the ADR. Some massive global mutual funds opt for them, too. It’s a convenience thing.

    Unless, as you point out, there is an arbitrage difference between the foreign and local shares, in which case I’d buy the best value if it were significant. Or, if you plan on investing indefinitely in Swiss-based companies, in which case the CHF piling up would be useful.

    I’m fine with either. Do whatever you want. If it’s cost effective and you prefer the direct Swiss listing, do it. It sounds like you’ve run the numbers and $20,000 is that threshold for you based on your commission schedule. I don’t see anything wrong with that thinking.